For the past several years, investors around the world who are interested in owning and holding certain cryptoassets for the long term have had the opportunity to deposit their assets with various companies and protocols and earn interest. One such company is CoinLoan, based in Europe and regulated under applicable EU financial law. It offers interest payments of up to 12.3% APY (annual percentage yield) and has a history of 100% on-time payments since its program was launched in 2018. Hodlnaut, headquartered in Singapore, similarly operates in compliance with Singapore’s Payment Services Act; as of January 25, 2022, it was in the process of seeking a Major Payment Institution license. It offers up to 12.73% APY on six supported cryptoassets. These kinds of crypto lending programs are widely available in many places around the globe.
Coinbase and BlockFi Crypto Lending
In June 2021, Coinbase, a publicly held company that operates the largest U.S.-based crypto exchange, announced plans to allow its customers, most of whom are in the U.S., to earn 4% interest on deposits of a specified cryptoasset through a new “Coinbase Lend” program. Although lower than rates offered elsewhere, this was considerably higher than anything available from conventional financial institutions and therefore gathered a significant level of interest from Coinbase customers. Unfortunately for those interested customers, Coinbase apparently received a Wells Notice from the SEC in September 2021, indicating the SEC had determined the planned program likely violated the federal securities laws due to it involving an illegal sale of unregistered, non-exempt securities. The SEC apparently declined to explain if it was treating the Lend program as involving the sale of investment contracts under the test originally announced by the U.S. Supreme Court in SEC v. W.J. Howey, 328 U.S. 293 (1946), or as notes under the family resemblance test announced in Reves v. Ernst & Young, 494 U.S. 56 (1990).
Although Coinbase publicly reported that it disagreed with the SEC’s conclusion, the company discontinued its planned crypto lending program for U.S.-based customers. The company has since announced plans to let users in other countries earn interest on some deposited cryptoassets, but that option will not be available to U.S. customers.
A few months later, the SEC shut down another crypto lending company operating in the U.S., announcing on February 14, 2022, that it had settled its claims against BlockFi, where a record-setting $100 million fine was imposed on the company for issuing its BlockFi Interest Accounts (BIAs) without first registering them for sale under the Securities Act of 1933 (the ’33 Act). According to the SEC, BlockFi held approximately $14.7 billion in BIA investor assets as of March 31, 2021 and had nearly 400,000 U.S. investors. Citing both Reves and Howey, the SEC’s order found that BlockFi’s lending product was a security and that future sales were prohibited unless and until the company registered its product with the SEC. BlockFi promptly discontinued offering its BIAs to new U.S. customers and stopped accepting new deposits even from existing customers in the U.S., although the program is still available elsewhere.
While there are some significant differences between the planned Coinbase Lend program and BlockFi BIAs, including the way they were described and promoted by the two companies, the outcome in both cases was the same: The decision of whether to risk depositing crypto and thereby earn a rate of interest significantly higher than rates available from conventional financial institutions was taken away from U.S. citizens in the name of protecting them. The rationale for deciding for the public was that these programs involved the sale of securities under a statute that was written nearly nine decades ago, when the world and its financial systems were vastly different from what we see today.
Why Were These Lending Products Deemed to be “Securities”?
Excluding one earlier action that focused on a completely fraudulent scheme by BitConnect and its founder and top promoter, the SEC’s first public action involving crypto lending was against Coinbase’s proposed Lend product, despite the fact that Coinbase had not only been engaged in ongoing discussions with the SEC for months, but was also unusually transparent in its activities as a publicly traded company. Moreover, it was not until the next year that the action against BlockFi was announced and settled, leaving a number of other companies offering crypto lending services in the U.S. uncertain about whether such activities are permissible.
In none of these actions was it clear whether the SEC was treating the lending program at issue as involving investment contracts or notes, citing both tests despite a clear admonition from the Supreme Court in Reves to avoid doing that. The Court in Reves explicitly “reject[ed] the approaches of those courts that have applied the Howey test to notes,” suggesting that in order to act in a manner “consistent with Congress’ intent” the appropriate test should be applied to each distinct category of instruments included within the definition of security. While SEC Chair Gary Gensler has repeatedly claimed that the scope of the federal securities laws is “clear,” the SEC’s failure to explain which test applies to these arrangements calls his assertion into question.
In fact, a more detailed consideration of the Coinbase Lend proposal suggests that the SEC’s conclusion is questionable. It certainly appears that Coinbase Lend would have involved the issuance of notes, albeit not necessarily notes that qualify as securities. While “notes” is not a defined term in the ’33 Act, it is generally understood that a note is the obligation of one person to repay a sum to another. This describes exactly the relationship between Coinbase and anyone participating in the Lend program: Coinbase would have been obligated to repay the value of deposited cryptoassets (with interest) to participants on demand. Thus, the appropriate test for evaluating the proposal should have been the Reves test for notes as securities.
The Supreme Court of course realized that only some notes should be regulated as securities, and in Reves set out a multi-factor test in order to ascertain which notes are within the ambit of the federal securities laws. Under Reves, one of the critical inquiries is supposed to be how the instrument is perceived by the purchasers. Coinbase continually explained that it planned on offering interest payments on deposit accounts, rather than facilitating any form of investment in the business itself. Moreover, there was never an express or even implied promise that customers would be entitled to a share in any excess profits that Coinbase might have earned. There were instead direct comparisons to other kinds of deposit accounts, albeit with the warning that Coinbase Lend would not be insured by any federal agency, such as the Federal Deposit Insurance Corporation (FDIC). The notes in Reves had explicitly been marketed as investments.
In addition, another part of the Reves test requires a consideration of whether other regulatory schemes reduce the risk of the investment. First, Coinbase is a public reporting company, meaning that there was plenty of financial data about the company, which promised to guarantee repayment of deposited amounts. In addition, Coinbase is regulated by FinCEN (the Financial Crimes Enforcement Network) as a money transmitter, subject to state licensing in every state in which it operates, and has obtained a BitLicense in New York and operates under its terms. Each of these regulatory schemes provide different levels of assurance about the stability of the company and the potential risks associated with depositing funds with it. The Court in Reves had noted that there were no other applicable regulations in that case.
Even if the appropriate test is somehow deemed to be the Howey investment contract analysis, it is not at all clear that the elements of that approach would have been met either. Given that the amounts on deposit with Coinbase truly would have been on “loan” to the company, there is a considerable question as to whether there would have been an “investment,” which is the first requirement. The second element of the Howey test asks for proof of a common enterprise, which could have been missing if that term requires either horizontal commonality (a link between the fortunes of the “investor” and the issuer) or narrow vertical commonality (requiring that the investor’s returns depend on the issuer’s profits). Since the Supreme Court has declined to resolve a circuit split as to the meaning of the second element, it is not surprising that there is confusion over its application. The third element of the Howey test asks if there is an expectation that profits will be earned by investors, and the Supreme Court recognized in Reves that “profit sharing under Howey is more narrowly defined,” involving the expectation that investors will either share in capital appreciation or earnings.
While BlockFi was not as clear in the way it promoted or described its BIAs, particularly at first, much of this analysis should apply to its product as well. Admittedly, BlockFi is not a reporting company and has not gone to the trouble of obtaining a BitLicense, but it is still subject to FinCEN oversight and regulation by a number of states as a money transmitter. Nonetheless, the ultimate conclusion of the SEC that BIAs were securities is far from clear-cut, notwithstanding BlockFi’s settlement with the SEC, which simultaneously resolved potential or ongoing investigations with thirty-two state securities commissions.
Impact of the SEC’s Actions
Obviously, the SEC’s actions directly impacted both Coinbase and BlockFi. Coinbase discontinued its planned Lend product before it was ever launched, and BlockFi stopped accepting deposits from U.S. customers. Neither company completely halted operations or stopped lending plans or programs elsewhere. In fact, the major impact of the SEC’s actions appears to have been to restrict U.S. citizens from earning interest on deposited cryptoassets. It is entirely possible that continued activity in this space by the SEC could make it completely impossible for U.S. citizens or residents to participate in or benefit from crypto lending programs.
Despite regular pronouncements from the SEC that it “does not evaluate the merits of any offering,” the effect of these crypto lending enforcement efforts is that the opportunity to earn interest on crypto deposits is progressively being made less and less available to U.S.-based customers. This certainly seems like a ruling that these programs, even in the absence of fraud, are lacking in merit. In effect, the SEC has substituted its judgment for that of the individual market participants as to the levels of acceptable risk for the promised rates of return.
The mission of the SEC is to protect investors while facilitating capital formation and maintaining fair, orderly, and efficient markets. Not only does shuttering crypto lending programs hinder capital formation for the underlying businesses, but it has also little to do with protecting investors who are essentially deprived of the opportunity to make financial decisions for themselves. Moreover, allowing crypto businesses to offer financial services that mimic similar services available in legacy financial settings would seem to be a more constructive way of ensuring fair and orderly markets. Instead, the SEC seems to have embarked on a path that does more to insulate legacy financial institutions from the potential competition that innovative technology could facilitate and less to protect those it has been directed to serve.
Carol Goforth is a University Professor and the Clayton N. Little Professor of Law at the University of Arkansas (Fayetteville). She has written a number of legal articles focusing on cryptoassets and has been cited in Forbes, Fortune, Reuters Legal, and elsewhere. Along with Yuliya Guseva, she is the author of West Academic’s Regulation of Cryptoassets (2d Ed., 2022).
This post is adapted from her paper, “Neither a Borrow Nor a Lender Be – Analyzing the SEC’s Reaction to Crypto Lending,” forthcoming in 18 U. Mass. L. Rev. (2022), and currently available on SSRN.
The views expressed in this post are those of the author and do not represent the views of the Global Financial Markets Center or Duke Law.