SEC Issues Warning to All Crypto Lenders and Participants Following BlockFi Consent Order

February 22, 2022

On February 14, 2022, BlockFi Lending LLC (“BlockFi”), a financial services company based in New Jersey, entered into a consent order (the “Consent Order”) with the Securities and Exchange Commission (“SEC”) to pay a total of $100 million in fines and penalties to the SEC and 32 states.

According to SEC Chair, Gary Gensler, this is the first case of its kind with respect to crypto lending platforms. Significantly, Gensler stated that “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.”

BlockFi’s Violative Conduct

By way of the Consent Order, the SEC found that BlockFi violated the registration and antifraud provisions of the Securities Act and the registration provisions of the Investment Company Act of 1940 (“ICA”), by failing to register the offers and sales of its retail crypto lending product, BlockFi Interest Accounts (“BIAs”). As a result of the Consent Order, along with BlockFi’s payment of $100 million in fines and penalties, BlockFi also agreed to cease unregistered offers and sales of the BIAs, and attempt to become ICA compliant within 60 days.

The Consent Order sets forth that since March 4, 2019, BlockFi had offered and sold their BIAs to investors, who in turn lent crypto assets to BlockFi in exchange for BlockFi’s promise to provide a variable monthly interest payment. Through this scheme, as of December 8, 2021, BlockFi and its affiliates held approximately $10.4 billion in BIA investor assets, and had approximately 572,160 BIA investors, including 391,105 investors in the United States, alone.

The Consent Order held that the BIAs were unregistered securities since they were notes based on the Supreme Court ruling in Reves v. Ernst & Young. In Reves, the Supreme Court established a test presuming a note to be a security unless (1) it falls into certain judicially created categories of financial instruments that are not securities, or (2) bears a “Family resemblance” to notes in those categories based on: (i) the motivation of the seller and buyer, (ii) the plan of distribution of the instrument, (iii) the reasonable expectation of the investing public, and (iv) the presence of alternative regulatory regimes. In the Consent Order, the SEC applied the Supreme Court’s Reves test and found that BlockFi offered and sold BIAs to obtain crypto assets for the general use of its business; the BIAs were offered and sold to a broad segment of the general public; BlockFi promoted BIAs as an investment; and that there was no alternative regulatory scheme or other risk reducing factors with respect to the BIAs. Therefore, the BIAs did not fall within any of the exceptions and were, as a result, a security.

Additionally, the SEC found that the BIAs were unregistered securities because BlockFi offered and sold the BIAs as investment contracts, under SEC v. W.J. Howey Co. The Supreme Court in W.J. Howey Co. held that to establish that a product is an investment contract, it must be proven that (1) there is an investment of money, (2) in a common enterprise, (3) with profits to be derived solely from the efforts of others. With regard to BlockFi, the SEC found that the BIAs were sold in exchange for the investment of money in the form of crypto assets; that BlockFi pooled the BIA investors’ crypto assets and used them for lending and investment activity generating returns for both BlockFi and BIA investors; and that BIA investors had a reasonable expectation of obtaining a future profit and sharing profits from BlockFi’s lending and principal investing activity in the form of interest payments.

Further, the SEC found that BlockFi made materially false and misleading statements on its website concerning its collateral practices and the risks associated with its lending activity. As a result of these materially false and misleading statements, BlockFi violated Sections 17(a)(2) and 17(a)(3) of the Securities Act.

Finally, the SEC found that BlockFi was operating as an unregistered investment company because it was an issuer of securities engaged in the business of investing, reinvesting, owning, holding, or trading in securities and owning investments securities as defined by Section 3(a)(2) of the ICA, having a value exceeding 40% of its total assets (exclusive of Government securities and cash items). The SEC also found that BlockFi violated Section 7(a) of the ICA by engaging in interstate commerce while failing to register as an investment company with the SEC.

The SEC’s Warning to Crypto Industry

The SEC’s enforcement action against BlockFi and the magnitude of the fine is a clear signal that the SEC is prepared to crack down on the crypto industry and force compliance with the securities laws. Following the SEC and BlockFi Consent Order, the Director of the SEC’s Enforcement Division, Gurbir S. Grewal issued a warning and stated that all crypto lenders and other industry participants should take immediate notice of the SEC and BlockFi Consent Order and come into compliance with the federal securities laws. SEC Chair, Gary Gensler has made it clear that the SEC will be imposing regulatory oversight over the crypto exchanges and where appropriate bring enforcement actions to force compliance with the securities laws.

For more information on the issues in this alert, please contact:

Howard R. Elisofon at +1 212 592 1437 or [email protected]
Arthur G. Jakoby at +1 212 592 1438 or [email protected]
Andrew Heighington at +1 (212) 592-1574 or [email protected]

© 2022 Herrick, Feinstein LLP. This alert is provided by Herrick, Feinstein LLP to keep its clients and other interested parties informed of current legal developments that may affect or otherwise be of interest to them. The information is not intended as legal advice or legal opinion and should not be construed as such.