SEC Targets Digital Asset Lending in Enforcement Action and Investor Bulletin

Background

BlockFi is a Delaware limited liability company 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. 

Three Types of Violations 

In connection with BlockFi’s BIA product, the SEC found three separate violations of U.S. securities laws. 

1. Sale of Unregistered Securities 

Under the Securities Act, every offer and sale of a security must either be registered with the SEC or subject to an exemption from registration. The SEC found that BlockFi’s BIA product violated Sections 5(a) and 5(c) of the Securities Act for the sale of unregistered securities and the failure to file a registration statement for securities. In the Order, the SEC provided two separate arguments for why BIAs may be considered securities. 

2. Materially False and Misleading Statements 

Sections 17(a)(2) and 17(a)(3) of the Securities Act prohibit any person offering securities from obtaining money or property using untrue statements or omissions of material fact and from engaging in any business that operates as a fraud or deceit upon the purchaser. 

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 

Section 3(a)(1)(C) of the Company Act defines an investment company to include any issuer 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 each issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.” An investment company meeting this definition must register with the SEC as an investment company and is subject to related regulatory requirements. 

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.⁸

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

As stipulated in the Order, 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.

Other Points of Interest 

SEC Commissioner Peirce Dissent

SEC Commissioner Hester Peirce dissented from the Order. Commissioner Peirce argued 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, Commissioner 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 Enforcement Division Director Statement 

On the day of the Order, Gurbir Grewal, director of the SEC’s enforcement division, stated that other digital asset lending platforms should “take immediate notice of today’s resolution and come into compliance with the federal securities laws.”

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. It also explained that digital asset deposits are not insured like typical bank or credit union deposits. Last, the Bulletin highlighted that interest-bearing digital asset deposit accounts may be used by the service provider for investment or lending activities that could subject deposited funds to additional risk.

Conclusion

The Order is consistent with the SEC’s public statements regarding the need for digital asset service providers to consider how U.S. securities laws apply to their particular products and services. It also provides insight, with respect to digital asset lending products, as to what the SEC considers securities under both the Securities Act and the Company Act. Digital asset market participants should consult with their legal advisers to comprehensively analyze how securities laws might affect their operations in light of this Order and Bulletin.