In the Matter of BlockFi Lending LLC (SEC Cease-and-Desist Order)
On February 14, 2022, the SEC announced an enforcement settlement related to BlockFi Lending LLC, a digital asset borrowing and lending platform. The SEC found that BlockFi offered unregistered securities to U.S. investors, made material misrepresentations about its lending activities, and operated as an unregistered investment company. BlockFi entered into a joint settlement with the SEC and the North American Securities Administrators Association (NASAA) in which it agreed to pay $100 million in fines and penalties, cease offering its unregistered lending services to new U.S. investors, and attempt to bring its business within the provisions of the Securities Act of 1933 (Securities Act) and the Investment Company Act of 1940 (Company Act) within 60 days.
BlockFi was formed in 2018 and a wholly owned subsidiary of BlockFi Inc., with its principal place of business in Jersey City, New Jersey. BlockFi’s business involves providing users digital asset services such as providing loans against digital assets and allowing users to lend digital assets for a return.
On March 4, 2019, BlockFi began offering customers BlockFi interest accounts (BIAs). In a BIA, investors can deposit a variety of digital assets, including BTC, ETH, and USDC, to BlockFi in exchange for BlockFi’s promise to provide a variable monthly interest payment. Investors may withdraw deposited amounts at any time. BlockFi pooled customers’ BIA assets and paid interest to customers from income generated by lending the digital assets to institutional and corporate borrowers, lending U.S. dollars to retail investors, and investing in equities and futures.
The SEC found Three Separate Violations
Sale of Unregistered Securities
The SEC provided two separate arguments for why BIAs may be considered securities:
(a) The BIAs were securities under the Reves test. The SEC found that BIAs are notes that are securities under the test established by the U.S. Supreme Court in Reves v. Ernst & Young, applying the four-part Reves “family resemblance” analysis and concluded the BIAs are securities:
Use of invested funds: BlockFi offered and sold BIAs to obtain digital assets for general use in running its lending and investment activities. Purchasers bought BIAs to receive interest ranging from 0.1% to 9.5% on the loaned digital assets.
Distribution of offering: BlockFi offered and sold BIAs to a broad segment of the general public.
Promotion efforts: BlockFi promoted BIAs as an investment, specifically as a way to earn a consistent return on digital assets and for investors to “build their wealth.”
Alternative schemes of regulation: No alternative regulatory scheme or other risk-reducing factors exist with respect to BIAs.
(b) The BIAs were investment contracts under the Howey test. The SEC found the BIAs had the characteristic elements of investment contracts under the test established by the U.S. Supreme Court in SEC v. W.J. Howey Co. and therefore were securities:
Investment of money: BlockFi users invested money by depositing their digital assets into the BIAs.
Expectation of future profits: Investors had a reasonable expectation of future profits by investing in BIAs based on BlockFi’s statements about how it would generate the yield to pay BIA investors interest. For example, BlockFi marketed “an industry-leading 6.2% [annual percentage yield]” and described the BIAs as “an easy way for crypto investors to earn bitcoin as they HODL.”
Investment into a common enterprise: BIA users invested their funds alongside other BIA users’, which were pooled for BlockFi’s lending and investing activities. BlockFi also earned revenue for itself through its deployment of the loaned assets. Therefore each investor was in a common enterprise horizontally with other investors and vertically with BlockFi itself.
Profits based on the efforts of a third party: BlockFi had complete legal ownership and control over the digital assets deposited in BIAs and determined how and how much to hold, lend, and invest.
2. Materially False and Misleading Statements
Based on the Order, the BlockFi company website stated that institutional loans were “typically” overcollateralized when only 17% to 24% of institutional loans were overcollateralized. The SEC noted that investors relied on this information when choosing to invest in the platform. As such, BlockFi violated Sections 17(a)(2) and 17(a)(3) of the Securities Act by making a materially false and misleading statement concerning its collateral practices and, which related to the risks associated with its lending activity.
3. Unregistered Investment Company
The SEC found that BlockFi was an investment company under the terms of the Company Act because it was an issuer of securities and at least 40% of its assets consisted of securities, specifically the loans it made to counterparties.
Issuer of securities: The SEC found BlockFi to be an issuer of securities using the analysis under Reves and Howey that the BIAs were securities issued by BlockFi to its customers.
Engaged in securities activities: The SEC found that BlockFi was engaged in securities investing because BlockFi invested in and owned investment securities having a value of over $4 billion relative to BlockFi’s $4.8 billion in assets. This ratio exceeded the statutory 40% threshold established by Section 3(a)(1) of the Company Act. For the purposes of this calculation, the SEC considered loans of digital assets and U.S. dollars to counterparties, investments in digital asset trusts and funds, and intercompany receivables as securities.
The SEC said that BlockFi engaged in interstate commerce through its institutional and retail product offerings across the U.S. and did not register with the SEC or meet any of the statutory exemptions. Therefore, the SEC found that BlockFi violated Section 7(a) of the Company Act by engaging in interstate commerce while failing to register as an investment company with the SEC.
BlockFi argued that it was exempt from registration under the exemption for market intermediaries under Section 3(c)(2) of the Company Act, which provides that market intermediaries that provide contemporaneous trades on both sides of a market, a practice commonly known as market making, can be exempt from the definition of an “investment company.”
The SEC, however, focused on facts that suggested BlockFi was not on both sides of the market and that the relevant financial contracts were not individually negotiated and/or were not entered into in response to a counterparty’s request for a quotation or otherwise structured to accommodate a counterparty’s objectives. The SEC therefore concluded that BlockFi did not primarily act as a market intermediary for purposes of the Company Act.
Subsequent Events and Remedial Efforts for BlockFi
BlockFi publicly announced changes to its product offerings to bring its activities into compliance with securities regulation. BlockFi users in the U.S. will retain their BIAs and continue to receive interest but will no longer be able to deposit funds to their BIAs. Non-U.S. users of BlockFi BIAs will be unaffected. Ultimately, BlockFi intends to offer a similar experience through a new registered product called BlockFi Yield. BlockFi plans to register this new product under the Securities Act along with an indenture and T-1 filing under the Trust Indenture Act. As part of the Order, however, BlockFi must demonstrate to the SEC that it is in compliance with the Company Act.
BlockFi also has undertaken to comply with the Company Act within 60 days by either (1) filing a notification of registration as an investment company or (2) taking steps to no longer qualify as an investment company. As a condition of the settlement, BlockFi must be in compliance with the Company Act before a Form S-1 for BlockFi Yield (or other similar products) can be declared effective.
Miscellaneous
SEC Commissioner Hester Peirce Dissent. Commissioner Peirce dissented from the Order, arguing that requiring Form S-1 registrations for this type of product will be a large burden for digital asset companies and will ultimately hurt U.S. competitiveness and consumers in the digital asset ecosystem. Commissioner Peirce also questioned the feasibility of restructuring BlockFi’s activities to come into compliance with the Company Act, especially within the 60-day window provided in the Order. Instead, Commission Peirce suggested that the SEC should use its Section 6(c) exemption authority under the Company Act to craft a bespoke set of conditions that would address the investor protection concerns that the Company Act was designed to address. The exemption option, she said, would be timely and achievable for BlockFi.
SEC Investor Bulletin on Crypto Asset Interest-bearing Accounts. In conjunction with the Order, the SEC published an Investor Bulletin (Bulletin) regarding “Crypto Asset Interest-bearing Accounts.” The Bulletin highlights that digital asset deposit accounts are distinct from traditional bank accounts and are not subject to federal and state banking regulation.
The entire SEC caese-and0desist order can be viewed here.
