On February 14, 2022, the Securities and Exchange Commission announced a settlement with a crypto lending company in a “first-of-its-kind enforcement action” for failing to register as an investment company under the Investment Company Act of 1940, as amended (the “Investment Company Act”). In the novel settlement, BlockFi Lending LLC (“BlockFi”) agreed to pay $100 million in penalties — $50 million of which will be paid to the SEC, and the remaining $50 million allocated to 32 different state regulators for similar charges. As part of the settlement, BlockFi has undertaken to comply with the Investment Company Act either by registering as an investment company or by proving to the SEC Staff that it is not required to do so. BlockFi has 60 days from entry of the order to comply and may obtain an extension of another 30 days. Should BlockFi successfully come into compliance, it could be the first SEC-registered entity to offer a digital asset lending product. Despite BlockFi’s groundbreaking settlement, BlockFi still faces a putative class action by investors.
In 2019, BlockFi began offering and selling BlockFi Interest Accounts (“BIAs”) to investors, through which investors loaned cryptocurrency to BlockFi in exchange for variable monthly interest payments. Investors would transfer cryptocurrency assets to a crypto wallet address assigned by BlockFi, or the investor would purchase crypto assets with fiat currency (e.g., the U.S. dollar) to invest in a BIA. BlockFi Trading, a subsidiary wholly owned by BlockFi, would then transfer the investor’s assets to BlockFi, and those assets were then held in third-party custodian wallets. Investors were allowed to withdraw the equivalent to the crypto assets “loaned” to BlockFi with certain limitations. Investors could also borrow money against the crypto assets “loaned” to BlockFi.
Against this backdrop, the SEC charged BlockFi with (1) selling unregistered securities, (2) failing to register as an investment company, and (3) making material misstatements about the risks associated with BIAs. The case is rooted in the SEC’s determination that the BIAs constitute securities. Applying both the Reves v. Ernst & Young, 494 U.S. 56, 64-66 (1990) test and SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946), the SEC’s settled action alleges that the BIAs were both “notes” and “investment contracts.” Under the four-part Reves test, the SEC contends that the BIAs are notes, finding that BlockFi sold BIAs in exchange for crypto assets “to run its lending and investment activities to pay interest to BIA investors.” The BIAs were sold to the general public and promoted as an “investment … to earn a consistent return on crypto assets and for investors to ‘build their wealth.’” Finally, the SEC found “no alternative regulatory scheme or other risk reducing factors exist with respect to BIAs.” Put another way, BlockFi sold notes because it sold investments to the broader public to expand its business operations.
Securities Offering Allegations
Under Howey, the SEC determined that the BIAs were “investment contracts” because they were sold to the public “in exchange for the investment of money in the form of crypto assets.” BlockFi then pooled the digital assets and packaged them as loan products. According to the SEC, the revenue that BlockFi earned through its lending operation and the profits of BIA investors were “linked to those of the promoter, i.e., BlockFi.” BlockFi’s multiple public statements concerning its business structure “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.” BlockFi had complete discretion concerning its lending activities and the crypto assets borrowed from investors, telling investors that “[BlockFi] managed the risks involved.” Given that the BIAs were securities, the SEC charged Blockfi with failing to register them with the SEC.
Investment Company Allegations
The determination that the BIAs were securities opened the door to charging BlockFi with failing to register as an investment company. The SEC contends that “BlockFi operated as an unregistered investment company” due to its issuance of securities and its engagement in the practice of “investing, reinvesting, owning, holding, or trading in securities and owning investment securities” under Section 3(a)(2) of the Investment Company Act. In December 2020, BlockFi held around $4.8 billion in total assets including loans, cryptocurrency asset trusts, and intercompany receivables. Together, those assets constituted more than 40% of BlockFi’s total assets, which the SEC asserted meant that BlockFi owned “investment securities” under Section 3(a)(2) and operated as an “investment company” under Section 3(a)(1)(C) of the Investment Company Act. The SEC charged BlockFi with violating Section 7(a) of the Investment Company Act, which makes it unlawful for an unregistered investment company to, among other things, directly or indirectly, “‘[o]ffer for sale, sell, or deliver after sale, by the use of the mails or any means or instrumentality of interstate commerce, any security or any interest in a security’ or ‘engage in any business in interstate commerce.’” 15 U.S.C. § 80a-7.
The SEC noted that BlockFi generally failed to satisfy any statutory exemptions or exclusions from the definition of an investment company and expressly rejected BlockFi’s assertion that it satisfied the definition of the “market intermediary” exclusion under Section 3(c)(2), in part, because “its principal source of gross income was not derived from intermediary business and related activities; and [BlockFi] did not regularly engage in the business of entering into transactions on both sides of the market for a financial contract.”
Significantly, BlockFi’s undertakings with respect to the Investment Company Act findings are bifurcated into either filing a notification of registration as an investment company or “Completing steps such that BlockFi is no longer required to be registered under Section 7(a) of the Investment Company Act and providing the Commission staff with sufficient credible evidence that it is no longer required to be registered under the Investment Company Act.” The path BlockFi chooses to pursue with respect to these undertakings will likely inform how other crypto lending platforms may seek to comply with the Investment Company Act moving forward. Finally, the SEC contends that BlockFi made a “materially false and misleading statement on its website from March 4, 2019 to August 31, 2021, concerning its collateral practices and therefore, the risks associated with its lending activity.” According to the SEC, BlockFi on multiple occasions stated that its institutional loans were “typically” over-collateralized when that statement was false as it related to most of BlockFi’s institutionalized loans. In fact, from 2019 through 2021, at most, approximately 24% of BlockFi’s institutional loans were over-collateralized. Because of its misrepresentations concerning the level of risk attached to its products, the SEC determined that BlockFi’s investors “did not have complete and accurate information with which to evaluate the risk that, in the event of defaults by its institutional borrowers.”
Notably, on the same day the SEC announced its settlement with BlockFi, Commissioner Hester M. Peirce issued a statement dissenting from the Settlement’s approach to crypto lending. While Commissioner Peirce agreed that is important to prove transparency to customers who lend crypto assets, she stated that she did not think that the SEC’s approach was the best way to protect crypto lending customers. First, Commissioner Peirce noted that it will take significant time for BlockFi to have a Form S-1 approved by SEC’s staff. She also expressed doubts that BlockFi could successfully register as an investment company, given that it issues debt securities. Commissioner Peirce suggested that the SEC should “work with BlockFi under [the SEC’s] Section 6(c) exemptive authority to craft a bespoke set of conditions that make sense in this context.” She noted that the Section 6(c) process allowed for better public input, which is important given the impact that the BlockFi settlement will have on competing crypto lenders.
Class Action Lawsuit
Against this backdrop, on March 1, 2022, a BlockFi investor filed a putative class action lawsuit in the U.S. District Court for the District of New Jersey. The complaint asserts causes of action for selling unregistered securities under Section 5 of the Securities Act of 1933 and Sections 25110 and 25503 of the California Corporations Code, as well as a cause of action for unjust enrichment. See John Mangano v. BlockFi et al., case number 2:22-cv-01112. Thus, although BlockFi may be on a path to resolving its issues with the SEC, it still must contend with investors.
As the cryptocurrency markets continue to develop, and as the SEC remains steadfast in viewing most cryptocurrencies as securities under the Reves and Howey tests, we can expect to see the continued expansion of SEC enforcement cases into new areas of the securities laws. Thus, as in 2021, when the SEC brought novel cases against cryptocurrency exchanges for failing to register as an exchange, we can expect 2022 to bring additional novel cases against crypto-lending platforms for failing to register as an investment company. We can also expect to see more class actions by crypto investors.
 While BlockFi is the first SEC settlement where a respondent has undertaken to register as an investment company, prior SEC settlements have involved undertakings to register crypto assets as securities. See, e.g., In the Matter of CarrierEQ, Inc. DBA Airfox, Admin. File No. 3-18898 (https://www.sec.gov/litigation/admin/2018/33-10575.pdf); In the Matter of Paragon Coin, Inc., Admin File No. 3-18897 (https://www.sec.gov/litigation/admin/2018/33-10574.pdf)
 Section 3(c)(2) of the Investment Company Act defines a “market intermediary” as “any person that regularly holds itself out as being willing contemporaneously to engage in, and that is regularly engaged in, the business of entering into transactions on both sides of the market for a financial contract or one or more such financial contracts,” and whose “gross income normally is derived principally from such business and related activities.”
 Peirce, Hester M., Statement on Settlement with BlockFi Lending LLC (February 14, 2022) available at https://www.sec.gov/news/statement/peirce-blockfi-20220214?utm_medium=email&utm_source=govdelivery. Ms. Pierce’s statement also addresses BlockFi’s misrepresentations, which she agrees were “serious,” but thought the penalty itself was disproportionate.
 Hailey Konnath, BlockFi Account Holders File Suit In Wake of $100M SEC Deal, Law360 (March 1, 2022, 10:45 PM EST), https://www.law360.com/articles/1469667/blockfi-account-holders-file-suit-in-wake-of-100m-sec-deal.