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The SEC Begins Regulation of Cryptocurrency Interest Account Offerings

On June 29, 2021, a major cryptocurrency exchange (the “Crypto Exchange”) announced a new program called “Lend” in which it proposed offering customers a 4% interest rate on cryptocurrency tied to USD.[1] But on September 7, 2021, the Crypto Exchange announced that the U.S. Securities and Exchange Commission (the “SEC”) had issued a Wells notice, a formal notice that the agency was planning to sue them for offering the program.[2] While the Crypto Exchange took the position that it was unclear why the SEC had issued this notice, it was evident from public comments that the SEC had been contemplating whether investment cryptocurrency programs should be classified as securities.[3]  On September 20, 2022, the Crypto Exchange announced that it was dropping its Lend program.

This post will discuss the two cases that the SEC relied on as the basis for issuing its Wells Notice to the Crypto Exchange, as well as the future for these types of programs.

Background

Federal law defines a security extremely broadly, including notes, stocks, investment contracts, and even fractional undivided interests in oil, gas, or other mineral rights.[4] Any public offers or sales of securities must be registered with the proper authorities.

The Crypto Exchange’s Lend program was advertised as a “high-yield alternative to traditional savings accounts” and offered 4% interest on a USD Coin (“USDC”), which was a “stablecoin that [could] always be redeemed one-to-one for USD $1.00.”[5] Customers could purchase USDC with money, lend the USDC to the Crypto Exchange, and earn 4% interest on the coin. the Crypto Exchange was not alone in offering this type of product; at the time, multiple lending platforms offered similar interest account offerings.[6]  

The SEC accused the Crypto Exchange’s Lend program of offering an unregistered sale of securities thereby violating registration requirements. The SEC saw the Crypto Exchange’s Lend program as both an investment contract and a note, classifications that would bring the Lend program under the purview of federal securities law. In doing so, the SEC relied on two Supreme Court cases: S.E.C. v. Howey, for determining if a product is an investment contract, and Reves v. E&Y, for determining if a product is a note.

S.E.C. v. Howey, a decision from 1946, involved land sales and service contracts for citrus groves in Florida, but more importantly, set out a three-prong test for defining an investment contract.[7] Under the eponymous Howey test, an investment contract is “a contract, transaction or scheme whereby a person [1] invests his money in [2] a common enterprise and [3] is led to expect profits solely from the efforts of the promoter or a third party . . . .”[8]

Reves v. E&Y, a decision from 1990 about a farmer’s cooperative and an accounting firm, established “a presumption that every note is a security,” but also noted that this presumption could be rebutted if the note bore a “family resemblance” to excepted categories.[9] In order to provide more guidance, the Court established “the family resemblance test” to determine whether a note is a security.[10] The Court set out four factors to assess when evaluating a note: [1] the motivations of the seller and the buyer, i.e. whether the seller is looking to raise money and the buyer is looking to profit, [2] the plan of distribution and whether it involves common trading for speculation or investment, [3] the reasonable expectations of the investing public, and [4] whether there is another regulatory scheme that would render the application of the Securities Acts unnecessary.[11]

In a speech on August 3, 2021, SEC Chairman Gary Gensler stated that he believed that crypto lending platforms “implicate[d] the securities laws” and that if these lending platforms were found to be offering securities, they “fall[] into SEC jurisdiction.”[12] About one month later, through its Wells notice to the Crypto Exchange, the SEC revealed the legal bases for its conclusion. The SEC has taken the position that Howey and Reves provide bases for determining whether cryptocurrency interest account offerings are securities.

The Future

The Crypto Exchange disputed the idea that the Lend product offering was a security, arguing that its Lend program was neither an investment contract nor a note.[13] The Crypto Exchange asserted that customers would not be engaging in traditional “investing,” “but rather lending the USDC they hold on the Crypto Exchange’s platform in connection with their existing relationship.”[14] As a result, the Crypto Exchange stated that it would not be launching Lend until at least October 2021, but it “continues to welcome additional regulatory clarity.”[15]

The Crypto Exchange’s Lend program never made its debut. On September 17, 2021, the Crypto Exchange disclosed that it would not be launching the program.[16] Days after the Lend program’s launch was cancelled, SEC Chairman Gary Gensler insisted that cryptocurrency trading and lending platforms “should figure out how to register [within] the investor protection remit” and stated that he “fear[ed] we will keep bringing these enforcement cases.”[17]

And in fact, the SEC did just that. On February 14, 2022, the SEC charged BlockFi Lending LLC (“BlockFi”) with failing to register the offers and sales of its cryptocurrency lending product, BlockFi Interest Accounts (“BIAs”).[18] BlockFi’s BIAs operated in a similar manner to the Crypto Exchange’s proposed Lend program. The BIAs offered consumers the chance to earn interest on their cryptocurrencies and advertised annual percentage yields of up to 9.25%.[19] Rather than relying on either classifying the BIAs as an investment contract or a note, the SEC used both Howey and Reves. The SEC’s order found that the BIAs were securities because they were notes under Reves and that BlockFi had offered and sold the BIAs as investment contracts under Howey.[20]

BlockFi agreed to a settlement with the SEC that required it to pay a $50 million penalty to the SEC, $50 million to 32 states to settle claims in those states, cease its unregistered offers and sales of its lending product, and attempt to bring its operations into compliance with federal securities law within 60 days.[21] On the same day the settlement was announced, BlockFi announced that it would be launching a new product, BlockFi Yield (“Yield”).[22] Much like the BIAs, Yield will offer consumers a chance to earn interest on their crypto assets, but it will be officially registered with the SEC as a security.[23]

The Crypto Exchange and BlockFi have provided other cryptocurrency platforms a preview of the SEC’s intentions in this area. Recent reports indicate that the SEC is continuing to investigate unregistered cryptocurrency interest account offerings, and while those platforms have not yet registered their products as securities, the SEC scrutiny is unlikely to stop.[24] With the BlockFi settlement, Gurbir S. Grewal, Director of the SEC’s Division of Enforcement, gave insight into the future of cryptocurrency lending programs, warning that platforms “should take immediate notice of today’s resolution and come into compliance with the federal securities laws.”[25]


[1] Update as of 5pm ET, Friday, September 17th: we are not launching the USCD APY program announced below, Coinbase (June 29, 2021), https://blog.coinbase.com/sign-up-to-earn-4-apy-on-usd-coin-with-coinbase-cdad79e5f5eb.

[2] Paul Grewal, The SEC has told us it wants to sue us over Lend. We don’t know why., Coinbase (Sept. 7, 2021), https://blog.coinbase.com/the-sec-has-told-us-it-wants-to-sue-us-over-lend-we-have-no-idea-why-a3a1b6507009. A Wells notice is a letter that the SEC sends to inform the recipient that the agency is planning to bring an enforcement action against them. The Wells notice sets out the charges that the SEC intends to bring against the recipient and offers the recipient a chance to submit a written statement to the ultimate decision maker. Wells Notice, Legal Information Institute, https://www.law.cornell.edu/wex/wells_notice (last visited Mar. 7, 2022).

[3] Gary Gensler, Remarks Before the Aspen Security Forum, U.S. Sec. & Exch. Comm’n Commission (Aug. 3, 2021), https://www.sec.gov/news/public-statement/gensler-aspen-security-forum-2021-08-03.

[4] 15 U.S.C.S. § 77b (a)(1).

[5] Update as of 5pm ET, Friday, September 17th: we are not launching the USCD APY program announced below, Coinbase (June 29, 2021), https://blog.coinbase.com/sign-up-to-earn-4-apy-on-usd-coin-with-coinbase-cdad79e5f5eb.

[6] Joe Light et al., Crypto Lending Firms Celsius Network, Gemini Face SEC Scrutiny, Bloomberg (Jan. 26, 2022, 1:44 PM EST), https://www.bloomberg.com/news/articles/2022-01-26/crypto-lending-firms-celsius-network-gemini-face-sec-scrutiny; Benjamin Bain et al., BlockFi Faces SEC Scrutiny Over High-Yield Crypto Accounts, Bloomberg (Nov. 17, 2021, 8:00 AM EST), https://www.bloomberg.com/news/articles/2021-11-17/blockfi-faces-sec-scrutiny-over-high-yielding-crypto-accounts.

[7] S.E.C. v. W. J. Howey Co., 328 U.S. 293 (1946).

[8] Id. at 298-99.

[9] These categories are: (1) notes delivered in consumer financing, (2) notes secured by a mortgage on a home, (3) short-term notes secured by a lien on a small business or some of its assets, (4) notes evidencing a “character” loan to a bank customer, (5) short-term notes secured by an assignment of accounts receivable, (6) notes which simply formalize an open-account debt incurred in the ordinary course of business, and notes evidencing loans by commercial banks for current operations. Reves v. Ernst & Young, 494 U.S. 56, 65-66 (1990) (citing Exch. Nat’l Bank of Chicago v. Touche Ross & Co., 544 F.2d 1126, 1138 (2d Cir. 1976) and Chem. Bank v. Arthur Andersen & Co., 726 F.2d 930, 939 (2d Cir. 1984)).

[10] Reves v. Ernst & Young, 494 U.S. 56, 65-66 (1990).

[11] Id. at 66-67.

[12] Gary Gensler, Remarks Before the Aspen Security Forum, U.S. Sec. & Exch. Comm’n Commission (Aug. 3, 2021), https://www.sec.gov/news/public-statement/gensler-aspen-security-forum-2021-08-03.

[13] Paul Grewal, The SEC has told us it wants to sue us over Lend. We don’t know why., Coinbase (Sept. 7, 2021), https://blog.coinbase.com/the-sec-has-told-us-it-wants-to-sue-us-over-lend-we-have-no-idea-why-a3a1b6507009.

[14] Id.

[15] Id.

[16] Update as of 5pm ET, Friday, September 17th: we are not launching the USCD APY program announced below, Coinbase (June 29, 2021), https://blog.coinbase.com/sign-up-to-earn-4-apy-on-usd-coin-with-coinbase-cdad79e5f5eb.

[17] Tom Zanki, Crypto Platforms To See More SEC Crackdowns, Gensler Says, Law360 (Sept. 21, 2021, 6:06 PM EDT), https://www.law360.com/articles/1423841/crypto-platforms-to-see-more-sec-crackdowns-gensler-says

[18] BlockFi Agrees to Pay $100 Million in Penalties and Pursue Registration of its Crypto Lending Product, U.S. Sec. & Exch. Comm’n Commission (Feb. 14, 2022), https://www.sec.gov/news/press-release/2022-26.

[19] Ryan Browne, Peter Thiel-backed crypto start-up BlockFi to pay $100 million in settlement with SEC, 32 states, CNBC (Feb. 14, 2022, 7:41 PM EST), https://www.cnbc.com/2022/02/14/crypto-start-up-blockfi-to-pay-100m-in-settlement-with-sec-32-states.html.

[20] S.E.C. Order, In the Matter of BlockFi Lending LLC, File No. 3-20758,  (Feb. 14, 2022) , https://www.sec.gov/litigation/admin/2022/33-11029.pdf.

The SEC opinion applied the Reves test and found that [1] BlockFi offered the BIA program for the general use of its business and purchasers bought the BIAs to receive interest, [2] BIAs were offered and sold to a broad segment of the general public, [3] BlockFi promoted the BIAs as an investment, and [4] no alternative regulatory scheme or other risk reducing factors applied to the BIAs. Id. at 8.

The SEC opinion then applied the Howey test and found that [1] BlockFi sold BIAs in exchange for investment of money in the form of crypto assets, [2] BlockFi pooled the investors’ crypto assets and that each investors’ returns were a function of the pooling of the loaned crypto assets, and [3] 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.” Id. at 8-9.

[21] BlockFi Agrees to Pay $100 Million in Penalties and Pursue Registration of its Crypto Lending Product, U.S. Sec. & Exch. Comm’n Commission (Feb. 14, 2022), https://www.sec.gov/news/press-release/2022-26.

[22] Regulatory Developments, BlockFi (Feb. 14, 2022), https://blockfi.com/regulatory-developments/.

[23] Id.

[24] Joe Light et al., Crypto Lending Firms Celsius Network, Gemini Face SEC Scrutiny, Bloomberg (Jan. 26, 2022, 1:44 PM EST), https://www.bloomberg.com/news/articles/2022-01-26/crypto-lending-firms-celsius-network-gemini-face-sec-scrutiny.

[25] BlockFi Agrees to Pay $100 Million in Penalties and Pursue Registration of its Crypto Lending Product, U.S. Sec. & Exch. Comm’n Commission (Feb. 14, 2022), https://www.sec.gov/news/press-release/2022-26.