BlockFi Settlement With SEC Says Certain Interest-Bearing Crypto Accounts Will Be Considered Securities BlockBlog

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On February 14, 2022, the Securities and Exchange Commission (SEC) announced a first-of-its-kind enforcement action against BlockFi Lending LLC (BlockFi), a crypto lending platform, indicating that it intends to treat these products as securities and aggressively regulate the crypto area. This is in line with SEC Chairman Gary Gensler’s warning in November 2021 that the SEC will examine the economic realities of a financial product, regardless of label or purported mission. The SEC has colluded with BlockFi to: (1) offer and sell its retail crypto lending product in securities without a registration statement; (2) violating investment company law by operating as an unregistered investment company; and (3) materially false and misleading statement on its website. As a result of this enforcement action, BlockFi agreed to pay a $50 million fine to the SEC. Separately, BlockFi agreed to pay $50 million in fines to settle with 32 states that had made similar charges.

BlockFi Interest Accounts

The SEC charges centered on BlockFi’s financial product known as BlockFi Interest Accounts (BIAs). BlockFi sold BIAs as a product where investors could lend their crypto assets to BlockFi in exchange for BlockFi’s promise to provide a monthly interest payment in cryptocurrency. BlockFi said it uses these borrowed crypto assets to lend these assets to institutional investors or invest in “SEC-regulated stocks and primarily CFTC-regulated futures.”1 which would generate revenue for both BlockFi and BIA investors. According to the SEC order, BlockFi “pooled the loaned assets and exercised complete discretion over the amount to be held, loaned and invested.[,] had full legal ownership and control of the loaned crypto assets [and] regularly touted the benefits investors can realize by investing in an SDAC. »2

Crypto loan under Howey and dreams

The SEC has concluded that the BIAs are securities subject to registration under both the dreams test and the Howey test. Under Section 2(a)(1) of the Securities Act3 and section 3(a)(10) of the Foreign Exchange Act,4 any “note” or “investment contract” is considered a security, which must be registered with the SEC under Section 5 of the Securities Act.5

The Supreme Court of the United States has provided the fundamental test for interpreting which products are subject to registration as “securities” in SEC vs. Howey. More specifically, in
Howeythe Court considered whether an offer of units of a citrus grove coupled with a contract to service the grove was an “investment contract” within the meaning of section 2(a)(1) of the securities.6 the Howey test involves an analysis of the four characteristics of an “investment contract”: (1) the investment of money; (2) in a joint venture; (3) with an expectation of profits; (4) arising solely from the efforts of others.7

In Reves v. Ernst & Youngthe United States Supreme Court rejected the Howey grades analysis test. Instead, it applied a two-step analysis to determine whether a financial product is a “security” subject to registration.8 First, the Court considered a list of judicially created categories that are exempt from registration.9 Second, after concluding that a rebuttable presumption had not been established at the first stage, the Court considered four factors to determine whether the product bore a strong “family resemblance” to the established list. In the second step, the Court considered (1) the motivation for entering into the transaction; (2) the distribution plan; (3) the reasonable expectations of the investing public; and (4) whether there are risk reduction factors that would make enforcement of securities laws unnecessary.ten

The SEC argued that BlockFi offered BIAs as “investment contracts” and “notes.” The SEC noted that BlockFi sells BIAs in exchange for investing in crypto assets and uses those assets to generate returns for investors and BlockFi.11Through its BIA advertisements, BlockFi has given investors a reasonable expectation of profit from their accounts.12Therefore, according to the SEC, the BIAs have satisfied all four prongs of the Howey test.

The SEC further found BlockFi’s BIAs to be “ratings” according to the four-part analysis set forth in
dreams.13 BIAs were created to generate revenue for BlockFi, through its lending and investing activities, and they were offered to a large segment of the public. As mentioned earlier, BlockFi has created a reasonable expectation of profit for investors by earning profits from BlockFi’s management of loaned crypto assets. There were no other laws or regulations that would reduce the risk posed by ZACs. Accordingly, the BIAs were notes and therefore securities subject to SEC regulation.

Go forward

The settlement with BlockFi is notable as the first action of its kind against a crypto lending platform. In September 2021, when Coinbase was forced to cancel its similar lending program after receiving a Wells notice, the company complained that the SEC was unclear in its assessment of crypto lending against the
Howey and dreams trials.14 The SEC has now responded.

The settlement portends the SEC’s desire to control an area described by Chairman Gensler as the “Wild West.”15 It is now increasingly likely that the SEC will readily consider crypto financial products as “securities” subject to its regulatory framework. Gensler remarked that “[t]Today’s regulations make it clear that crypto markets must comply with proven securities laws [and
that crypto lending platforms] should immediately take notice of today’s resolution and comply with federal securities laws.”16 Companies that offer crypto-related financial products should be aware of the message that this regulation implies.

BlockFi, for its part, announced its intention to file or submit an S-1 registration with the SEC for its new product, BlockFi Yield, which would be the first interest-bearing crypto security registered with the SEC.17 It is unclear whether BlockFi will achieve this ambition. As Commissioner Hester Peirce noted in her dissent, even if BlockFi completes its S-1 process, it still must register as an investment firm under Section 3(a)(2) of the law on investment companies.18 However, BlockFi cannot register as an investment company as long as it issues debt securities, unless it qualifies for an exemption.19 It remains to be seen how BlockFi and other crypto platforms will navigate this regulatory landscape.

Winston & Strawn Partner Jeremy Chu contributed to this blog post.

Footnotes

1. BlockFi Lending LLC, Order Instituing Cease-and-Desist Proceedings, Securities Act Release No. 11029 (February 14, 2022).

2.
ID. ¶¶ 9, 15.

3. 15 US Code § 77b.

4. 15 US Code § 78c.

5. 15 US Code § 77e.

6. 328 US 293 (1946).

7.
ID. at 301.

8. 494 US 56, 64-66 (1990).

9.
ID. at 64-65 years old.

ten.
ID. at 66-70.

11.BlockFi Lending LLC, above footnote 1, ¶ 31.

12.
View ID.

13.
ID. ¶ 30.

14. Paul Grewal, The SEC told us they wanted to sue us for loans. We don’t know whyThe Coinbase Blog (September 7, 2021), https://blog.coinbase.com/the-sec-has-told-us-it-wants-to-sue-us-over-lend-we-have-no-idea -why-a3a1b6507009.

15. Gary Gensler, Remarks before the Aspen Security ForumUS Securities and Exchange Commission (August 3, 2021), https://www.sec.gov/news/public-statement/gensler-aspen-security-forum-2021-08-03.

16. United States Securities and Exchange Commission, press release, BlockFi agrees to pay $100 million (February 14, 2022), https://www.sec.gov/news/press-release/2022-26.

17.
BlockFi enters historic resolution with federal and state regulatorsBlockFi (February 14, 2022), https://blockfi.com/regulatory-developments/.

18. Hester M. Peirce, Statement on Settlement with BlockFi Lending LLCUS Securities and Exchange Commission (February 14, 2022), https://www.sec.gov/news/statement/peirce-blockfi-20220214#_ftnref5.

19.
To see 15 United States Code § 80a-18.

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