The cryptocurrency and blockchain industry has developed over the past decade with a large and increasingly glaring void: What regulations ultimately will apply and who will regulate the space? Much regulatory focus to date has been on policing fraud through regulatory and civil enforcement cases.1 Regulation by enforcement is not the shortest path to clarity, however, as the industry can only learn what not to do one case at a time.
Many fact patterns from this approach involve obvious violations of existing law, including money laundering, grand larceny and overt violations of the securities laws.2 However, most legitimate blockchain-based businesses are complicated and nuanced, and the industry has suffered from a dearth of official guidance on what’s OK and what’s not. Two recent developments have given the blockchain industry a preview of what regulation might look like as the industry matures.
The first is a proposed amendment to Rule 3b-16 of the Securities Exchange Act of 1934 that significantly expands the definition of an “exchange” and that could encompass so-called decentralized crypto exchanges, requiring them to comply with the broker-dealer registration and compliance regime or to register as national securities exchanges. The second is a settlement by the Securities and Exchange Commission (SEC or the Commission) Division of Enforcement and state securities regulators with a customer account provider whose customers earn compensation in the form of cryptocurrency. The settlement provides that the account, which calls for “interest payments,” constitutes an unregistered securities offering in violation of Section 5 of the Securities Act of 1933, and that the entire account structure meets the definition of an “investment company” under the Investment Company Act of 1940. Importantly, the settlement does not address more generally whether cryptocurrency or tokens as payment are securities, only that the account itself constitutes an “investment contract” that is a security under current law.
“Exchange” Defined
On January 26, 2022, the SEC released a proposal that would expand the definition of an “exchange.”3 The current rule requires that to be an exchange, a portal must bring together “orders.” In simple terms, an order is a binding indication of interest that can be executed on the site. The proposed amended rule expands this to include non-order trading interest and other indications of a willingness to buy or sell a security. The rule amendment also removes the requirement that to be an exchange, a system must provide a trading facility or establish rules for trading. The new amendment will include “communication protocols” (which is not defined) as part of the definition. The Commission gives examples of communication protocols that include negotiation systems, conditional order systems and request for quote systems where buyers and sellers can come together, connect with each other and execute trades on or off the site. The Commission noted that communication protocols do not fall under the current rules because they do not offer firm orders to be executed, but they function as exchanges and the public would benefit from having them regulated.
This will have the effect of regulating the peer-to-peer trading market under the broker-dealer system and require digital asset protocols to register as alternative trading systems (ATS) or require such protocols to register as a national securities exchange under Section 6 of the Securities Exchange Act.4
Significantly, to be covered by the rule, the subject of the trade must be a security. But it is difficult to know at this juncture whether many cryptocurrencies and tokens that are currently listed by blockchain-based trading firms are securities. It is likely that many tokens are securities, and in the absence of a clear “use case” justification that deviates from the Howey and Reeves “common enterprise” standards, many law firms and others in the blockchain bar take the view that most tokens are securities and must be offered and traded in compliance with federal and state securities laws.
The proposal appears to be poised for passage, as it is 654 pages and has an unusually short 30-day comment period. Operators of communications portals that act as exchanges under the proposed rule will need to register as a broker-dealer and then qualify as an ATS, outsource significant operations to a registered broker-dealer, or pivot operations to function outside the new rule. It is difficult to imagine a token quotation model fashioned as a communications, indication-of-interest or request-for-quote platform that will not be covered by the new rule.5
BlockFi Settlement
On February 14, 2022, leading cryptocurrency lending firm BlockFi Lending LLC6 settled charges with the SEC and several state securities regulators regarding the offering of its BlockFi Interest Account (BIA).7 The BIA earns interest for deposited crypto assets. The form of interest is in like-kind crypto assets that the customer has on deposit, similar to a savings account at a bank. BlockFi was able to provide higher returns than standard savings accounts because it could lend the crypto deposited as collateral to institutional traders and other borrowers.
The SEC took the view that the account arrangement was an investment contract that met the test of a security under Supreme Court precedent. Under the Howey test, an investment contract is a security if it is an investment of money in a common enterprise with the expectation of profits derived solely from the efforts of others. The SEC viewed these accounts as investment contracts that paid regular returns similar to bonds in an arrangement that satisfied the Howey factors. It found that BlockFi was a common enterprise working to build returns for investors, and that the customers were relying on the efforts of BlockFi to deliver returns on their deposits.
Moreover, the SEC found that the accounts themselves were “notes” under the Reeves standard.8 Under Reeves, the Court has held that notes are securities unless they bear a strong “family resemblance” to a list of judicially crafted structures that are not securities. The SEC did not believe the accounts met the family resemblance carve-out, and thus are securities.
The tough question here is whether something that resembles an interest-bearing bank account bears enough of a resemblance to a structured note so as to be characterized as a security. Bank accounts are not securities. The settlement begins a possible expansion of the Howey and Reeves standard to include account-like structures in an unprecedented manner.
"This is the first case of its kind with respect to crypto lending platforms," SEC Chair Gary Gensler said. "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. It further demonstrates the Commission’s willingness to work with crypto platforms to determine how they can come into compliance with those laws."9
It is important to note two points in connection with the settlement:
- The settlement is just that—a settlement—and no tribunal formally adjudicated the matter of whether a BIA is a security.
- No determination has been made that the interest paid to BIA holders—cryptocurrencies such as Bitcoin and Ethereum—is a security. The settlement only covers the contracts themselves. It is a trickier question whether the cryptocurrencies are securities, with authorities split on the issue.10
Why It Matters
- The digital assets industry has been starving for regulatory certainty for more than five years on these issues. While some clarity has been provided recently, much uncertainty remains.
- The amendments to Rule 3b-16 of the Securities Exchange Act of 1934 will be costly for exchange operators. The trade-off is that the rules will be open and uniform and discourage operators from venturing overseas or engaging in evasive structuring.
- Certainty will be expensive. Compliance with the Securities Act of 1933 and the Investment Company Act of 1940 in a manner allowing widespread retail participation involves multiple complex submissions to the SEC and state securities authorities, which typically require review by the staff that can involve months of comment letters and responses.
- The BlockFi settlement is another example of regulation by enforcement. Rather than a comprehensive body of rules for everyone to follow, this provides little guidance for operators who must judge their facts against a settling respondent’s, requiring subjective decisions that could end up being too conservative or (worse) not conservative enough. Nobody knows whether the SEC staff is correct in its determination of securities status, but here we have an example of a well-advised and funded company that opted to settle the matter rather than litigate. That’s nearly as authoritative as a court precedent.
1 See, e.g., SEC Obtains Final Judgment Against Kik Interactive for Unregistered Offering (Oct. 20, 2020).
2 For example, engaging in unregistered public offerings of securities (see SEC v. Telegram Group Inc. and TON Issuer Inc.) (Oct. 11, 2019); Theft of Bitcoin from custodial wallet (see US v. Lichtenstein & Morgan) (Feb. 7, 2022)
3 Notionally, the release appears to be a technical amendment to Regulation ATS to expand the scope to include exchanges of government-backed securities.
4 There are only a handful of national securities exchanges (NYSE, Nasdaq, CBOE, regional stock exchanges) and forming and complying as a national securities exchange is extremely costly. National Securities Exchanges.
5 In an unusual move, SEC Commissioner Hester M. Peirce, a noted supporter of the blockchain community, published a dissent from the rule proposal. She notes the impossible timetable for comments and the far-reaching impact of the expansion of the definition of exchange to communication protocols. “What the staff is recommending for our consideration today is an expansion in the definition of exchange that would apply to any trading venue, including so-called communication protocol systems, for any type of security, not just for government or fixed-income securities. This change could deter innovation and dissuade new entrants from entering into the market for trading venues and execution services, but communication protocol services have become more sophisticated and now play a significant role in the trading of certain types of securities. I could have supported a proposal that allowed for careful consideration and informed comment on how this change would affect innovation and competition in this space…A final message to those who operate any service that is designed to facilitate any communication between potential buyers and sellers of any type of security: Read this release. Even if you have nothing to do with government securities or even fixed-income, or with traditional securities, read this release. Preferably as soon as it is published on the Commission’s website. It covers a lot of ground, and you should not assume that it has nothing to do with you, because it probably does.” Dissenting Statement on the Proposal to Amend Regulation ATS (Jan. 26, 2022).
6 Manatt represents BlockFi, although our representation is not related to these matters and all of the information set forth herein is publicly available and has been published by the company.
7 BlockFi Agrees to Pay $100 Million in Penalties and Pursue Registration of its Crypto Lending Product (Feb. 14, 2022).
8 Reeves v. Ernst & Young, 494 U.S. 56 (1990).
9 BlockFi Agrees to Pay $100 Million in Penalties and Pursue Registration of its Crypto Lending Product (Feb. 14, 2022).
10 See, e.g., “SEC Chair Says Bitcoin Is Not A Security” .