Banking

States object to BlockFi’s interest-bearing account

The fintech BlockFi has been told by four states to stop offering a product that looks like a high-yield savings account.

The acting attorney general of New Jersey, Andrew Bruck, ordered the Jersey City company on July 20 to stop providing the BlockFi Interest Account, in which customers have placed $14.7 billion of bitcoin, ether and other cryptocurrencies in exchange for promises of healthy returns — including a 7.5% annual percentage yield as of Wednesday. Within three days of the New Jersey action, regulators in Alabama, Texas and Vermont raised concerns about the account.

Why? The states say they are concerned about the emergence of BlockFi and other startups like it that seek to reinvent traditional financial products without working within the law or established regulatory frameworks. BlockFi is vague about what it does with customers’ money to earn that return, state officials say. The BlockFi account is not a bank savings account backed by the Federal Deposit Insurance Corp., nor is it an investment covered by the Securities Investor Protection Corp. It’s actually an unregistered security that leaves investors exposed to risk, state officials contend.

BlockFi did not respond to a request for an interview. In a tweet on July 22, the company said it’s speaking with multiple regulators to demonstrate that “the BlockFi Interest Account is not a security and should not be regulated as one.”

“We firmly believe that the BIA is lawful and appropriate for crypto market participants, and we remain steadfast in our commitment to fight for consumers’ rights to earn interest on their crypto assets,” the tweet said. “We welcome discussions with regulators and believe that appropriate regulation of this industry is key to its future success.”

BlockFi — whose main business is loaning money to borrowers to cryptocurrency holders — has not shunned regulators, according to Michelle Gitlitz, global head of Crowell & Moring’s Blockchain and Digital Assets practice. It has obtained money transmitter and lending licenses in several states, she said.

“This isn’t an unregulated company,” said Gitlitz, who isn’t affiliated with BlockFi. “I commend BlockFi on being transparent about the fact that they’re speaking with the regulators and they’re not disputing that appropriate regulation is key to success. Now the regulators are saying, you may have those licenses and you may be registered as a federal money services business, but we also believe that you’re offering unregistered securities.”

As a crypto lender, BlockFi is one of several young tech companies that make loans using bitcoin or other cryptocurrencies as collateral. One example is Denver-based Salt Lending, which in September settled charges by the Securities and Exchange Commission that it conducted an unregistered initial coin offering of $47 million of digital tokens. Another is Unchained Capital, an Austin, Texas, company that provides financial services to cryptocurrency holders (and that registered its equities offering with the SEC). A third, London-based Nexo, says it has 1.5 million customers of its cryptocurrency borrowing platform.

All these companies let cryptocurrency investors leverage their crypto holdings for some purpose, such as to buy real estate. All present themselves as lower-cost, more efficient alternatives to bank loans. Nexo’s tagline is, “Disrupting the financial system, one bit at a time.” BlockFi calls itself “The Future of Finance.”

What bothers the states

According to Bruck, BlockFi pools the cryptocurrency it receives through its interest account to fund its cryptocurrency lending operations and proprietary trading, and the accounts are really unregistered securities.

“Our rules are simple: If you sell securities in New Jersey, you need to comply with New Jersey’s securities laws,” Bruck said. “No one gets a free pass simply because they’re operating in the fast-evolving cryptocurrency market. Our Bureau of Securities will be monitoring this issue closely as we work to protect investors.”

Bruck pointed out that money in BlockFi’s interest-bearing accounts is not protected by the FDIC or the SIPC.

“Cryptocurrency investment products offered and sold on decentralized finance platforms carry significant risks, even beyond those associated with the volatility of cryptocurrency,” said Kaitlin Caruso, acting director of the New Jersey Division of Consumer Affairs. “Platforms like BlockFi may mirror the traditional financial structures that we know and trust, but in reality they can leave investors extremely vulnerable.”

A day after the New Jersey order came out, Alabama Securities Commission Director Joseph Borg issued a show-cause order that gives BlockFi 28 days to demonstrate why it shouldn’t be directed to cease and desist from selling unregistered securities in the state. Like New Jersey officials, Borg said BlockFi had been funding its cryptocurrency lending operations and proprietary trading at least in part through the sale of unregistered securities in violation of securities law.

The next day, the Vermont Department of Financial Regulation issued a similar 30-day show-cause order against BlockFi. The department said it had been asking the company about its interest-bearing accounts since August 2020, when BlockFi Lending applied for a Vermont lender license, and that it had not received a satisfactory response.

That same day, the Texas State Securities Board issued notice that it plans to hold a hearing on Oct. 13 about whether to propose a cease-and-desist order against BlockFi. The Texas notice also discussed BlockFi Interest Accounts and the fact that they are not FDIC or SIPC insured and that BlockFi has not registered them with the SEC or the Texas Securities Board.

How is this a security?

At first blush, an account that pays interest on cryptocurrency holdings looks and feels nothing like company stock. But the idea that it is a security is not far-fetched, according to Preston Byrne, partner at New York-based Anderson Kill.

“The United States has an all-encompassing regime when it comes to the sale of investment products and those investment products being treated as securities under securities law,” he said. “The seminal case on the matter concerned the production of oranges from an orange grove where oranges were substituted for investments.”

This is a reference to SEC v. W. J. Howey Co., in which the U.S. Supreme Court held that the offer of a land sales and service contract was an investment contract under the Securities Act of 1933. The case, in which William Howey sold portions of his orange groves to buyers who leased the land back to him in hopes of profit, resulted in the so-called “Howey test” courts use to determine whether an instrument qualifies as an investment contract. It defined an investment contract as a “scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”

In another frequently cited case, in the 1960s, a Utah court determined that Continental Marketing’s sales of live beavers to investors with the promise that the beavers would rise in value because they would breed more beavers involved investment contracts and therefore were legally securities.

“It’s certainly not an unreasonable conclusion for state regulators to draw” that BlockFi’s interest-bearing accounts could be considered a security, Byrne said.

What the states are likely looking for is disclosure for investors, he said.

“The purpose of registration is that it’s a disclosure regime,” Byrne said. “The SEC doesn’t control what investments people bring to the market and sell to the public. That’s up to people who are actually marketing those products. What it does is ensure that there’s a disclosure regime and a reporting regime in relation to the product. That’s why you file a registration statement and then do quarterly filings thereafter.”

Future of BlockFi?


BlockFi’s approach to selling interest-bearing savings products may be short-lived, Byrne predicted. If a company that is not a bank offers a high-yield account, that is considered a security, he said.

“It’s really easy for a business that’s facilitating transactions between various counterparties to stumble into the regulated space,” Byrne said. “Startups are not geared to be financial institutions. Startups are meant to be nimble and not have complicated and burdensome compliance functions. So a lot of startups have looked at this and said, we can intermediate all of these transactions and we’ll do it much more efficiently than traditional banks because we don’t have the overhead. In so doing, a lot of startups inadvertently cross over from nonregulated into regulated territory. That’s where a lot of the regulatory problems now come from, particularly in the crypto lending space.”

Gitlitz does not foresee BlockFi having to shut down its interest-bearing accounts but says the company and others like it will have to figure out a way to provide investor and consumer protection.

“If you’re in traditional financial services, there are certain rules and regulations that apply to you,” Gitlitz said. “And if you’re in decentralized finance there are certain rules and regulations that you may think don’t apply to you, but they very well may.”



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