Securities Enforcement and Regulatory Update

SEC Targets Digital Asset Lending in Enforcement Action and Investor Bulletin

February 18, 2022

On February 14, 2022, the U.S. Securities and Exchange Commission (SEC) announced an enforcement settlement (the Order) related to BlockFi Lending LLC (BlockFi), a digital asset borrowing and lending platform.¹ The SEC found that BlockFi offered unregistered securities to U.S. investors, made material misrepresentations about its lending activities, and operated as an unregistered investment company. SEC Commissioner Hester Peirce published a dissent.² On the same day, the SEC released an Investor Bulletin highlighting the key differences between a digital asset lending program and a traditional bank deposit account.³

Without admitting or denying the SEC’s findings, BlockFi entered into a joint settlement with the SEC and the North American Securities Administrators Association (NASAA) in which it agreed to pay $100 million in fines and penalties, cease offering its unregistered lending services to new U.S. investors, and attempt to bring its business within the provisions of the Securities Act of 1933 (Securities Act) and the Investment Company Act of 1940 (Company Act) within 60 days.⁴

This enforcement action demonstrates the SEC’s continued focus on the digital asset ecosystem. In light of this settlement, market participants involved with digital asset borrowing and lending activities should carefully consider how securities laws may apply, even in cases where the digital assets themselves may not be securities.

Background

BlockFi is a Delaware limited liability company formed in 2018 and a wholly owned subsidiary of BlockFi Inc., with its principal place of business in Jersey City, New Jersey. BlockFi’s business involves providing users digital asset services such as providing loans against digital assets and allowing users to lend digital assets for a return.

On March 4, 2019, BlockFi began offering customers BlockFi interest accounts (BIAs). In a BIA, investors can deposit a variety of digital assets, including BTC, ETH, and USDC, to BlockFi in exchange for BlockFi’s promise to provide a variable monthly interest payment. Investors may withdraw deposited amounts at any time. BlockFi pooled customers’ BIA assets and paid interest to 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.

Three Types of Violations

In connection with BlockFi’s BIA product, the SEC found three separate violations of U.S. securities laws.

1. Sale of Unregistered Securities

Under the Securities Act, every offer and sale of a security must either be registered with the SEC or subject to an exemption from registration. The SEC found that BlockFi’s BIA product violated Sections 5(a) and 5(c) of the Securities Act for the sale of unregistered securities and the failure to file a registration statement for securities. In the Order, the SEC provided two separate arguments for why BIAs may be considered securities.

The BIAs were securities under the Reves test. The SEC found that BIAs are notes that are securities under the test established by the U.S. Supreme Court in Reves v. Ernst & Young.⁵ The SEC applied the four-part Reves “family resemblance” analysis and concluded the BIAs are securities.⁶ The SEC reasoned:

Use of invested funds: BlockFi offered and sold BIAs to obtain digital assets for general use in running its lending and investment activities. Purchasers bought BIAs to receive interest ranging from 0.1% to 9.5% on the loaned digital assets.

Distribution of offering: BlockFi offered and sold BIAs to a broad segment of the general public.

Promotion efforts: BlockFi promoted BIAs as an investment, specifically as a way to earn a consistent return on digital assets and for investors to “build their wealth.”

Alternative schemes of regulation: No alternative regulatory scheme or other risk-reducing factors exist with respect to BIAs.

The SEC considered each of these factors as weighing in favor of the BIAs’ being notes, which qualify as securities under the Reves test.

The BIAs were investment contracts under the Howey test. The SEC found the BIAs had the characteristic elements of investment contracts under the test established by the U.S. Supreme Court in SEC v. W.J. Howey Co. and therefore were securities.⁷ The SEC reasoned:

Investment of money: BlockFi users invested money by depositing their digital assets into the BIAs.

Expectation of future profits: Investors had a reasonable expectation of future profits by investing in BIAs based on BlockFi’s statements about how it would generate the yield to pay BIA investors interest. For example, BlockFi marketed “an industry-leading 6.2% [annual percentage yield]” and described the BIAs as “an easy way for crypto investors to earn bitcoin as they HODL.”

Investment into a common enterprise: BIA users invested their funds alongside other BIA users’, which were pooled for BlockFi’s lending and investing activities. BlockFi also earned revenue for itself through its deployment of the loaned assets. Therefore each investor was in a common enterprise horizontally with other investors and vertically with BlockFi itself.

Profits based on the efforts of a third party: BlockFi had complete legal ownership and control over the digital assets deposited in BIAs and determined how and how much to hold, lend, and invest.

The SEC said that because the BIAs offered by BlockFi were securities under the Securities Act, each transaction must be registered or qualify for an exemption. BlockFi did not file a registration statement with the SEC for the BIAs, nor did it qualify for an exemption from registration under the Securities Act for those offers and sales. As a result, BlockFi violated Section 5(a) of the Securities Act by selling unregistered securities to customers and violated Section 5(c) of the Securities Act by failing to file a registration statement for securities issued by BlockFi.

2. Materially False and Misleading Statements

Sections 17(a)(2) and 17(a)(3) of the Securities Act prohibit any person offering securities from obtaining money or property using untrue statements or omissions of material fact and from engaging in any business that operates as a fraud or deceit upon the purchaser.

Based on the Order, the BlockFi company website stated that institutional loans were “typically” overcollateralized when only 17% to 24% of institutional loans were overcollateralized. The SEC noted that investors relied on this information when choosing to invest in the platform. As such, BlockFi violated Sections 17(a)(2) and 17(a)(3) of the Securities Act by making a materially false and misleading statement concerning its collateral practices and, which related to the risks associated with its lending activity.

3. Unregistered Investment Company

Section 3(a)(1)(C) of the Company Act defines an investment company to include any issuer that “is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of each issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.” An investment company meeting this definition must register with the SEC as an investment company and is subject to related regulatory requirements.

The SEC found that BlockFi was an investment company under the terms of the Company Act because it was an issuer of securities and at least 40% of its assets consisted of securities, specifically the loans it made to counterparties.⁸

Issuer of securities: The SEC found BlockFi to be an issuer of securities using the analysis under Reves and Howey that the BIAs were securities issued by BlockFi to its customers.

Engaged in securities activities: The SEC found that BlockFi was engaged in securities investing because BlockFi invested in and owned investment securities having a value of over $4 billion relative to BlockFi’s $4.8 billion in assets. This ratio exceeded the statutory 40% threshold established by Section 3(a)(1) of the Company Act. For the purposes of this calculation, the SEC considered loans of digital assets and U.S. dollars to counterparties, investments in digital asset trusts and funds, and intercompany receivables as securities.

The SEC said that BlockFi engaged in interstate commerce through its institutional and retail product offerings across the U.S. and did not register with the SEC or meet any of the statutory exemptions. Therefore, the SEC found that BlockFi violated Section 7(a) of the Company Act by engaging in interstate commerce while failing to register as an investment company with the SEC.

BlockFi argued that it was exempt from registration under the exemption for market intermediaries under Section 3(c)(2) of the Company Act, which provides that market intermediaries that provide contemporaneous trades on both sides of a market, a practice commonly known as market making, can be exempt from the definition of an “investment company.”

The SEC, however, focused on facts that suggested BlockFi was not on both sides of the market and that the relevant financial contracts were not individually negotiated and/or were not entered into in response to a counterparty’s request for a quotation or otherwise structured to accommodate a counterparty’s objectives. The SEC therefore concluded that BlockFi did not primarily act as a market intermediary for purposes of the Company Act.

Subsequent Events and Remedial Efforts for BlockFi

As stipulated in the Order, BlockFi publicly announced changes to its product offerings to bring its activities into compliance with securities regulation.

BlockFi users in the U.S. will retain their BIAs and continue to receive interest but will no longer be able to deposit funds to their BIAs. Non-U.S. users of BlockFi BIAs will be unaffected. Ultimately, BlockFi intends to offer a similar experience through a new registered product called BlockFi Yield. BlockFi plans to register this new product under the Securities Act along with an indenture and T-1 filing under the Trust Indenture Act. As part of the Order, however, BlockFi must demonstrate to the SEC that it is in compliance with the Company Act.

BlockFi also has undertaken to comply with the Company Act within 60 days by either (1) filing a notification of registration as an investment company or (2) taking steps to no longer qualify as an investment company. As a condition of the settlement, BlockFi must be in compliance with the Company Act before a Form S-1 for BlockFi Yield (or other similar products) can be declared effective.

Other Points of Interest

SEC Commissioner Peirce Dissent

SEC Commissioner Hester Peirce dissented from the Order. Commissioner Peirce argued that requiring Form S-1 registrations for this type of product will be a large burden for digital asset companies and will ultimately hurt U.S. competitiveness and consumers in the digital asset ecosystem. Commissioner Peirce also questioned the feasibility of restructuring BlockFi’s activities to come into compliance with the Company Act, especially within the 60-day window provided in the Order. Instead, Commissioner Peirce suggested that the SEC should use its Section 6(c) exemption authority under the Company Act to craft a bespoke set of conditions that would address the investor protection concerns that the Company Act was designed to address. The exemption option, she said, would be timely and achievable for BlockFi.

SEC Enforcement Division Director Statement

On the day of the Order, Gurbir Grewal, director of the SEC’s enforcement division, stated that other digital asset lending platforms should “take immediate notice of today’s resolution and come into compliance with the federal securities laws.”

SEC Investor Bulletin on Crypto Asset Interest-bearing Accounts

In conjunction with the Order, the SEC published an Investor Bulletin (Bulletin) regarding “Crypto Asset Interest-bearing Accounts.” The Bulletin highlights that digital asset deposit accounts are distinct from traditional bank accounts and are not subject to federal and state banking regulation. It also explained that digital asset deposits are not insured like typical bank or credit union deposits. Last, the Bulletin highlighted that interest-bearing digital asset deposit accounts may be used by the service provider for investment or lending activities that could subject deposited funds to additional risk.

Conclusion

The Order is consistent with the SEC’s public statements regarding the need for digital asset service providers to consider how U.S. securities laws apply to their particular products and services. It also provides insight, with respect to digital asset lending products, as to what the SEC considers securities under both the Securities Act and the Company Act. Digital asset market participants should consult with their legal advisers to comprehensively analyze how securities laws might affect their operations in light of this Order and Bulletin.

¹SEC, Settlement Order regarding BlockFi Lending LLC (Feb. 14, 2022), available at https://www.sec.gov/litigation/admin/2022/33-11029.pdf.
²Hester Peirce, SEC Commissioner, Statement on Settlement with BlockFi Lending LLC (Feb. 14, 2022), available at https://www.sec.gov/news/statement/peirce-blockfi-20220214.
³SEC Office of Investor Education and Advocacy, Investor Bulletin: Crypto Asset Interest-bearing Accounts, (Feb. 14, 2022) available at https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins-97.
⁴15 U.S.C. § 77; 15 U.S.C. § 80a.
⁵494 U.S. 56, 64–66 (1990).
⁶Id.
⁷328 U.S. 293, 301 (1946).

⁸Section 3(a)(1)(A) also defines an investment company to mean an issuer that “is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities.” The SEC did not address whether BlockFi was an investment company by reason of Section 3(a)(1)(A).

弁護士広告—Sidley Austin LLP はグローバルな法律事務所です。当事務所の所在地および連絡先情報は、www.sidley.com/en/locations/offices に掲載されています。

Sidley は、本情報をクライアントおよび関係者の皆様へのサービスとして、教育目的のみに提供しています。本情報は、法的助言として解釈または依拠されるべきものではなく、また弁護士と依頼者の関係を生じさせるものでもありません。読者は、専門家の助言を求めることなく本情報に基づいて行動すべきではありません。Sidley および Sidley Austin とは、www.sidley.com/disclaimer に記載のとおり、Sidley Austin LLP およびその関連パートナーシップを指します。

© Sidley Austin LLP