While loving couples were celebrating St. Valentine’s, the SEC, in its first-ever action against crypto lending platforms, charged BlockFi Lending LLC (BlockFi) with failing to register the offers and sales of its retail crypto lending product. 

Let's take a step back and add some background here. BlockFi is a crypto lending platform that offers BlockFi Interest Accounts (BIAs) to the general public, who lent crypto to BlockFi and receive variable monthly interest.

Legal analysis

SEC found BIAs to be securities; thus, BlockFi had to register its offers and sales of BIAs or qualify for an exemption from SEC registration. In its analysis, SEC cited not only the commonly used definition of the investment contract from Howey (SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946)) but the “family resemblance” test from Reves (Reves v. Ernst & Young, 494 U.S. 56, 64–66 (1990)) as well. To clarify, while the so-called “Howey test” answers whether the offering is an investment contract, in Reves case, the Supreme Court introduced a presumption that the note is a security unless it falls into one of the exceptions. SEC stated that BlockFi offered and sold BIAs to run its lending and investment activities and paid interest for them; BIAs were offered and sold to a broad segment of the general public and were promoted as an investment. Finally, “no alternative regulatory scheme or other risk-reducing factors exist with respect to BIAs” – stated SEC in the order. 

While applying the Howey test, SEC stated that “BlockFi sold BIAs in exchange for the investment of money in the form of crypto assets. BlockFi pooled the BIA investors’ crypto assets, and used those assets for lending and investment activity that would generate returns for both BlockFi and BIA investors. The returns earned by each BIA investor were a function of the pooling of the loaned crypto assets, and the ways in which BlockFi deployed those loaned assets. In this way, each investor’s fortune was tied to the fortunes of the other investors. In addition, because BlockFi earned revenue for itself through its deployment of the loaned assets, the BIA investors’ fortunes were also linked to those of the promoter, i.e., BlockFi. Through its public statements, BlockFi created a reasonable expectation that BIA investors would earn profits derived from BlockFi’s efforts to manage the loaned crypto assets profitably enough to pay the stated interest rates to the investors....”

Cumulatively, SEC used Reves to find BIAs to be securities as notes and Howey to find them investment contracts. In both scenarios, BIAs are securities. SEC took a new approach by applying a standard for promissory notes to crypto lending. Applied alone, the Howey test might not be enough to consider BIAs as securities. However, being tied to finding that BIAs are notes and securities under Reves, it is possible to reach this conclusion.

Going down the slippery slope, SEC also found that BlockFi is an unregistered investment company because of offering and selling securities, which BIAs are found to be. Additionally, SEC stated that BlockFi misled investors regarding the level of risk in its loan portfolio and lending activity, which would not be an issue if SEC did not find BIAs securities. 

Settlement

BlockFi, without admitting or denying the SEC’s findings, agreed to pay a $50 million penalty, cease its unregistered offers and sales of the BIAs, and attempt to bring its business within the provisions of the Investment Company Act within 60 days. BlockFi’s parent company also announced that it intends to register under the Securities Act of 1933 the offer and sale of a new lending product. BlockFi agreed to pay an additional $50 million in fines to 32 states to settle similar charges in parallel actions.

Dissent

What’s notable is that SEC Commissioner Hester M. Pierce dissented, taking a position that a humongous fine of $100 million and strict approach will not help investors. She notes that such a disproportionate fee is usually applied to deter bad conduct, which is not the case here, as BlockFi has not failed to pay its customers interest or return the crypto they lent. Second, such a harsh reaction may force crypto lending companies to avoid U.S. customers at all rather than push towards transparency and regulation. 

As to BlockFi, the requirements that the SEC placed in front of it are hard to fulfill in provided by SEC timeframe and put BlockFi months from coming back to the market. Commissioner Pierce says, and we tend to agree here that “the [SEC]’s lack of experience with the market intermediary exclusion combined with the nature of BlockFi’s business suggests that the sixty-day timeframe (even if extended an additional 30 days) allocated for BlockFi to “provid[e] the Commission staff with sufficient credible evidence that it is no longer required to be registered under the Investment Company Act” is extremely ambitious.”

Conclusion

We agree with Commissioner Pierce that this settlement leads to an uneasy sentiment of market participants, suggesting that it is better to stay away from crypto lending in the U.S. until the SEC’s approach shifts more towards crypto-friendly, rather than “we ignore you until we fine you.” 

The approach taken by SEC adds a new risk factor for future crypto lending platforms. Previously companies worried only about the “Howey test,” which is mostly about the way you offer and market the product, and the expectations of the investors. Now the application of the Reves case adds a concern about the substance of the product, making it dangerous to accept crypto from investors to fund a company’s business activities in exchange for interest without registering a securities offering.