The recent BlockFi settlement with the Securities and Exchange Commission (SEC) made clear that the agency considers certain digital-asset product offerings “securities” under two long-standing tests. The action also marked the application of an additional regulatory regime to the industry, as this is the first digital asset case to bring charges under the Investment Company Act of 1940.

This is likely not what the industry was hoping for, as it shows the agency continues to aggressively retrofit existing rules and Supreme Court cases to the fast-evolving digital currency world.

At Patomak we believe it is time for Congress and regulators – the SEC, Commodity Futures Trading Commission (CFTC), Federal Reserve, and Office of the Comptroller of the Currency, to name a few – to focus on developing a sensible, timely, and achievable regulatory framework for digital assets. This would allow for both regulation and innovation in the U.S., rather than allowing other countries to take the lead in this space. But in the meantime, the agencies are relying on regulations and cases determined before cryptocurrency was even contemplated.

The Reves and Howey Tests as Applied to Digital Assets

The February 14, 2022, SEC Order states that BlockFi Interest Accounts (BIAs) – which provided customers with monthly interest payments in exchange for depositing their cryptocurrencies – were securities because they were “notes under Reves v. Ernst & Young, and investment contracts under SEC v. W.J. Howey Co.”

The Reves Test: What Makes BIAs “Notes”

The SEC applied the Reves four-part analysis and concluded that BIAs were notes, and thus securities. Generally speaking, a note is presumed to be a security unless it falls into certain exceptions, which the SEC asserted that BIAs did not. Specifically, the SEC alleged:

1. Motivations of buyer and seller: BIAs were used to obtain crypto assets for general use in BlockFi’s business. BlockFi used BIAs to run its lending and investment activities and investors purchased BIAs to earn interest on the loaned crypto assets.
2. Plan of distribution: BIAs were broadly offered and sold to the public. Almost 600,000 persons invested approximately $15 billion in BIAs.
3. Expectations of investing public: BIAs were promoted as an investment that can earn a consistent high return on crypto assets.
4. Risk-reducing factors: An alternative regulatory scheme currently does not exist with respect to these BIAs.

The Howey Test: What Makes BIAs “Investment Contracts”

The Howey test is the analysis most commonly cited by the SEC as the relevant framework for assessing whether a digital asset is a security. As applied to BIAs, the SEC alleged:

1. Investment of money: BlockFi sold BIAs in exchange for an investment of money in the form of crypto assets.
2. In a common venture: BlockFi pooled the investors’ crypto assets and the returns earned by each investor were a function of the pooling of the loaned crypto assets.
3. Reasonable expectation of profits: BlockFi promoted how it would generate the yield to pay interest to BIA investors, and investors had a reasonable expectation of future profit.
4. Profits derived from the efforts of others: BIA investors’ profits were linked to those of BlockFi. BlockFi had control over the borrowed crypto assets and had complete discretion over the holding, lending, and investment of such assets.

The SEC’s determination that BIAs are securities meant that the company was required to register its offers and sales of BIAs, but it failed to register or to qualify for an exemption.

The SEC highlighted the action as the “first-of-its-kind” in that it also charged BlockFi for operating as an unregistered investment company. BlockFi met the definition of an investment company as it issued securities and owned, invested, and traded in securities with values exceeding 40% of its total non-government securities and non-cash assets.

The SEC order included the diagram, depicted below, of the general structure of a potentially regulated BlockFi yield product. The SEC’s inclusion of this structure may signal that it will assert that similar structures will fall under SEC jurisdiction.

SEC Commissioner Peirce’s Dissent Raises Important Questions  

In dissenting to this enforcement action, SEC Commissioner Hester Peirce raised some important questions about the SEC’s regulatory approach, including:

• Is the SEC approach to crypto lending the best way to protect customers? She opines it is not.
• Would a framework other than the securities regulations be better suited for these products? She notes that “applying the securities regulatory framework has consequences, some of which may be unfortunate.”

Commissioner Peirce further argues that the settlement, while offering some benefits for increased transparency to customers, may stop firms from offering these products to retail customers in the United States until the company has registered a new crypto lending product on Form S-1. Preparing (including meeting all the requisite criteria), filing, and achieving effectiveness of an S-1 is often a long process, and with regulatory skepticism around crypto, it is likely to take even longer.

In addition to the S-1 registration process, the SEC order sets the precedent that firms like BlockFi cannot operate as an unregistered investment company without seeking an exemption or exclusion from registration, which will be another challenging task. When discussing this Investment Company Act registration requirement, Peirce reiterated her concern that it will do little to protect investors. As an alternative, Peirce suggested that the SEC could work with BlockFi and use its Investment Company Act 6(c) exemptive authority to craft a tailored set of conditions for exemption.

Patomak Take Aways

Statements and Settlements are the Primary Signals

This latest enforcement action highlights again that regulators are still trying to apply existing frameworks to the vastly different and evolving digital asset space. Commissioner Peirce’s  statement on the BlockFi enforcement action draws several parallels to statements by CFTC Commissioner Dawn Stump regarding CFTC settlement orders and charges against Kraken and Bitfinex around operating unregistered DCMs and FCMs while engaging in retail commodity transactions.

Despite the challenges with the regulators’ current approach, Patomak continues to believe it is important for firms operating in the digital asset space to conduct a thorough analysis of how their businesses fit into the existing rules. At present, many see little value in engaging with regulators, but informed engagement may be appropriate in some instances.

Implications for Other Digital Products

The implications of the BlockFi enforcement action for other types of digital asset products, such as digital tokens, however, appear somewhat limited. Unlike digital tokens, the features of crypto lending products like BIAs more closely align with the securities-law framework based on their clear opportunities for profit, the advertised payment of interest, and the efforts of the lending platform to generate profits.

Looking Ahead 

We are awaiting the outcome of SEC vs. Ripple which may provide some regulatory clarity. However, it will likely take some time before that case and any resulting appeals are settled.

States are also becoming involved in the enforcement regime for crypto, as evidenced by the parallel actions brought by 32 states in the BlockFi case. The industry can expect to see similar multistate enforcement actions in the future.

We also expect additional high-profile settlements from both the SEC and the CFTC. Bloomberg recently reported that the SEC is investigating other firms around their crypto-lending offerings.

How Patomak Can Help

Whether at the SEC, CFTC, or any other federal and state regulatory agency, Patomak is ready to help assess and navigate emerging risks and opportunities related to public policy developments. If you have questions, please contact Paul Watkins, Sudhir Jain, Laura Magyar, or your existing contact at Patomak.