What Business Development Companies Risks Exist in Crypto?

The SEC applies the Howey test, a foundational standard from securities law, to determine whether a digital asset constitutes an investment contract and thus a security. Under this test, a security exists where there is an investment of money in a common enterprise with a reasonable expectation of profits derived from the efforts of others. Many cryptocurrency offerings fail to meet one or more prongs of this test, but others do, and the SEC has pursued enforcement actions against projects and platforms that offered tokens without registering them as securities. For BDCs, this means that portfolio investments in crypto business entities must include rigorous due diligence regarding whether the underlying assets or business model involve unregistered securities, which could expose the BDC to regulatory liability and reputational harm.

Business development companies that invest in cryptocurrency platforms or custodians must ensure those entities maintain adequate anti-money laundering (AML) and know-your-customer (KYC) controls. The Financial Crimes Enforcement Network (FinCEN) requires certain cryptocurrency businesses to register as money services businesses and comply with AML rules. A BDC's portfolio company that fails to implement robust AML controls, or that serves customers in jurisdictions subject to U.S. .anctions, creates compliance risk for the BDC itself. Courts and regulators have demonstrated willingness to hold upstream investors accountable for inadequate oversight of portfolio company compliance practices, particularly where the BDC had notice of weak controls.

Business development companies are subject to statutory limits on leverage and must maintain certain coverage ratios to protect senior security holders. The Investment Company Act generally restricts a BDC's senior securities to no more than 50 percent of total assets. When a BDC allocates a material portion of its portfolio to cryptocurrency investments, which are highly volatile and may be difficult to liquidate quickly, the fund's leverage constraints become tighter and may limit the BDC's ability to make additional investments or return capital to shareholders. Investors should examine whether the BDC's leverage ratio provides adequate cushion given the correlation between crypto volatility and broader market downturns.

In New York, where many BDCs and investment funds are domiciled or litigate shareholder disputes, courts have applied heightened scrutiny to disclosure adequacy in emerging asset classes. When a BDC's prospectus or periodic reports omit material risks or fail to update disclosures as the regulatory environment shifts, shareholders have brought derivative and class action claims alleging breach of fiduciary duty or securities law violations. The Southern District of New York and New York state courts have permitted such cases to proceed past motion to dismiss where the complaint alleges specific facts showing that management knew or should have known of undisclosed risks. This procedural pattern means that inadequate or stale crypto-related disclosures can create litigation exposure for the BDC and its directors, even if no regulatory enforcement action has been initiated.

Many cryptocurrency investments involve custody or operational risks that traditional portfolio companies do not present. A BDC that invests in a cryptocurrency exchange, wallet provider, or custodian must verify that the portfolio company maintains adequate controls over private keys, implements multi-signature authorization protocols, and maintains insurance coverage for digital assets. Courts and regulators have scrutinized BDCs that invested in platforms later compromised by hacks or operational failures, questioning whether the BDC's due diligence process included site visits, technical audits, or independent security assessments. Investors should ask whether the BDC obtained third-party security certifications or conducted penetration testing of portfolio company systems before committing capital.

The regulatory treatment of cryptocurrency continues to evolve through SEC enforcement actions, congressional legislation, and international coordination. A BDC that made crypto investments during a period of lighter regulatory scrutiny may find that changing regulatory guidance or new legislation materially alters the risk profile of those investments. Investors should examine whether the BDC's investment policies include mechanisms for periodic reassessment of regulatory risks and whether the fund has established criteria for exiting investments if regulatory developments render them non-compliant or materially riskier. A BDC that fails to adjust its portfolio or disclosures in response to clear regulatory shifts may face shareholder litigation or SEC inquiry.