ASIC v Block Earner: when are crypto asset based products regulated Financial Products?
19 February 2024
What you need to know
On the 9th of February 2024, Justice Jackman of the Federal Court of Australia handed down one of the first judicial considerations of the application of the Australian financial services regime to crypto asset based products in Australian Securities and Investments Commission (ASIC) v Web3 Ventures Pty Ltd (Block Earner).
The case considered the legal characterisation of the following Block Earner products".
- Earner - a product that allowed users to lend cryptocurrency to Block Earner in order to receive a fixed rate return over the term of the loan. In the usual cases, Block Earner converted the customer's AUD into the cryptocurrency nominated by the customer and at the end of the loan the customer was entitled to an AUD amount calculated by reference to the price of the crypto currency plus a fixed rate of return.
- Access - a product that provided users access to the "Aave" and "Compound" Decentralised-Finance (DeFi) protocols. They provided a platform for users to lend out their crypto currency holdings to borrowers and earn interest on that basis, using algebraic models to adjust interest rates based on supply and demand.
ASIC alleged that Block Earner had engaged in unlicenced financial services conduct in offering these products as they were either managed investment schemes, facilities though which a person makes a financial investment, or derivatives for the purposes of the Corporations Act 2001 (Cth) (Corporations Act).
The Court found that:
- the Earner product was a managed investment scheme and a facility for making a financial investment, meaning that Block Earner had operated an unregistered managed investment scheme and carried on a financial services business without an Australian Financial Services License; and
- the Access product was not a financial product of the kind alleged by ASIC.
The Court's analysis in relation to Earner relied heavily on the representations made by Block Earner on its website as to the operation of the product. It is a timely reminder that great care needs to be taken with all customer facing collateral, not just terms and conditions.
The judgment also shows the complexity in the application of financial services laws to crypto asset based products. Whilst the judgment contains some clarity, some key questions remain unresolved. In light of the complexity and uncertainty, it is likely that ASIC will continue to test the application of the regulation and the regulatory boundaries in relation to crypto asset based products.
Why was Earner a financial product?
The Representation
Block Earner's website contained for a period the following answer to the question "How is fixed yield generated?":
Deposits into the Block Earner 7% fixed option, automatically convert your Australian dollars into the USD-backed stablecoin (USDC) via our exchange services and these stablecoins are then lent to us. Block Earner delivers risk-adjusted, high returns by working exclusively with partners whose investment strategies are proven, sustainable and measured.
Block Earner is able to generate returns by pooling customer funds and lending it to our trusted partners, who are all vetted in accordance with our risk policy, thereby receiving a favourable yield rate.
This representation to the effect that Block Earner was able to generate returns by pooling customer funds and lending it to third parties, thereby receiving a favourable yield rate, was a key factor in the Court's decision. Whilst Block Earner claimed the representation was a mistake, the Court found it was consistent with Block Earner's business model.
Managed Investment Scheme (MIS)
An MIS is relevantly a scheme with the following features:
(i) people contribute money or money’s worth as consideration to acquire rights (interests) to benefits produced by the scheme (whether the rights are actual, perspective or contingent and whether they are enforceable or not);
(ii) any of the contributions are to be pooled, or used in a common enterprise, to produce financial benefits, or benefits consisting of rights or interest in property, for the people (the members) who hold interests in the scheme (whether as contributors to the scheme or as people who have acquired interests from holders);
(iii) the members do not have day-to-day control over the operation of the scheme (whether or not they have the right to be consulted or give directions) (section 9(a) of the Corporations Act).
The Court found that:
- Users contributed money or money’s worth jointly with all other users, as consideration to acquire the right to the promised fixed interest yield under the Earner product.
- Block Earner represented it would be able to pay that yield because of the benefit produced by the scheme of enabling Block Earner to earn revenue in a greater amount by deploying the pooled contributions from users (as well as its own cryptocurrency) in lending that pooled cryptocurrency to third parties at a higher rate; and
- Block Earner represented that the purpose of that pooling was to provide it with the wherewithal from which it would pay users the yield.
- The representation satisfied the implicit requirement in the definition of a MIS that contributors must objectively intend that pooling to produce financial benefits:
- Users did not have day-to-day control over the scheme, as it was operated solely by Block Earner
That was the case even though:
- the terms of use did not refer to pooling for a common benefit
- there was no direct correlation between the revenue earned by Block Earner using the loaned crypto currency and the fixed yield paid to users.
Accordingly, the Court found that the Earner product was an unregistered MIS.
Financial investment
The Court found that users made financial investment within the meaning of section 763B of the Corporations Act. The Court found that Block Earner used the money or monies were given to it by investors to generate a financial return or other benefit for the investors, by generating revenue from which it would be able to pay the fixed yield which it was legally obliged to pay. The representation provided a basis for inferring that investors intended Block Earner would use the crypto currency to generate a financial return or benefit by Block Earner generating revenue from which it would be able to pay the fixed yield.
Potential difficulties in the application of the MIS Regime if crypto currency is property
The Court recognised that there were potential difficulties in the application of the MIS Regime to Earner if crypto currency was found to be a kind of property and that if it was, it might impact on the analysis of the Earner product as a MIS.
However, the parties accepted that it was not necessary for the Court to decide that question and therefore the Court did not do so. Accordingly, the question remains open as to whether cryptocurrency is property and if it is, whether there are insuperable difficulties in the application of the MIS Regime that would lead to the conclusion that products like Earner are not MISs.
Why was Access not a Financial Product?
Managed Investment Scheme
The Court found that the Access product was not a managed investment scheme. From the user's perspective, money was paid for access to existing DeFi protocols, and the financial performance of tokens was treated on an individual basis.
Importantly, ASIC submitted that in order to satisfy section 9(a)(ii) (in relation to pooling):
- it only needed to establish that contributions are to be pooled and that there are financial benefits through the scheme to those who hold interest in the scheme, and
- it did not need to establish any link between the pooling and the financial benefit.
That argument was rejected by the Court. The Court found that there was a requirement for a purposive link between the contributions that are pooled for the purpose of the scheme and the production of benefits that is objectively disclosed.
Financial Investment
The Court held that the Access product was not a facility for making a financial investment.
In doing so, the Court characterised Block Earner at [75] as acting as "a broker, effecting transactions on behalf of its customers, who were themselves using money or money's worth to generate a financial return or other benefit for themselves".
Derivative
ASIC submitted that the Access product was a derivative because, in the case of the user being paid in AUD, the amount of AUD paid would vary according to the value of the tokens and the value of the crypto currency into which those tokens were converted, or if it was repaid in crypto, the value of the crypto currency would vary according to the value of the tokens.
Whilst the Court indicated there was considerable force in those submissions, it did not need to consider it further. That is because it found the Access product constituted a contract for the future provisions of services, with the relevant "future services" being the provision of cryptocurrency exchange services once a user elects to cease using the Access product. which is specifically excluded from being a derivative.
However the fact that the Court indicated there was force to ASIC's submissions means that great care must be taken in considering the application of the derivatives provisions to crypto-based assets.
What you need to do
- Take care with all customer facing collateral, not just the terms and conditions. The case is a timely reminder of how customer facing representations can impact the analysis of whether a financial service is provided that is subject to Chapter 7 of the Corporations Act.
- The case is another demonstration of the complexity of the application of financial services laws to crypto asset based products. Crypto assets based products and services need to be very carefully reviewed and considered. In light of the complexity and uncertainty, it is likely that ASIC will continue to test the application of the regulation and the regulatory boundaries relating to crypto currency related products.
Authors: Narelle Smythe, Partner; and Conor Tarpey, Lawyer.
