On Monday, February 14, 2022, the Securities and Exchange Commission (SEC) charged cryptocurrency lending company BlockFi Lending LLC (“BlockFi”) with failing to register the offers and sales of its retail crypto lending product, violating the registration provisions of the Investment Company Act of 1940, and making certain material misrepresentations regarding the level of risk associated with its product. To settle the charges, BlockFi agreed to pay a $50 million penalty, cease its unregistered offers and sales of the lending product—BlockFi Interest Accounts (“BIAs”)—and bring its business within the provisions of the Investment Company Act within 60 days. BlockFi also agreed to pay an additional $50 million in fines to 32 different states to settle similar charges.
Under Sections 5(a) and 5(c) of the Securities Act of 1933 (the “Securities Act”), any securities that are offered or sold must be registered with the SEC unless they qualify for an exemption. And under Sections 3(a)(2) and 7(a) of the Investment Company Act of 1940 (the “Investment Company Act”), issuers of securities that are (1) engaged in the busines of investing, reinvesting, owning, holding, or trading in securities and owning investment securities that (2) have a value in excess of 40% of the issuer’s assets must register as an investment company with the SEC.
According to the SEC’s order, beginning in March 2019, BlockFi offered and sold BIAs to the public without registering them as required, but prior to the order, there was arguably some degree of open question as to how crypto lending products such as BIAs would be treated. The SEC applied the longstanding tests set forth in Reves v. Ernst & Young
, 494 U.S. 56, 64–66 (1990), and SEC v. W.J. Howey Co
., 328 U.S. 293, 301 (1946), and concluded that the BIAs were securities both because they were notes and also because BlockFi offered and sold the BIAs as investment contracts. Critical to the findings were that, at least as alleged by the SEC, through BIAs, investors lent crypto assets to BlockFi in exchange for the company’s promise to provide a variable monthly interest payment; investors in the BIAs 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 BIA investors interest; and investors had a reasonable expectation that BlockFi would use the invested crypto assets in BlockFi’s lending and principal investing activity, and investors would share in the resulting profits in the form of interest payments resulting from BlockFi’s efforts. Because the SEC found that the BIAs were securities, the order found that BlockFi operated for more than 18 months as an unregistered investment company because it issued securities and also held more than 40 percent of its total assets, excluding cash, in investment securities, including loans of crypto assets to institutional borrowers.
The size of the SEC fine was likely influenced by the fact that the SEC also found that BlockFi had made certain material misrepresentations regarding the level of risk associated with BIAs. In particular, the SEC alleged that BlockFi made a statement in multiple website posts that its institutional loans were “typically” over-collateralized, when in fact, most institutional loans were not. And while the SEC did not allege that this in fact led to losses, and specifically noted that these misstatements were the result of an “operational oversight,” the SEC likely concluded that the risk of misstatement was increased by the lack of registration.
The SEC’s action against BlockFi is the first of its kind, though not the first sign that the SEC is focused on crypto lending products; it has previously been reported that at least one other crypto company withdrew a contemplated crypto lending product after receiving similar inquiries from the SEC. Commenting on the Order, SEC Chair Gary Gensler noted:
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.
The SEC’s latest action is another reminder that its existing rules can apply to any number of scenarios in the rapidly developing fintech space generally, and crypto currency trading specifically, and that the SEC (and other regulators) will particularly apply scrutiny whenever retail customers are impacted.