Recently a ‘Cease and Desist Order’ was issued against BlockFi by the securities bureau of New Jersey prohibiting any further business activity in that state for the illegal sale of unregistered securities which included its high interest paying crypto savings accounts.

Texas and Alabama are additional states which have issued similar orders subject to hearings with BlockFi representatives, where BlockFi will be required to show cause why such orders should not be issued, and that they have not in fact been selling unregistered securities illegally within those states.

How did we get to this point and has BlockFi in fact been selling unregistered securities illegally?

Without going into micro-detail regarding the business model of BlockFi, what they have been doing is highly innovative and disruptive of the banking industry as a whole. Has the banking industry called upon their government regulatory agents to crack down on the competition or has BlockFi legitimately endangered the financial well-being of their depositors?

BlockFi offers the ability to receive high interest rates by merely allowing them the use of a depositor’s crypto-assets. Such deposits are not risk free but are in the nature of a promissory note, profit-sharing arrangement, or a debt-type obligation by BlockFi wherein the interest is guaranteed as stated in their monthly disclosures, subject to change at BlockFi’s discretion. New Jersey’s definition of a ‘security’ is as follows:

“Security” means any note; stock; treasury stock; bond; debenture; evidence of indebtedness; certificate of interest or participation in any profit-sharing agreement, including, but not limited to, certificates of interest or participation in real or personal property; collateral-trust certificate; preorganization certificate or subscription; transferable share; investment contract; voting-trust certificate; certificate of deposit for a security; certificate of interest in an oil, gas or mining title or lease; a viatical investment; or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. “Security” does not include any insurance or endowment policy or annuity contract under which an insurance company promises to pay a fixed or variable number of dollars either in a lump sum or periodically for life or some other specified period.

This definition is so general that just about any financial instrument short of a bank check may be deemed a security. While clearly BlockFi’s interest accounts would fall under numerous definitions above, the real question is how such accounts are similar or different from regular bank accounts, which would certainly also fall under the definition above as, at the very least, ‘evidence of indebtedness’, ‘certificate of interest’, ‘note’, ‘certificate of interest’ or even a ‘bond’. New Jersey has postponed the effective date of their C&D order against BlockFi to early September; additional delays may be forthcoming.

Texas defines a security as:

…any limited partner interest in a limited partnership, share, stock, treasury stock, stock certificate under a voting trust agreement, collateral trust certificate, equipment trust certificate, preorganization certificate or receipt, subscription or reorganization certificate, note, bond, debenture, mortgage certificate or other evidence of indebtedness, any form of commercial paper, certificate in or under a profit sharing or participation agreement, certificate or any instrument representing any interest in or under an oil, gas or mining lease, fee or title, or any certificate or instrument representing or secured by an interest in any or all of the capital, property, assets, profits or earnings of any company, investment contract, or any other instrument commonly known as a security, whether similar to those herein referred to or not. The term applies regardless of whether the “security” or “securities” are evidenced by a written instrument. Provided, however, that this definition shall not apply to any insurance policy, endowment policy, annuity contract, optional annuity contract, or any contract or agreement in relation to and in consequence of any such policy or contract, issued by an insurance company.

A similar overly general definition, even broader than New Jersey’s, that would encompass just about every form of financial document evidencing a business arrangement to pay by one party to another. Notice that under both state’s laws insurers are exempt from securities laws merely by virtue of being licensed insurance companies, but obviously they are nonetheless issuing securities.

Again, BlockFi’s interest accounts would likely be deemed to be ‘securities’ under this definition as well. Furthermore, you should be aware that a common three-page promissory note, secured or not, such as one given by a friend or family member for a friendly loan, is potentially a security under both definitions above. Even a limited partnership interest is in and of itself a ‘security’ under TX law, which is why an LLC should more often than not be used in place of a limited partnership. Would regulators go after someone giving their child a car loan? Certainly this would never happen, although clearly done in violation of TX law.

Crypto-assets are deemed to be personal property by the IRS, as is cash or fiat currency. CFTC claims crypto-assets are commodities. Treasury Department claims they are currencies… Federal regulators are fighting for control of the nascent industry. Again, how are BlockFi’s interest accounts different from a standard savings account held at a bank?

Both accounts allow deposits and withdrawals any time, both pay variable periodic interest upon deposit, both types of assets are used or lent out by the account issuer as they deem fit to generate income… The only difference appears to be that banks are licensed/chartered and FDIC insured, while BlockFi is merely a licensed money transmitter with private insurance. So theoretically, if BlockFi became a licensed/regulated bank or a broker-dealer under state or federal law then it would be free from regulatory scrutiny.

But the true question is whether any of BlockFi’s actions have endangered or harmed the public or its account holders? Since they have paid all interest as promised, and no public declarations have been openly made by anyone who claims that proper interest was not in fact paid, the answer would most likely be ‘no’. The purpose of state securities law is to protect the public, and if no one was harmed then there is little or nothing for regulators to intervene in, even if they can fit the financial product under the definition of a ‘security’.

The fact of the matter is that many financial transactions which could fall under the definitions above occur on a daily basis in these and all other states, without regulatory intervention. Regulators’ job is not to act as a stand-in parent or to police every transaction; it is to intervene when harm is occurring or has occurred, and in this case, it makes little to no sense to prohibit BlockFi from obtaining new customers in their states while allowing them to continue paying interest to current customers from the above states. If the securities were issued illegally initially then BlockFi customers are apparently under eminent risk of loss, and immediate redemption of all the infringing accounts should be mandatory.

Texas also claims that there is insufficient disclosure by BlockFi as to the risks of opening interest accounts with them and as to how deposited funds are used by BlockFi. That is a simple fix: mandate additional disclosures of material information, which is always welcomed and they should have made these disclosures of their own volition. Hopefully this occurs in a detailed prospectus going forward, though it would probably require disclosure of confidential/proprietary information to competitors. It is foreseeable that some states will limit BlockFi’s customer base to accredited investors only with a standard private placement memorandum and subscription agreement required. Otherwise, BlockFi may need to move out of conducting operations in some states as they have done with respect to NY.   

We will forego Alabama’s similar actions and discussion of their definition of a ‘security’ since we can assume the analysis will likely be quite similar.

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