The Securities and Exchange Commission (SEC) has not hesitated to conclude that crypto assets are securities subject to the Securities Act of 1933, but with BlockFi, the SEC went a step further and, for the first time with respect to a crypto lending platform, found that BlockFi was subject to the Investment Company Act of 1940 pursuant to a February 14th cease-and-desist order.
BlockFi Lending LLC (BlockFi) is a New Jersey-based financial services company owned by BlockFi, Inc. According to the SEC, in March of 2019, BlockFi began selling BlockFi Interest Accounts (BIAs) to investors. Pursuant to the BIAs, investors lent crypto currencies such as Bitcoin and Ether to BlockFi in exchange for BlockFi’s promise to pay a variable monthly interest payment. BlockFi promoted the BIAs through its website and social media accounts, including YouTube, Twitter, and Facebook. BlockFi generated the interest paid out to BIA investors by further loaning the pooled crypto assets, making cash loans and by investing in equities and futures. BlockFi had hundreds of thousands of BIA investors and held billions of dollars in BIA investor assets. Notably, there was no allegation that BlockFi failed to make the required interest payments to investors.
Notes are Securities Under the Securities Act
The SEC concluded that the BIAs are investments contracts and therefore securities under the Howey test, which the SEC has relied on previously to treat crypto assets as securities. In addition, the SEC took the position that the BIAs are notes under the four-part test articulated in Reves v. Ernst & Young and therefore securities. Many practitioners don’t think of non-convertible notes as securities, but the BlockFi case provides a powerful reminder that absent certain judicially created exceptions, notes are securities under the Securities Act that can only be sold pursuant to an exemption or effective registration.
Having sold the BIAs to thousands of investors, including retail investors, BlockFi violated Sections 5(a) and 5(c) of the Securities Act by selling unregistered securities. The SEC also charged that BlockFi misled investors concerning the level of risk in its loan portfolio. BlockFi stated on its website that its institutional loans were “typically” over-collateralized. BlockFi did initially seek to make over-collateralized loans but found that it was unable to attract many institutional borrowers. BlockFi relaxed its lending requirements but failed to update its website to reflect that fact.
The SEC concluded that this was materially false and misleading and was not cured by the more general risk factors posted on the website. Even if an offering exemption for the BIAs had been available, language on the website that had not been updated (the SEC noted due to “operational oversight”) resulted in BlockFi violating Sections 17(a)(2) and 17(a)(3) of the Securities Act. Companies raising capital (and their counsel) must not only carefully craft the offering document, but also scrub all public statements that could be considered misleading relating to the investment and continue to monitor those statements during the offering period, as even an inadvertent failure to update can lead to a violation.
Counsel Must Carefully Review the Investment Company Act
But the SEC wasn’t satisfied with these Securities Act violations and also charged BlockFi with operating as an unregistered investment company under the Investment Company Act of 1940. The SEC argued that the crypto assets and loans held by BlockFi constituted “investment securities” that constituted more than 40% of BlockFi’s total assets and therefore that BlockFi was an “investment company” under Section 3(a)(1)(C) of the Investment Company Act. Because BlockFi had not registered as an investment company or sought an exemption from registration, BlockFi violated Section 7(a) of the Investment Company Act. Many practitioners are aware of the Securities Act ramifications of an offering, but don’t necessarily take the next step to analyze the Investment Company Act issues, which can be complex, particularly for funds. The BlockFi case makes clear that counsel must carefully review the Investment Company Act and carefully document their analysis as a routine part of any offering that might implicate the Act.
The SEC and BlockFi Lending LLC Reach a Settlement
Pursuant to the cease-and-desist order, BlockFi agreed to:
- Pay civil money penalties of $50 million to the SEC (separately, BlockFi agreed to pay an additional $50 million penalty to settle charges brought by state regulators);
- Cease offering unregistered securities (BlockFi announced that it plans to file an S-1 registering “BlockFi Yield” to be offered in exchange for the BIAs); and
- Register under the Investment Company Act or takes steps so that it is no longer required to register under the Act.
In a press release announcing the settlement, SEC Chair Gary Gensler said:
“This is the first case of its kind with respect to crypto lending platforms. Today’s settlement makes clear that crypto markets must comply with time-tested securities laws, such as the Securities Act of 1933 and the Investment Company Act of 1940. It further demonstrates the Commission’s willingness to work with crypto platforms to determine how they can come into compliance with those laws.”
However, SEC commissioner Hester Peirce issued a dissenting statement wondering whether the combined $100 million penalty was disproportionate, noting that “there is no allegation that BlockFi failed to pay its customers the money due them or failed to return the crypto lent to it.” She argued that applying the securities regulatory framework to crypto lending products might simply make them unavailable to US retail customers. She particularly questioned the utility of applying the Investment Company Act to BlockFi and concluded by stating:
“For the sake of the American public, our own reputation, and the companies that heed our call to come in and talk to us, we need to do better than we have so far at accommodating innovation through thoughtful use of the exemptive authority Congress gave us.”
In a related development, also on Feb. 14, the SEC’s Office of Investor Education and Advocacy and the SEC’s Enforcement Division Retail Strategy Task Force jointly issued an investor bulletin warning investors that crypto asset interest-bearing accounts are not as safe as interest-bearing accounts with a bank or credit union.
The KJK securities team can offer legal counsel across the spectrum of corporate and securities law. For more information on Securities Compliance, please contact Christopher Hubbert (CJH@kjk.com; 216.736.7215) or another member of KJK’s Corporate & Securities practice group.