The crypto industry has long profited from an uncertainty narrative around the application of whether financial services laws apply to crypto assets. While the application of existing law to crypto assets has been clear for years – i.e., the law applies, we now have additional judicial authority and an active prosecution in the Hala case set out below that support the application of financial services tests.
The Block Earner judgment and Hala prosecution should leave the web 3 community with the clear and unequivocal guidance they have been seeking as well as clarity on the application of criminal penalties and imprisonment when licensing requirements are not met.
The recent Federal Court case between the Australian Securities and Investments Commission (ASIC) and Web3 Ventures Pty Ltd (Block Earner) confirmed the application of existing financial services law to crypto assets. The judgment, perhaps not surprisingly, calls for crypto asset providers to be compliant with existing regulations when offering services to Australian customers.
Block Earner, provided crypto backed loans that allowed retail investors to earn fixed yield via their Earner product, and access to decentralised finance (DeFi) lending protocols through their Access product. ASIC alleged that both the Earner and Access products were either a managed investment scheme, an investment facility and/or a derivative, requiring Block Earner to hold an Australian Financial Services Licence (AFSL).
The Court found in favour of ASIC’s claims that the Earner product met the test of a managed investment scheme and investment facility under the Corporations Act 2001 (Cth). However, the Access product fell just short of being considered a derivative under Australian law. Stirling & Rose considers some of the key takeaways below.
Allegations and Outcomes
ASIC commenced its action against Block Earner in November 2022, considering this a ‘test case’ for crypto assets in the Australian regulatory framework.
Block Earner’s Earner product offered fixed returns on deposited cryptocurrency (such as Bitcoin and Ethereum). Block Earner managed deposited user funds and pooled them to generate returns, regardless of the underlying performance. Users could withdraw their deposited crypto, but with some limitations and potential early withdrawal penalties. ASIC’s three claims were decided as follows:
1. Managed Investment Scheme: The Court found that the Earner product met the criteria of a managed investment scheme under the Corporations Act. Users contributed funds to obtain a benefit (payment of interest), to a common pool managed by Block Earner, and lacked day-to-day control over their invested assets. The Court determined that despite ambiguous language in the Terms of Use, the public website gave the impression to users that they would be pooling funds (see below).
2. Investment Facility: The Court found that Block Earner used user funds to generate financial returns (fixed interest) through activities like high-yield loans, and there was no day-to-day control over their contribution, satisfying the criteria for an investment facility.
3. Derivative: The Court noted that given Earner was already found to be not a registered scheme with more than 20 members, it is excluded from the definition of a derivative under the Corporations Act.
The Access product facilitated user access to DeFi lending protocols like Aave and Compound. Users deposited their cryptocurrency of choice through Block Earner who then connected those funds to the chosen DeFi protocol. Deposited funds were not held by Block Earner, but rather directly within the chosen DeFi protocol’s smart contracts. The Court determined that the Access product:
1. Managed Investment Scheme: Was not a managed investment scheme despite finding that a scheme did exist. However, user contributions weren’t pooled for a common purpose through Block Earners ‘omnibus’ account, as users retained individual ownership of their crypto assets and there was no evidence of generated benefits through use.
2. Investment Facility: Was not found as an investment facility as users only transferred their funds to generate financial returns through DeFi protocols. Block Earner merely facilitated access. An analogy was drawn to examples not constituting making a financial investment under s 763B.
3. Derivative: While ASIC argued the variable ‘yield’ could qualify Access as a derivative, the court found it exempt as merely a ‘contract for the future provision of services,’ the primary service being access to DeFi protocols. The Court noted that had it not fallen under this exemption ASIC’s argument would have prevailed under the broad definition of a derivative.
Takeaway: Applicability of Financial Services Regime
Jackman J took a nuanced view of Block Earner’s products when applying the existing financial services regime to their products. The digital nature of crypto assets leads many to believe that tokens are distinguished from ‘TradFi’ products and services such as securities, derivatives and managed investment schemes. In Stirling & Rose’s view, many blockchain based digital assets are in fact financial products. Adding blockchain to your financial services products does not cauterise them from the application of the law.
Regardless of independent characterisations, ASIC has long stated that entities who are offering crypto assets must carefully consider all the rights and features of their proposed crypto asset, as well as the way it will offered. From there, Information Sheet 225 (INFO 225) explicitly clarifies that AFS licensing requirements, capital raising provisions under the Corporations Act and other regulatory requirements must be adhered to. Crypto assets can, will and do fall under established categories like managed investment schemes, derivatives, or securities.
Additional prosecutions
ASIC has recently charged Gold Coast man Aryn Hala with nine offences of providing unlicensed financial services under s 911A (1) of the Corporations Act 2001 (Cth). The maximum penalty for each offence is five years imprisonment.
ASIC alleges that Mr Hala encouraged customers to establish self-managed super funds to then loan money to his own company for the purposes of ‘investment’, particularly in crypto assets where customers were promised annual returns of at least 10-20%.
The matter has been adjourned to 15 April 2024 and Mr Hala has been released on bail.
Public-Facing Materials and Terms of Use
At [29] of the judgment, Jackman J reviews the language found on the Block Earner website’s public FAQ. The question online reads
‘How is fixed yield generated?’
The answer:
‘Deposits into the Block Earner 7% fixed option, automatically convert your Australian dollars into the USD-backed stablecoin (USDC) via our exchange services… Block Earner is able to generate returns by pooling customer funds and lending it to our trusted partners.’
Mr Karaboga swore in his affidavit the answer was written by a junior employee, and not reviewed carefully before publication. He also stated Block Earner’s obligation to pay interest to users did not depend on these transactions and this was set out in the Terms of Use. ASIC’s original letter to Block Earner raised concerns of such statements found on their website and an amendment to the FAQ was made following its receipt.
The use of the word ‘pooling’ was repeatedly referred to throughout the judgment with ASIC using the language as grounds for identifying the relevant ‘scheme’ to satisfy the criteria under the Corporations Act. The Court found these marketing materials to provide a basis for inferring that investors did intend that Block Earner would use their money to generate a financial return, despite Terms of Use that contradicted this line.
Block Earner’s Terms of Use for its Earner product were seemingly contradictory to the FAQ:
‘by participating in Lend, you do not intend for Block Earner to use the loaned Eligible Cryptocurrency to generate a financial benefit or act as an investment for you;’
They were also explicit in getting users to accept the following (emphasis and formatting ours):
“You acknowledge and agree that we do not hold, or operate under … an Australian financial services licence (AFSL) and that the Services do not constitute … the requirement for us to hold an AFSL under the Corporations Act 2001 (Cth) … In particular, the access services and Lend are not financial products (as that term is defined in the Corporations Act).”
The Court considered the ‘relative prominence’ of statements found in the Terms of Use above compared to the FAQ, finding it was more likely that users were forming opinions based on what was on the website. Despite having a clickwrap “I agree” to be bound by the Terms of Use, the Block Earner case shows that merely stating a crypto product does not fall within the regulatory perimeter does not make it so.
Conclusion
Following the judgment, ASIC Deputy Chair Sarah Court cautioned firms offering crypto asset products to “consider whether their offerings are financial products under the existing regime” and “if they are, ensure that they are appropriately licensed and authorised before distributing them.”
Stirling & Rose has written extensively on the regulatory treatment of crypto assets in Australia – advocating for a principles-based approach integrated into our existing law, including the Corporations Act.
To read more, see our CASSPr submission in 2022 and Token Mapping submission in 2023. To discuss financial services licensing for your crypto product or service, please get in touch with us at info@stirlingandrose.com or on LinkedIn.