Federal Court of Australia considers whether cryptocurrency yield products are regulated

Australian Securities and Investments Commission v Web3 Ventures Pty Ltd [2024] FCA 64

FACTS

The plaintiff (ASIC) sought declarations and orders against the defendant trading as Block Earner (Block Earner) in relation to contraventions of the Corporations Act 2001 (Cth) (Act) in connection with two Block Earner products known as “Earner” and “Access”. The Earner product was available from around 17 March 2022 until 16 November 2022, while the Access Product was available from around March 2022. Block Earner also operated a digital currency exchange permitting users to exchange Australian dollars (AUD) into cryptocurrencies including USD Coin (USDC), Paxos Gold (PAXG), Bitcoin (BTC) and Ethereum (ETH). ASIC did not contend that USDC, PAXG, BTC and ETH are financial products within the meaning of the Act.

ASIC contended that the Earner and Access products were financial products because each product was one or more of a managed investment scheme (MIS), a facility through which a person makes a financial investment (Investment Facility), or a derivative. If Earner or Access were financial products, it was common ground that Block Earner had contravened s 911A of the Act by carrying on a financial services business without holding an Australian financial services licence. Further, if either Earner or Access was an MIS, then it was common ground that Block Earner had contravened s 601ED(5) of the Act by operating an unregistered MIS.

The judgement, which found partially in ASIC’s favour in relation to the Earner product, finishes the liability phase of the proceeding; the penalty phase will now commence. 

THE EARNER PRODUCT

The Earner product allowed customers to lend to Block Earner cryptocurrency (generally converted by Block Earner from and back to AUD) and receive a fixed rate return over the term of the loan. Block Earner generated income for itself by lending the cryptoassets to third parties. Users received a pre-agreed fixed interest rate regardless of Block Earner’s earnings from its lending activities with third parties. For a number of months during the relevant period, Block Earner’s website stated that “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” (the Representation).

Was the Earner product an MIS? (Answer: yes)

“Managed investment scheme” is defined in s 9 of the Act as (emphasis added):

(a) a scheme that has 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 [scheme members];
(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) […].

The judge accepted that there existed at the relevant time a “scheme,” on the basis of multiple particulars in ASIC’s Amended Concise Statement.

The judge accepted the submission of Block Earner that the word “contribution” connotes pooling and suggests that the investor is not acting alone or intending to act alone and independently in the payment of money so as simply to recover a return on their own investment. He nevertheless found the contribution element satisfied, as Block Earner was able to generate returns by pooling customer funds and lending pooled funds to third parties, receiving a favourable yield rate. Distinguishing a line of cases involving promissory notes, here there had been a representation that the payment of principal or interest due would be derived from a particular source.

It was also clear from the Representation that the contributions made by users were to be “pooled”, albeit that this was changed in May 2022. This was also despite a user acknowledgement in the terms of use which provided that “by participating in [Earner], 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” (the Acknowledgement).

The judge found a lack of day-to-day control by users over the scheme, although they had control over when they entered and exited the scheme.

Both parties accepted that it was not necessary for the judge to decide whether cryptocurrency is property in order to resolve the proceedings. He found it would not therefore be appropriate to decide whether there were insuperable difficulties in the application of Part 5C of the Act which would compel a conclusion that the Earner product does not satisfy the definition of “managed investment scheme.”

Was the Earner product an Investment Facility? (Answer: yes)

Section 763B defines when a person makes a financial investment for the purposes of the definition of Investment Facility (which is one type of financial product: s 763A), providing that for the purposes of Chapter 7, a person (the investor) makes a financial investment if:

(a) the investor gives money or money’s worth (the contribution) to another person and any of the following apply:

(i) the other person uses the contribution to generate a financial return, or other benefit, for the investor;
(ii) the investor intends that the other person will use the contribution to generate a financial return, or other benefit, for the investor (even if no return or benefit is in fact generated);
(iii) the other person intends that the contribution will be used to generate a financial return, or other benefit, for the investor (even if no return or benefit is in fact generated); and

(b) the investor has no day-to-day control over the use of the contribution to generate the return or benefit.

While the three limbs of para (a) are alternatives, the judge found all three were satisfied. There was the use of the contribution to generate a financial return or other benefit for the investor within subparagraph (a)(i). This was so even though the revenue generated by the use of the contribution enabled Block Earner to make a profit. Further, it did not matter that Block Earner also used its own financial resources, in combination with the investors’ contributions, in generating that financial return or other benefit. A similar finding was made with respect to subparagraph (a)(iii). His Honour also found subparagraph (a)(ii) was satisfied, relying on the prominence of the Representation relative to the Acknowledgement. Moreover, the question as to what actual intention was formed by investors remains one of fact, so a term of use purporting to state the investors’ intention was not relevant.

Was the Earner product a derivative? (Answer: no)

As the judge found that the Earner product was an unregistered MIS with more than 20 members, it followed that the Earner product was not a derivative: s 761D(3)(c).

THE ACCESS PRODUCT

Decentralised finance (DeFi) refers to peer-to-peer finance enabled by smart contracts rather than a centralised intermediary, like a bank. Block Earner’s Access product was marketed as providing users with access to the Aave and Compound protocols, being third party DeFi cryptoasset lending protocols. By using the Access service, Block Earner’s users could access Aave and Compound without entering into distinct transactions to exchange cryptocurrency to DeFi-specific digital tokens.

Block Earner maintained an “omnibus” wallet holding DeFi-specific tokens for all users using the Access service. After first converting users’ AUD to eligible cryptocurrency, Block Earner sent that cryptocurrency to the omnibus wallet in daily batches. It kept a ledger of how much cryptocurrency had been sent on behalf of each user, and under the terms of use, Block Earner was required to pass on all earnings from an Access service user’s DeFi-specific tokens through to that user.

Was the Access product an MIS? (Answer: no)

While the judge found there was a scheme over which users had no day-to-day control, the judge was not satisfied that users did “contribute” money or money’s worth, in the requisite sense of doing so jointly with others or to furnish a common fund. From the user’s perspective, the money which they had paid in, and the financial performance of the tokens purchased with it, were treated on an individuated basis. At all times, users retained “ownership” of their DeFi-specific digital tokens, according to the agreed facts.

He also found there was no “pooling” of contributions, notwithstanding the existence of the “omnibus” wallet holding all user eligible cryptoassets for each protocol. He agreed with an ASIC submission on another point that the statutory language requires that there be “a link between the contributions that are pooled and the production of benefits, … which is objectively disclosed,” and found there was no such link in the case of the Access product.

He also found that while the pooling of cryptocurrency into an omnibus wallet may have reduced fees to Block Earner, there was no evidence this was a benefit to the members of the scheme; in any case it was too late for an application to amend the Amended Concise Statement on this point. There was also no evidence that the saving in account fees was ever disclosed to users. It could not be inferred that users objectively intended that their payments would be pooled to produce financial benefits for them in that way.

The result was that ASIC had not made out that the Access product was an MIS.

Was the Access product an Investment Facility? (Answer: no)

While the three limbs of the definition in s 763B(a) are alternatives, the judge found that none was met by the Access product. As to subparagraph (a)(i), Block Earner was in the position of 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. The judge referred to Note 2(b) to s 763B which forms part of the Act, can be used as an aid in its interpretation, and excludes from the concept of making an investment the mere giving of money to a financial services licensee for the purchase of shares.

As to subparagraphs (a)(ii) and (a)(iii), there was no evidence that investors or Block Earner intended that the contribution would be “used” in the requisite sense to generate a financial return or other benefit for the investor. The relevant intention which could be inferred was that investors would in substance be using their money(’s worth) to generate a financial return or benefit for themselves, with the role of Block Earner being that of a broker or intermediary to effect the transaction on the part of the investors.

Was the Access product a derivative? (Answer: no)

The definition of derivative is a complex one and is set out in s 761D of the Act, to which s 761B is relevant. (Its meaning is also affected by regulation 7.6.04, oddly not mentioned in the judgement).

ASIC submitted that the Access product is a derivative because, in the usual case of the user being repaid in AUD, the amount of AUD to be paid will vary according to the value of the tokens and the value of the cryptocurrency into which those tokens are converted.

While the judge found there was considerable force in ASIC’s submissions to the effect that s 761D(1) is satisfied, he also found that he need not decide that question, because the Access product constituted a contract for the future provision of services within the meaning of s 761D(3)(b), and was therefore excluded from being a derivative. The future provision of services was at least the primary, if not the only, subject matter of the Access product, and could not be regarded as merely incidental or ancillary to some other purpose.

A longer version of this note, including comments and observations, is published through the author’s LinkedIn profile here.