Earlier this year, on February 14, 2022, the SEC issued BlockFi Lending LLC (“BlockFi”), a crypto lending platform, a cease and desist order (the “Order”). See BlockFi Lending LLC. The Order prohibits BlockFi from engaging in the sale of certain products, considered securities in the Order, until its business operations are brought into compliance. Additionally, BlockFi agreed to pay massive penalties. The SEC press release on the Order is available here: BlockFi press release. This note discusses five key takeaways from the BlockFi case that crypto industry participants should keep in mind when evaluating business ventures, but first some background.
Background of the facts
BlockFi is a wholly owned subsidiary of BlockFi, Inc., and is based in New Jersey. From 2019 to the date of the Order, BlockFi sold BlockFi Interest Accounts (“BIA”) to investors. Through BIAs, investors would lend crypto assets to BlockFi in exchange for promised variable monthly interest payments. BlockFi has earned revenue to make interest payments by lending crypto assets to institutional and commercial borrowers, lending US dollars to retail investors, and investing in stocks and futures. In 2021, BlockFi and its affiliates held over $10 billion in BIA investor assets, invested by nearly 600,000 BIA investors. Nearly two-thirds of these investors came from the United States.
1. In determining whether an arrangement, product or contract is a security, the SEC takes a functional approach.
There is an old saying that “there is more than one way to skin a cat”. There is also more than one way for the SEC to determine that something is a security. In the order, the SEC found that the BIAs were notes in addition to being investment contracts.
BIAs may not look exactly like a note in the traditional sense. BlockFi did not refer to them as notes. Nevertheless, the SEC found that “these were notes under Reves v. Ernst & Young494 US 56, 64–66 (1990), and its progeny”, on the basis that (1) BIAs were generally used to finance (with crypto assets) its lending and investment activities and that buyers bought them to make a profit, (2) BIAs were widely sold to the general public, (3) BlockFi promoted BIAs as an investment, and (4) there was no applicable regulatory regime (other than the law securities) or other factors that reduced the risk of the BIAs.
Additionally, the SEC found that BIAs were investment contracts. Generally, under Howey test, any product or arrangement is a contract of investment if it involves (1) an investment of money (2) in a joint venture (3) with expectations of profit (4) to be derived from the efforts of others, especially their entrepreneurial spirit or management efforts). See SEC vs. WJ Howey Co., 328 U.S. 293, 301 (1946). As BlockFi sold BIAs for cash in the form of crypto assets, then pooled those assets and used them for lending and investing activities to generate returns for BlockFi and investors, the SEC found that the BIA was an investment contract. Investors expected profits from BlockFi’s management efforts based on statements regarding how BlockFi would generate a return to pay BIA investors’ interest payments by investing their crypto assets in its lending and investment business. ‘investment.
Both analyzes exemplify the functional approach of the SEC (and, generally, the Court) when it comes to applying securities law and determining whether a product or arrangement is a security. . Essentially, parties should not rely on formalistic arguments as to why an item does not fit the definition of titles or certain terms used in the definition of titles. If a product or arrangement with which a person intends to raise or fundraise is presumably a security, it is a good idea to apply for registration or legally use a registration exemption.
2. Public protection: it’s not all about power and authority
The order highlights that BlockFi made a material misrepresentation to BIA investors regarding the level of risk in its loan portfolio. In several postings on its website, BlockFi said its loans were “generally” over-collateralized, but they weren’t. The company had wanted this to be the case but ultimately was unable to secure significant collateral from institutional lenders. The highest percentage of oversecured loans in its portfolio in a year was 24%. This made BlockFi’s statement materially misleading and overestimated BlockFi’s ability to repay interest to BIA holders in the event of significant loan failures by its borrowers. The SEC concluded that these were violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act, to which potential criminal liability attaches. In the course of filing a registration statement and related due diligence, these inaccuracies likely would have been detected and removed from the company’s potential public statements.
3. Securities law is only one challenge among others. Your business may face compliance challenges related to multiple regulatory regimes
The SEC also found that BlockFi was an investment company as defined in Section 3(a)(1)(C) of the Investment Company Act. “Investment firm” includes any issuer of securities which “carries on or proposes to carry on the business of investing, reinvesting, possessing, holding or dealing in securities, and owns or proposes to acquire securities investment securities with a value greater than 40% of the value of that issuer’s total assets (excluding government securities and cash items) on a non-consolidated basis.” BlockFi granted loans to borrowers that were investment securities under the law and more than 40% of the value of its total assets were in the form of loans.As a result, the SEC determined that BlockFi must register under the law on investment companies, but had not done so.
4. Don’t forget the pound of flesh! Cooperation is helpful, but breaches can still be extremely costly
As noted in the order, BlockFi cooperated with the SEC’s investigation into its operations. In order to avoid further legal action, which could have resulted in civil and criminal lawsuits, BlockFi offered large settlement payments, one to the US government and one to the states (like “ANASA”), each will receive $50 million for a total of $100 million in agreed fines. In addition, BlockFi has agreed to the following commitments:
- Cease and desist from offering BIAs and cease accepting additional investments from current BIA holders.
- Register under the Investment Companies Act or take steps to no longer require registration under that Act.
- The condition of SEC acceptance of a registration statement for BlockFi Yield (a product separate from the business group) or any similar product to fulfillment of BlockFi’s compliance with investment company law .
5. It’s not just the SEC. States are also active… and they are collaborating!
In addition to SEC enforcement actions, as members of the North American Securities Administrators Association (“NASAA”), state regulators formed a “multi-state task force” and investigated whether BIAs involved the offering and sale of unregistered securities. The Multistate Task Force contacted BlockFi in January 2021 and informed the company that selling BIA may violate state securities laws. Along with similar actions from regulators in New Jersey, Alabama, Vermont, Kentucky, and Washington, the Texas State Securities Board served BlockFi on July 22, 2021 with a Notice of Administrative Hearing threatening multiple actions. Following investigations, cooperation and negotiations involving the company, the SEC, Texas and other members of the Multistate Task Force have agreed to settle their charges and enter cease and desist orders. abstain “agreed”. The Texas State Securities Board issued its BlockFi Consent Order on February 14, 2022:
Finally, crypto entrepreneurs should note that the Texas Securities Act (which is substantially similar to the US Securities Act of 1933) is enforced even locally. The Texas Securities Act gives the Securities Commission the power to impose administrative penalties, including cease-and-desist orders and fines. Additionally, pursuant to Section 3 of the Texas Securities Act, the Securities Commissioner is responsible for reporting criminal activity for prosecution to county or district attorneys. If these local authorities do not prosecute the violations, the Securities Commissioner must present the case for prosecution to the Attorney General, who must act on their behalf.