SEC Enforcement Action Against BlockFi Lending LLC Provides Clarity Regarding Digital Asset Lending but Leaves Questions Unanswered
March 29, 2022
The Securities and Exchange Commission issued an order on February 14, 2022 (Order) settling charges against BlockFi Lending LLC (BlockFi) relating to alleged violations of the Securities Act of 1933 and the Investment Company Act of 1940.1 The BlockFi Order represents the SEC’s first enforcement action against a crypto lending platform.
As discussed in more detail below, BlockFi was charged with failing to register its retail crypto lending product, BlockFi Interest Accounts (BIAs), as securities and with operating as an unregistered “investment company” in a manner inconsistent with the 1940 Act.2 The SEC also charged BlockFi with making materially false and misleading statements concerning the risks associated with BIAs. In its settlement, BlockFi agreed: to pay a $50 million penalty; cease the offers and sales of the BIAs; and attempt to comply with the 1940 Act within 60 days. BlockFi also agreed with the North American Securities Administrators Association to pay an additional $50 million in fines to 32 states to settle similar charges.
The Order is another reminder of the SEC’s continued focus on the digital asset industry. In light of this settlement, market participants involved with digital asset borrowing and lending may want to consider carefully that securities laws can apply, even if the underlying digital assets themselves may not be securities.
Background
BlockFi, a financial services company that provides digital asset borrowing and lending services to users, is a wholly owned subsidiary of BlockFi Inc. BlockFi has financed this lending activity in part through BIAs, in which investors lent crypto assets to BlockFi in exchange for BlockFi’s promise to provide a variable monthly interest payment; investors could withdraw deposited amounts at any time. According to the SEC, BlockFi has been offering and selling BIAs to the public since March 4, 2019. The SEC stated in the Order that BlockFi pooled customers’ BIA assets and paid interest to BIA customers from income generated by: lending the digital assets to institutional and corporate borrowers; lending U.S. dollars to retail investors; and investing in equities and futures.
Securities Classification Analysis
In the Order, the SEC took the position that the BIAs were securities because: (i) they were notes under the test established in Reves v. Ernst & Young, 494 U.S. 56, 64-66 (1990) (Reves Test); and (ii) they were investment contracts under the test established in SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946) (Howey Test).3 Setting forth two different legal theories on which to base its claim that BIAs are securities could indicate that the SEC is trying to establish a broad basis and precedents for claims in the future that other crypto lending services involve securities.
The Reves Test
In Reves, the Supreme Court stated that a note is presumably a security unless it (i) falls into certain enumerated categories of exemptions or (ii) bears a “family resemblance” to the notes that are within these enumerated categories. In determining whether a note is a security under the Reves Test, the following characteristics of the note in question are considered: (i) the motivations of a reasonable seller and buyer; (ii) the plan of distribution of the instrument; (iii) the reasonable expectation of the investing public; and (iv) the presence of alternative regulatory schemes that significantly reduce the risk. In applying the Reves test in the Order, the SEC noted that:
(i) the motivations of a reasonable seller and buyer: BlockFi offered and sold BIAs to obtain digital assets for the general use of its business (i.e., to run its lending and investment activities to pay interest to BIA investors), and purchasers bought BIAs to receive interest ranging from 0.1% to 9.5% on the lent digital assets.
(ii) the plan of distribution of the instrument: BIAs were offered and sold to a broad segment of the general public.
(iii) the reasonable expectation of the investing public: BlockFi promoted BIAs as an investment that would provide purchasers with a way to earn a consistent return on digital assets and to “build their wealth.”
(iv) the presence of alternative regulatory schemes that significantly reduce the risk: No alternative regulatory scheme or other risk reducing factors existed with respect to BIAs.
In light of its analysis of the Reves Test characteristics, the SEC concluded that the BIAs were notes that constitute securities under the federal securities laws.
The Howey Test
In Howey and its many progeny, the courts have stated that an “investment contract” exists when there is (i) the investment of money (ii) in a common enterprise (iii) with a reasonable expectation of profits to be derived primarily from the efforts of others. Because the SEC believes the first two prongs are typically satisfied, the main issue under Howey generally rests on whether a purchaser has a reasonable expectation of profits to be derived primarily from the efforts of others. Pointing out that this inquiry into reasonable expectations is based on objective considerations, the SEC focused on the way that BIAs are offered and sold. The SEC identified the following characteristics as especially relevant in its view: (i) reliance on the effort of others; (ii) a reasonable expectation of profits; and (iii) other relevant considerations (e.g., whether the instrument is offered and sold for use or consumption by purchasers).
In applying the Howey test in the Order, the SEC based its findings on the following characteristics:
(i) the investment of money: BlockFi sold BIAs in exchange for the investment of money in the form of digital assets.
(ii) in a common enterprise: BlockFi pooled the BIA investors’ digital assets and used those assets for lending and investment activity that would generate returns for both BlockFi and BIA investors. The returns earned by each BIA investor were a function of the pooling of the lent digital assets. In the ways in which BlockFi deployed those lent assets, each investor’s fortune was tied to the fortunes of the other investors. In addition, because BlockFi earned revenue for itself through its deployment of the lent assets, the BIA investors’ fortunes also were linked to BlockFi. Therefore, according to the SEC, each investor was in a common enterprise both horizontally with other investors and vertically with BlockFi itself.
(iii) with a reasonable expectation of profits to be derived primarily from the efforts of others: Through its public statements, BlockFi created a reasonable expectation that BIA investors would earn profits derived from BlockFi’s efforts to manage the lent digital assets profitably enough to pay the stated interest rates to the investors. BlockFi had complete ownership and control over the borrowed digital assets, and it determined how much to hold, lend and invest. BlockFi’s lending activities were at its own discretion, and BlockFi advertised that it managed the risks involved. Similarly, its investment activities were undertaken at its own discretion.
Investment Company Status Analysis
Based in part on the finding that the BIAs are securities, the SEC further found that, as the issuer of the BIAs, BlockFi operated as an unregistered investment company.4 Under the 1940 Act, an issuer is an “investment company,” and therefore required to register with the SEC, if it is engaged, or proposes to engage, in the business of investing, reinvesting, owning, holding or trading in securities that have a value exceeding 40% of the issuer’s total assets on an unconsolidated basis.5 The SEC historically has taken the position that the definition of “securities” for purposes of the 1940 Act is not necessarily equivalent to the definition of that term under the Securities Act or the Securities Exchange Act of 1934, and should be construed more broadly under the 1940 Act in light of the statute’s remedial purpose.6 As a result, the SEC and its staff have taken the position that certain notes or loans that have been determined by courts not to constitute securities under other federal securities laws could be securities for purposes of the 1940 Act.7
In this action, the SEC found that, after launching the BIAs, BlockFi pooled its borrowed crypto assets with its other assets and used the commingled funds to make loans to institutional and retail borrowers. The SEC found that these loans, along with investments in crypto asset trusts and funds and intercompany receivables, were “investment securities” under Section 3(a)(2) of the 1940 Act, constituting more than 40% of BlockFi’s assets.8 As a result, the Order states that BlockFi was an “investment company” that had not registered under, and otherwise was operating in a manner inconsistent with, the 1940 Act.9
Materially False and Misleading Statements
Further, the SEC charged that BlockFi made materially false and misleading statements in the offer and sale of securities under Sections 17(a)(2) and 17(a)(3) of the Securities Act. According to the SEC, BlockFi made several posts on its website regarding the level of risk in its loan portfolio, stating that the institutional loans BlockFi made “typically” were overcollateralized, when actually about 17% of its crypto loans were overcollateralized for the period in question. Therefore, the SEC charged that BlockFi did not provide complete and accurate information regarding the risks to investors in the offer and sale of BIAs.
Looking Forward: Compliance with the Securities Act, State Regulatory Regimes and the 1940 Act
To comply with the Securities Act, BlockFi has stated that it will seek to register a new product that will be similar to the BIAs, called BlockFi Yield, by filing an S-1 registration statement and an indenture and Form T-1 under the Trust Indenture Act of 1939.10 A Form T-1 is filed by the issuer of debt securities and provides information about its trustee (typically, a bank or trust company).
BlockFi also has committed to pursuing state registration. For example, as part of its settlement with New Jersey, BlockFi agreed that before it would offer or sell securities, it would: apply to be a broker-dealer or agent in that state; engage a registered broker-dealer; or establish that it is exempt.11
As part of its settlement with the SEC, BlockFi has undertaken that, within 60 days of the Order, it will come into compliance with the 1940 Act by either: filing a notification of registration under Section 8(a) of the 1940 Act and then, within 90 days, filing an appropriate registration statement; or completing steps so that BlockFi is no longer required to register under the 1940 Act.
While those other than BlockFi are not in a position to analyze or comment on its plans to comply with the 1940 Act, coming into compliance with the 1940 Act can be a complex and time-consuming process, particularly for companies not intending to operate as a registered investment company. The 1940 Act was passed in order “to mitigate and, so far as is feasible, to eliminate the conditions … which adversely affect the national public interest and the interest of investors.”12 Therefore, Congress created, and the SEC promulgates rules under, a broad fiduciary regulatory regime that encompasses not just disclosures but also prohibitions and restrictions on certain conduct that risks harming investors. The core provisions of the 1940 Act include (among many other requirements and limitations): broad and inflexible limitations on transactions with affiliates and on capital structure; strict rules requiring mark-to-market valuation and mandating outside audits; limitations on investment concentration; rules incentivizing third-party custody of company assets; rules on redemptions and repurchases of investor interests in the company; and limits on investments in other securities-related businesses. The lynchpin of the 1940 Act’s regulatory regime is oversight of company operations by a board of directors, the majority of whom must be functionally independent. The board has the power to terminate any investment advisory agreement with the company’s manager at any time, with only 60 days’ notice, and any agreement (after an initial two-year term) must be renewed annually both by the board and by a majority of the independent directors.
A central characteristic of the 1940 Act is that most of its core provisions are deliberately overbroad. Congress designed them to capture not just abusive conduct but also unproblematic practices, to ensure that there would be no loopholes. To provide flexibility to this structure, and to allow the law to evolve over time to reflect financial innovations and changing business practices, Congress gave the SEC broad authority to grant exemptions to certain companies and for entire categories of conduct and practices. However, the SEC and its staff have largely exercised this exemptive authority in narrow and tailored ways. This result is partly because the SEC staff is conservative in protecting its jurisdiction and authority, and is careful to avoid the inadvertent creation of loopholes. However, more systematically and importantly, the SEC has used its exemptive and rulemaking authority to create a regulatory regime that is primarily designed for a narrow, specific group of investment vehicles designed for retail investors – namely, mutual funds, exchange-traded funds, closed-end funds and similar investment vehicles. Financial companies that do not fit within this narrow business model can find the regulatory regime difficult to reconcile with their own businesses without significant expenses and restrictions.
Moreover, the applicable 1940 Act rules often vary widely based on the structure elected at the investment company’s formation. From the outset, structuring a registered investment company requires meticulous planning and understanding of a vast regulatory landscape. Nonetheless, with careful planning and deep understanding of the related costs and limitations, operating as a registered investment company is certainly feasible.
Additional SEC Statements
SEC officials contemporaneously commented on the Order, providing insight into its potential implications. Indicative of the potentially wide-reaching effects of the Order, following its issuance, Gurbir S. Grewal, the Director of the SEC’s Division of Enforcement, stated that “crypto lending platforms offering securities like BlockFi’s BIAs should take immediate notice of today’s resolution and come into compliance with the federal securities laws.”13 Further, on the same day the Order was issued, the SEC’s Office of Investor Education and Advocacy and the Division of Enforcement’s Retail Strategy Task Force jointly issued a bulletin meant to “educate investors about risks with accounts that pay interest on crypto asset deposits.”14 The bulletin directly links investors to the Order. Taken together, these further statements may indicate that the SEC intends to take action against other crypto lenders that do not comply with the Securities Act and the 1940 Act, where these would apply under the SEC’s analysis. However, SEC Commissioner Hester Peirce dissented from the action against BlockFi.15 In doing so, she questioned whether the securities law framework is the best way to provide transparency to crypto users, given the length and complexity of the process of getting a registration statement to effectiveness. She similarly questioned the purpose of applying the 1940 Act to crypto lending products, and noted that many exemptions would be required to “craft a bespoke set of conditions that make sense in this context.”
Conclusion
The SEC’s Order is novel, and potentially has wide-reaching implications for cryptocurrency and other digital asset lending platforms. Together, the categorization of the BIAs and of the underlying loans of digital assets as securities, as well as treating pools of such loans potentially as investment companies under the 1940 Act, has the potential to bring a wide range of entities under the regulatory framework governed by the 1940 Act. Other firms in the industry offering products similar to the BIA may want to study the Order carefully to determine whether they should make their operations compliant.
While the Order brings a limited measure of clarity to the industry, it also leaves a number of questions unanswered. In particular, the Order does not provide a roadmap or guidance for crypto lending firms to come into compliance with the 1940 Act. It does not indicate the degree of flexibility that the SEC and the staff will afford crypto lenders if they seek exemptive relief to fit the regulatory regime to the needs of their customers and businesses. And it does not signal the SEC’s core policy objectives in applying the 1940 Act to a set of industries that it was not originally designed to regulate. Thus, we are at the early stages of the regulatory path that the SEC has laid out for the industry – a path without a clear direction or endpoint.
Footnotes
2) BlockFi Agrees to Pay $100 Million in Penalties and Pursue Registration of its Crypto Lending Product (Feb. 14, 2022).
3) This case is not the first time that the SEC has alleged in an enforcement action against a digital asset company that a product is a security under both the Reves Test and the Howey Test. See Blockchain Credit Partners, AP File No. 3-20453 (Aug. 6, 2021).
4) See 15 U.S.C. 80a-7(a), requiring registration of investment companies under the 1940 Act.
5) 15 U.S.C. 80a-3(a)(1)(C). Section 3(a)(2) defines “investment securities” to include “all securities except: (A) Government securities; (B) securities issued by employees’ securities companies; and (C) securities issued by majority-owned subsidiaries of the owner, which (i) are not investment companies and (ii) [are not private funds].”
6) “While the language in the Investment Company Act’s definition of the term ‘security’ is identical to that in the Securities Act, the regulatory context under the Investment Company Act differs fundamentally from that under the Securities Act and the Securities Exchange Act.” Marine
Bank v. Weaver, Brief amicus curiae of the United States, No.80-1562, Supreme Ct. of the US (Oct. 1980).
7) See, e.g., Div. Inv. Mgmt., U.S. Sec. & Exch. Comm’n, Protecting Investors: A Half Century of Investment Company Regulation 67 n.251 (May 1992); Treatment of Asset-Backed Issuers Under the Investment Company Act, 76 Fed. Reg. 55308 (Sept. 7, 2011).
8) According to the Order, BlockFi’s loans, investments in digital asset trusts and funds, and intercompany receivables totaled over $1.9 billion, $1.5 billion, and $847 million, respectively, accounting for over 40% of BlockFi’s $4.8 billion in total assets on an unconsolidated basis.
9) BlockFi asserted that, to the extent it might have been an investment company under Section 3(a)(1), it could rely on an exception from the definition of “investment company” under Section 3(c)(2) of the 1940 Act for brokers and market intermediaries, which provides relief for (among others) companies acting on both sides of a transaction in what is commonly known as “market making.” However, the Order recites facts intended to suggest that BlockFi was not just performing market making functions, and apparently based on those facts, the SEC rejected BlockFi’s argument.
11) See In the Matter of BlockFi Lending, LLC, Consent Order, State of New Jersey Bureau of Securities.
12) 1940 Act Section 1(b)(8).
13) BlockFi Agrees to Pay $100 Million in Penalties and Pursue Registration of its Crypto Lending Product, U.S. Securities and Exchange Commission Press Release (Feb. 14, 2022).
14) Investor Bulletin: Crypto Asset Interest-bearing Accounts (Feb. 14, 2022).
15) Statement on Settlement with BlockFi Lending LLC, Commissioner Hester M. Pierce (Feb. 14, 2022).
*The authors would like to thank Cindy Wu for her contributions to the OnPoint.
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