ASIC has commenced civil penalty proceedings in the Federal Court against fintech company Block Earner alleging it provided unlicensed financial services in relation to its crypto-asset based products and that it operated an unregistered managed investment scheme. ASIC is seeking declarations, injunctions, and pecuniary penalties from the Court.

It is tricky territory, given crypto assets themselves are vastly different and behave differently as we outlined in our article here. For cryptocurrencies, many view them as quasi-financial products in and of themselves. Senator Bragg’s The Digital Assets (Market Regulation) Bill 2022 would have them classified as such, along with non-fungible tokens and other crypto products unrelated to financial services. But that legislation is not yet law, and only crypto derivatives, non-cash payment facilities (NCP) and funds-related products – which are tricky to identify in digital assets – are currently classed as financial products.

Complicating the matter is that there are no ‘issuers’ for crypto per se in a traditional financial services context, save for developers (who are rarely concerned with legal disclosure documents). Unlike derivatives, equities, bonds and other financial products, there is not the same level of information to test for crypto market participants. Together with ASIC’s action against BPS for its token comprising a non-cash payment facility (which you can read about here), it is clear ASIC is delving deeper into whether digital assets are financial products. We offer practical guidance for Web3 firms in this article.

Background

Block Earner offered a range of fixed-yield earning products based on crypto-assets under the names USD Earner, Gold Earner and Crypto Earner (Earner Products).

ASIC alleges that the Earner Products were financial products that should have been licensed because the products were a managed investment scheme, a facility through which a person makes a financial investment, and/or a derivative.

In announcing the action, Deputy Chair Sarah repeated ASIC’s position (which it stated in the Holon matter where it placed an interim stop order on a digital assets fund. Article here):

“ASIC is aware that many consumers are interested in purchasing or investing in crypto-assets. Crypto-assets are risky, inherently volatile and complex and ASIC remains concerned that potential investors in crypto-assets may not fully appreciate the risks involved. ASIC supports the development of an effective regulatory framework covering crypto-assets to protect consumers and investors.”

Managed investment scheme

Managed funds, or managed investment schemes, are pooled or collective investments, with various people brought together to contribute money to get an interest in the scheme. They are regulated by the Corporations Act 2001 (Cth) (Corporations Act).

Where there is a scheme or plan to pool together resources to produce some kind of return to investors, there may be a ‘managed investment scheme’ for the purposes of the Corporations Act.

Managed investment schemes are collective investment vehicles; they are used by groups of persons as vehicles through which they can make collective investments. A managed investment scheme is usually structured as a trust, most commonly a unit trust. However, other structures may also qualify as a managed investment scheme. A ‘managed investment scheme’ is defined by the Corporations Act as a program or plan of action in which (s 9):

“people contribute money or money’s worth as consideration to acquire rights ‘interests’ to benefits produced by the scheme (whether the rights are actual, prospective or contingent and whether they are enforceable or not);any of the contributions are to be pooled, or used in a common enterprise, to produce financial benefits, or benefits consisting of rights or interests in property, for the members who hold interests in the scheme (whether as contributors to the scheme or as people who have acquired interests from holders); and the members as a whole 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).”

AFSL

Chapter 7 of the Corporations Act 2001 (Cth) requires an entity to hold an AFSL if the entity carries on a business providing financial services and/or a financial product to clients. Financial services as defined in the Act, can include:

  • Providing financial product advice (personal and/or general);
  • Dealing in financial products (including issuing and/or arranging);
  • Making a market in financial products;
  • Operate a registered scheme; and
  • Providing a custodial or depository service.

Financial products are broadly defined as an instrument used to:

  • Manage a financial risk;
  • Make a financial investment; and
  • Make a non-cash payment.

There are a range of things which are specifically defined as financial products under the Corporations Act, including: securities e.g. shares, insurance (including life products and general insurance), interests in managed investment schemes, and derivatives

An entity may apply to be authorised to provide one or more types of financial services, and/or provide one or more financial product class to retail and/or wholesale clients. Financial product and service delineations and boundaries are complex and it is easy to overlook or inaccurately define an aspect of your activities.

As above, a managed investment scheme is the pooling of individuals money to be invested for a return. This behaviour falls squarely into the definition of a financial product, and is a security. The process of issuing units in a managed investment scheme will require a variety of AFSL authorities to ensure that the fund manager can legally provide the services associated with the managed investment scheme.

For this reason, anyone who plans to operate a managed investment scheme will need to hold an AFSL that allows the fund manager to, at a minimum

  1. provide general financial product advice only, for the following classes of financial products:
    1. interests in managed investment schemes
  2. deal in a financial product by:
    1. issuing, applying for, acquiring, varying, or disposing of a financial product in respect of the following classes of financial products:
      1. interests in managed investment schemes
    2. applying for, acquiring, varying, or disposing of a financial product on behalf of another person in respect of the following classes of products:
      1. deposit and payment products limited to:
        1. basic deposit products; and
        2. general insurance products
  3. provide the following custodial or depository services:
    1. operate custodial or depository services other than investor directed portfolio services;
    2. to wholesale (or retail) clients.

If a fund plans to offer other, or more complex products, there may be additional AFSL authorities required to legally operate and issue units e.g. deposit products or securities.

Earner features

ASIC alleges that the Earner Product had ‘Terms of Use’ where the consumer, in acquiring, investing in or using the Earner Product, deposits or ‘lends’ money (‘lend’ being the expression used in the Terms) to Block Earner, and Block Earner undertakes to repay that money. The word ‘lend’ here is critical, as debt does not generally fall within the AFS regime. But whether or not the product is really debt-based, in practice, is critical. The features of the product or service, rather than the words matter.

Block Earner posed the question “How is fixed yield generated?'” on its website under ‘Frequently Asked Questions’ (FAQs). Block Earner initially answered by stating “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 Terms provided that by using the Earner Product, consumers ‘lend’ the crypto assets (into which their AUD has been converted) to Block Earner, in return for daily interest which was paid in the same crypto-asset ‘loaned’ to Block Earner. Critically, users also agreed to grant Block Earner all rights and title to those crypto assets, for Block Earner to use at its sole discretion during the term of the ‘loan’. That is, they had not control over the assets – they were in Block Earner’s control.

There was no mechanism to exit the Earner Product by withdrawing underlying crypto-assets. There needed to be a ‘conversion’ back into AUD. That is, just as the consumer started with AUD deposited into their account with Block Earner upon entry into the Earner Product, the consumer also received AUD back into their account when they exited the Earner Product.

Financial product

ASIC contends that the Earner Product was a managed investment scheme within the definition in s 9 of the Corporations Act because it had the following features:

  1. consumers contributed money or money’s worth i.e. crypto-assets as consideration to acquire rights to benefits produced by the scheme i.e. the yield;
  2. there is an objectively discernible intention that the contributions are to be pooled to produce financial benefits for the members, including because Block Earner has told consumers via its website that the fixed yield is generated by pooling customer funds; and
  3. the members did not have day-to-day control over the operation of the scheme.

For completeness, ASIC also contends that the Earner Product was:

  1. an Investment Facility within the definition of s 763B of the Corporations Act, for the reasons set out above; and
  2. a derivative because the amount of consideration, measured in AUD (being the currency that users deposit and receive back) varied by reference to the value of the crypto-assets. This is the case because, on exiting the Earner Product, consumer’s funds were converted from the crypto-assets to AUD at the prevailing exchange rate applied by Block Earner.

Takeaways

As we set out in our latest financial services regulatory blog here, the crypto currency industry is in a difficult position until further clarity on the regulatory framework is put forward.

Until such time as clarity is forthcoming, it is paramount that exchanges, funds, issuers and other businesses marketing crypto currencies be certain of the rights attached to crypto-assets, as they are a key consideration in assessing their legal status as a financial product. It is also critical that these businesses understand the services they provide, and whether they constitute a managed investment scheme. Legal reviews of the products and arrangements should be undertaken if they haven’t already.

It is a difficult task. Rights may be described in the crypto-asset’s ‘white paper’, underlying contracts governing the token or from other circumstances (e.g. how the crypto-asset is marketed). ASIC has been very clear in INFO 225 that “What is a ‘right’ should be interpreted broadly. Rights that may arise in the future or on a contingency, and rights that are not legally enforceable, are included.”

There is uncertainty in the legal framework around crypto currencies, complexity in the products themselves, a low struct liability bar for getting it wrong and a hawkish regulator in ASIC. Time spent double checking the crypto assets and earning products is time well spent.