(Adds comment from Terraform Labs and SEC declined to comment)

By Jody Godoy

NEW YORK, July 31 (Reuters) - Terraform Labs and its founder, Do Kwon, must face fraud allegations brought by the U.S. Securities and Exchange Commission, a federal judge ruled on Monday.

Kwon and Terraform Labs were behind two cryptocurrencies whose implosion roiled crypto markets around the world last year. U.S. District Judge Jed Rakoff in Manhattan denied their motion to dismiss allegations that they defrauded investors and sold billions of dollars in digital assets that were unregistered securities.

A spokesperson for Terraform Labs said the company "will continue to fight the SEC's misguided and deeply flawed allegations and legal theories."

A spokesperson for the SEC declined to comment.

TerraUSD, an algorithmic stablecoin supposed to maintain a 1:1 peg to the U.S. dollar, derived its value through another paired token called Luna. Both tokens lost nearly all their value when TerraUSD, also known as UST, slipped below its 1:1 dollar peg in May 2022. Prior to its collapse, TerraUSD had a market cap of more than $18.5 billion and was the 10th largest cryptocurrency.

According to the SEC's complaint, Terraform Labs and Kwon misled investors about the stability of UST, and claimed that the firm's crypto tokens would increase in value. The regulator can move forward with the allegations, Rakoff wrote in his ruling.

Rakoff also disagreed with the approach another judge took in the recent Ripple Labs case. In that decision, U.S. District Judge Analisa Torres ruled that Ripple's XRP sales on public cryptocurrency exchanges were not offers of securities, in part because purchasers did not know if their funds went to Ripple or a third party.

SEC attorneys in the Terraform Labs case have said that part of the ruling by Torres was wrongly decided and that SEC staff are exploring ways to have it reviewed.

Rakoff on Monday wrote that the identity of the seller "has no impact" on whether a reasonable investor would interpret statements by Kwon and his company as a "promise of profits based on their efforts."

The case is SEC v. Terraform Labs Pte Ltd. et al., No. 23-01346, U.S. District Court, Southern District of New York (Reporting by Jody Godoy in New York; Editing by Will Dunham, Grant McCool and Leslie Adler)