Earlier this year, on February 14, 2022, the SEC issued to 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, deemed securities in the Order, until its business operations are brought into compliance. Additionally, BlockFi agreed to pay massive penalties. The SEC’s press release about the Order is available here: BlockFi Press Release. This note discusses five takeaways from the BlockFi matter that crypto industry participants should keep in mind when evaluating business projects, but first some background.
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 to investors BlockFi Interest Accounts (“BIAs”). Through the BIAs, investors would lend crypto assets to BlockFi in exchange for promised variable monthly interest payments. BlockFi earned revenue to make interest payments by loaning crypto assets to institutional and corporate borrowers, loaning U.S. dollars to retail investors, and investing in equities and futures. During 2021, BlockFi and its affiliates held over $10 billion in BIA investor assets, invested by nearly 600,000 BIA investors. Nearly two thirds of those investors were from the United States.
1. In determining whether an arrangement, product, or contract is a security, the SEC takes a functional approach.
An old adage says, “there is more than one way to skin a cat.” There is also more than one way for the SEC to find that something is a security. In the Order, the SEC found that BIAs were notes in addition to being investment contracts.
The BIAs might not look exactly like a note in the traditional sense. BlockFi did not refer to them as notes. Nevertheless, the SEC found that “they were notes under Reves v. Ernst & Young, 494 U.S. 56, 64–66 (1990), and its progeny,” on the basis that (1) the BIAs were used to generally fund (with crypto assets) its lending and investment business and purchasers bought them to receive a profit, (2) BIAs were sold broadly to the general public, (3) BlockFi promoted BIAs as an investment, and (4) there was no applicable regulatory scheme (aside from securities law) or other factors that reduced the risk of the BIAs.
Additionally, the SEC found that BIAs were investment contracts. Generally, under the Howey test, any product or arrangement is an investment contract if it involves (1) an investment of money (2) in a common enterprise (3) with expectations of a profit (4) to be derived from the efforts of others, especially their entrepreneurial or managerial efforts). See SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946). As BlockFi sold BIAs for money in the form of crypto assets, then pooled those assets, and used them for lending and investment activity to generate returns for both BlockFi and investors, the SEC found that the BIA was an investment contract. Investors had an expectation of profits from BlockFi’s management efforts based on statements regarding how BlockFi would generate yield to pay BIA investors’ interest payments by investing their crypto assets in its lending and investing activity.
Both analyses are exemplary of the SEC’s (and, generally, the Court’s) functional approach when applying securities law and determining whether a product or arrangement is a security. Essentially, parties should not rely on formalistic arguments regarding why an item does not fit within the definition of securities or of certain terms used in the definition of securities. If a product or arrangement with which a person intends to raise or collect funds is arguably a security, it’s a good idea to seek registration or to lawfully use an exemption from registration.
2. Public Protection: It’s not all about Power and Authority
The Order highlights that BlockFi made a material misrepresentation to BIA investors concerning the level of risk in its loan portfolio. In multiple posts on its website, BlockFi stated that its loans were “typically” over-collateralized, but they were not. The company had intended this to be the case but, ultimately, was unable to obtain significant collateral from institutional lenders. The highest percentage of over-collateralized loans in its portfolio in any year was 24%. This made BlockFi’s statement materially misleading and overstated BlockFi’s ability to repay interest to BIA holders in the event of significant loan failures from its borrowers. The SEC found 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 context of filing a registration statement and related due diligence, these inaccuracies would have likely been detected and deleted from the company’s prospective public-facing statements.
3. Securities law is only one challenge. Your business may face compliance challenges in connection with several 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 company” includes any issuer of securities 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 such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.” BlockFi made loans to borrowers which were investment securities under the act and over 40% of the value of its total assets were in loans. As a result, the SEC determined that BlockFi was required to register under the Investment Company Act but had failed to do so.
4. Don’t forget the pound of flesh! Cooperation helps but violations can still be extraordinarily costly
As discussed in the Order, BlockFi cooperated with the SEC’s investigation into its operations. In avoidance of further legal action, which could have resulted in civil and criminal charges, BlockFi offered large settlement payouts, one to the U.S. Government and one to the states (as “NAASA”), each to receive $50 million for a total of $100 million in agreed fines. In addition, BlockFi agreed to the following undertakings:
- To cease and desist offering BIAs and to cease accepting additional investment from current BIA holders.
- To register under the Investment Company Act or take action to no longer require registration under that act.
- The conditioning of the SEC’s acceptance of a registration statement for BlockFi Yield (a distinct product of the business group) or any similar product on compliance with BlockFi’s compliance with the Investment Company Act.
5. It’s not just the SEC. The states are active too … and they collaborate!
In addition to the SEC’s enforcement action, as members of the North American Securities Administrators Association (“NASAA”), state regulators formed a “Multistate Working Group” and investigated whether BIAs involved the offer and sale of unregistered securities. The Multistate Working Group contacted BlockFi in January 2021 and notified the company that the sale of BIAs may violate state securities laws. In conjunction with similar actions by 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 several actions. Following investigations, cooperation, and negotiations involving the company, the SEC, Texas and other members of the Multistate Working Group agreed to settle their charges and to entry of “agreed” cease and desist orders. The Texas State Securities Board published its consent order (BlockFi Consent Order) on February 14, 2022:
Finally, crypto entrepreneurs should note that the Texas Securities Act (which is substantially similar to the U.S. Securities Act of 1933) is enforced even at the local level. The Texas Securities Act furnishes the Securities Commission with authority to impose administrative sanctions, including cease and desist orders and fines. Further, pursuant to Section 3 of the Texas Securities Act, the Securities Commissioner is charged with reporting criminal activity for prosecution to county or district attorneys. If these local authorities fail to prosecute violations, the Securities Commissioner is to present the matter for prosecution to the Attorney General, who is to act in their stead.