Crypto Yield Products In The Crosshairs

• Published date: 21 October 2021
• Subject Matter: Corporate/Commercial Law, Technology, Corporate and Company Law, Contracts and Commercial Law, Securities, Fin Tech
• Law Firm: Bryan Cave Leighton Paisner LLP
• Author: Mr J. Ashley Ebersole and Brett R. Orren

A major U.S. cryptocurrency exchange recently disclosed its receipt of a Wells Notice from the SEC, which threatened charges for violating Section 5 of the Securities Act in connection with the planned launch of a 'yield farming' product ('Yield Product'). These products allow users to deposit their crypto and earn a yield, which is generated by the wallet, custodian, or platform's lending that deposited crypto out to others (similar to fiat currency or securities lending). Because Section 5 broadly prohibits offering any security absent SEC registration, the Wells Notice has raised questions and concerns about the legal status of the myriad existing Yield Products across the cryptosphere.

These concerns are exacerbated by the dearth of information from the SEC regarding the Wells Notice (and, by the exchange's account, the SEC staff's refusal to share the analysis or reasoning that underlie the claimed violations).

Law that May be in Play

The question has been asked 'how can lending be a security?' Given the different varieties of securities and the SEC's history in this space, it is perhaps more pertinent to ask whether lending can be an investment contract or a note (which are the contexts for the SEC's principal analyses of what constitutes a security). While we cannot claim to be privy to the SEC's thoughts or reasoning here, history and interactions with the agency and its digital asset/crypto activities lead us to think the its position here may be similar to that advanced in the 1985 case Gary Plastic Packaging Corp. v. Merrill Lynch. ¹ While Gary Plastic applied SEC v. W. J. Howey Co.'s² 'investment contract' analysis, considering Yield Products under the familiar 'family resemblance' test from Reves v. Ernst & Young³ for 'notes' also yields potential clues. These principles-based 'tests' require fact-specific analysis, and so cannot provide generic answers about any particular Yield Product's status under them.

1. Howey

The Howey Court held that offering and selling interests in Florida orange groves to hands-off investors who were located remotely constituted a variety of security known as an investment contract. 'The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.'⁴ An agreement constitutes an investment contract when all four factors are met: (1) investment of capital; (2) in a common enterprise; (3) with a reasonable expectation of profits; (4) derived from efforts of third parties. A key factor in Howey was...