Introduction

There is no love lost between the US Securities and Exchange Commission (SEC) and the crypto industry with tensions escalating over the past year. So it seems fitting that on Valentine’s Day, the SEC brought a first-of-its-kind enforcement action against a major cryptocurrency exchange, finding that the company’s crypto lending product, which was offered and sold to US investors, was a security requiring registration.¹ The $50 million penalty assessed by the SEC (and another $50 million by state securities regulators) follows a string of recent cases against firms—both registered and unregistered—and individuals in the crypto industry, and the SEC’s issuance of a proposed rule that may impact decentralized finance (DeFi) trading platforms.²

The SEC Order

According to the SEC’s Order, for nearly three years, BlockFi Lending LLC (BlockFi) offered and sold BlockFi Interest Accounts (BIAs) to the public. The product allowed investors to lend their crypto assets to BlockFi in exchange for a variable monthly interest payment that BlockFi generated primarily by making loans of the crypto assets to institutional borrowers (and later by investing in equities and futures). The Order states that as of December 8, 2021, BlockFi and its affiliates held approximately $10.4 billion in BIA investor assets, and had approximately 572,160 BIA investors, including 391,105 investors in the United States.

Critically, the SEC determined that BIAs were notes and thus securities requiring registration under the test propounded in Reves v. Ernst & Young, 494 US 56, 64–66 (1990), and investment contracts under SEC v. W.J. Howey Co., 328 US 293, 301 (1946). Applying the Reves four-part analysis, the Order states that, first, BlockFi offered and sold BIAs to obtain crypto assets for the general use of its business—that is, to run its lending and investment activities to pay interest to BIA investors who purchased BIAs to receive such interest. Second, BIAs were offered and sold to a broad segment of the general public. Third, BlockFi promoted BIAs as an investment—a way to earn a consistent return on crypto assets. Fourth, no alternative regulatory scheme or other risk reducing factors exist with respect to BIAs.

The SEC also determined the BIAs were investment contracts under the Howey test. According to the Order, BlockFi promised BIA investors a variable interest rate in exchange for crypto assets loaned by the investors, who could demand that BlockFi return their loaned assets at any time. BlockFi thus borrowed the crypto assets in exchange for a promise to repay with interest. Moreover, investors had a reasonable expectation of obtaining a future profit from BlockFi’s efforts in managing the BIAs based on BlockFi’s statements about how it would generate the yield to pay interest. Investors also had a reasonable expectation that BlockFi would use the invested crypto assets in BlockFi’s lending and principal investing activity, and that investors would share profits in the form of interest payments resulting from BlockFi’s efforts. Finally, BlockFi promoted the BIAs as an investment. Because BlockFi offered and sold these securities without a registration statement and without qualifying for an exemption from registration, it violated Sections 5(a) and 5(c) of the Securities Act.

In addition to the registration failure, the SEC found that BlockFi made false and misleading statements on its website for more than two years in violation of Sections 17(a)(2) and 17(a)(3) of the Securities Act concerning the level of risk in its loan portfolio and lending activity. Specifically, BlockFi stated in multiple website posts that its institutional loans were “typically” over-collateralized, when, in fact, most institutional loans were not.

Finally, the SEC found that BlockFi operated as an unregistered investment company because it issued securities (the BIAs) and also held more than 40 percent of its total assets, excluding cash, in investment securities, including loans of crypto assets to institutional borrowers, in violation of Section 7(a) of the Investment Company Act.

Without admitting or denying the SEC’s findings, BlockFi settled for a $50 million penalty to the SEC and $50 million in fines to 32 state securities regulators for similar charges. BlockFi also agreed to cease offering or selling BIAs in the United States. Separately, BlockFi announced that it welcomed the “regulatory clarity” the settlement achieved and that it will register a new crypto interest-bearing product with the SEC.³

Key takeaways

First, while the Order is not binding precedent on other firms, it certainly highlights the risk for other crypto-related firms continuing to play outside the SEC’s sandbox. Although this case is focused on a specific type of crypto-related product (not an issue with crypto assets or exchanges more broadly), it follows up on the SEC’s issues with Coinbase in 2021 where the SEC told Coinbase that if it went ahead with the release of a similar crypto-lending product, the SEC would sue.⁴ Coinbase eventually put its product on hiatus. That was a harbinger for this case.

Second, fighting an SEC claim on the basis of lack of jurisdiction is unlikely to work, unless the asset being promoted has already been determined to be regulated by another regulator in the United States, e.g., the Commodity Futures Trading Commission. The SEC is actively looking for creative ways to assert jurisdiction over various actors in the crypto industry. Firms seeking to avoid SEC sanctions should carefully analyze whether any products they offer or crypto assets traded on their platforms could be deemed a security that invokes SEC jurisdiction. Given the penalties in this case, firms should consider erring on the side of a more conservative analysis.

Third, the Order notes BlockFi’s cooperation and remedial efforts, including its intent to register a new, similar product with the SEC. The industry has historically been hesitant to cooperate with the SEC, often arguing instead that the SEC has no jurisdiction. This case could portend more cooperation with the SEC by crypto industry actors, including potentially registering more crypto assets to avoid negative scrutiny.

Conclusion

This Order represents a big shot at the crypto industry—a continuation of the SEC’s campaign of industry oversight. The SEC appears to be moving closer to other significant actors in the space—namely, exchanges (both centralized and decentralized). 2022 is shaping up to be a very active year in crypto industry regulation.

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