BlockFi Is in Regulators’ Crosshairs. DeFi Is Next

In the last couple of days, embattled cryptofinance company BlockFi has been hit with cease and desist notices from three different state regulators for its BlockFi Interest Account, or “BIA,” product – first, in its home state of New Jersey and today, we learn, Alabama and Texas as well. It seems likely more states and eventually the federal regulators will follow.

“But BlockFi offers interest accounts just like I have with my bank,” I hear you say, “as do many other DeFi businesses in crypto. It seems these products are offered everywhere in crypto. But I’ve had a bank account for years and my bank isn’t being hauled over the coals by state regulators.”

Preston Byrne, a CoinDesk columnist, is a partner in Anderson Kill’s Technology, Media and Distributed Systems Group. He advises software, internet and fintech companies.

So what’s going on? Is this a one-off instance of regulatory overreach or misinterpretation of crypto by legacy regulators, or is it a sign of things to come for all “decentralized” lenders selling investment products across state lines in the United States?

Before we answer that question, it’s important to do a quick review of the rules regarding securities regulation in the U.S. The principal statutes governing securities transactions are the Securities Exchange Act of 1934 and section five of the Securities Act of 1933, which says “unless a registration statement is in effect as to a security it shall be unlawful… to make use of any… communication in interstate commerce… to sell such security” unless an exemption applies.

In English, Section 5 means that you have to have a set of offering documents and those offering documents need to be registered with the U.S. Securities and Exchange Commission (SEC) before you can sell a security to the investing public.

There are a number of exemptions to this requirement. Most frequently encountered in cryptoland are Section 4(a)(2) exemptions for transactions not involving any public offering and Rule 506 exemptions for private placements to accredited investors.

Securities laws are designed to capture myriad arrangements where investors give money to a manager and expect to receive a return. For this purpose, the Securities Act and the Exchange Act define a “security” broadly as being “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest… transferable share…investment contract… or, in general, any interest or instrument commonly known as a ‘security.’”

The term “investment contract” is also construed broadly, beginning with the 75-year-old decision in SEC v. W.J. Howey Co. and its eponymous “Howey Test.” This test was described by the Supreme Court as embodying “a flexible rather than static…