In a series of remarks over the past year, SEC Commissioner Hester Peirce laid the groundwork for a potential SEC safe harbor for developmental token offerings, which could provide a registration exemption for three years to give token networks a sufficient incubation period to achieve “maturity.”
The theory behind the proposed safe harbor is that the current regulatory framework functions as a barrier to launching token networks because offerors fear they may be treated as securities before they have time to mature into decentralized networks. The safe harbor would exempt certain tokens, subject to various conditions, with the aim of creating a regulatory environment that promotes fairness and predictability, while encouraging new offerings and the concomitant competition and innovation that could flow therefrom.
Stuck in Port
Commissioner Peirce first raised the prospect of a token safe harbor last July during a speech in Singapore. She compared renegade red pandas and their predilection for life “outside the fence” to the ever-evolving fintech innovation that continues to frustrate the efforts of regulators to keep pace. While expressing a desire “to see more focused momentum at the US SEC toward finalizing our regulatory regime for digital assets,” she also acknowledged that there are two unique aspects of the US system that can make progress more difficult to come by. The first of these is the “sheer number of regulators”:
“Not only do we have the state-federal allocation of responsibility that I just mentioned, but we have multiple federal financial regulators. The SEC regulates only securities; other agencies regulate commodities, currencies, many derivatives, and bank products. Even the federal securities space is shared with a quasi-private regulator, the Financial Industry Regulatory Authority (FINRA), which regulates broker-dealers, and with other non-governmental regulators.”
The second, and perhaps most notable, aspect is the reality that “the definition of what constitutes a security is a bit nebulous”:
“Unlike many other countries, we do not have an exclusive list of what counts as a ‘security.’ The term of course includes stock, bonds, debentures, notes, puts, calls, and other classic ‘security’ instruments, but it also includes ‘investment contracts.’ The courts have defined the investment contract category of securities by considering whether it encompasses particular assets presented in litigation. In the grandfather of these cases, SEC v. Howey, our Supreme Court established a test for determining whether something was an investment contract and therefore a security under our laws. Howey involved interests in an orange grove, so it is clear that an instrument need not look, smell, or taste like a traditional security in order to be deemed one by our laws. Under Howey, something—including something that is a digital asset—is a security if it involves an investment in a common enterprise with an expectation of profits derived solely through the efforts of others.”
Within this nebulous framework, Commissioner Peirce pondered how tokens required to be issued as securities might eventually transition to the point of decentralization where they cease to be securities. She subsequently posited certain preliminary pillars of a safe harbor exemption for tokens to help facilitate such a transition:
- “[a] non-exclusive safe harbor for the offer and sale of certain tokens” that would “permit issuers to offer tokens under an alternative regime with robust requirements”;
- a “time-limited” exemption that would “guard against reliance on the safe harbor by projects without a workable plan to build operational networks”;
- permits trading in order to “get tokens in and out of the hands of developers and users”;
- “open digital token offerings to facilitate participation in open-source software development”; and
- disclosure requirements “important to purchasers of tokens intended for use in open-source networks” (for example, “providing clear disclosure of the assets’ functionality, including the mechanisms for changing holders’ rights and explaining how funds are to be used”).
The non-exclusive nature of the safe harbor would ensure that, even where a particular token offering failed to meet the requirements, it “might still comply with other of our rules, such as our private placement exemption.” Commissioner Peirce acknowledged that her concept was “very preliminary,” but that it “might be a way to ensure that the legal regime does not inadvertently choke token networks off before they get off the ground.”
Regulatory Catch 22
After laying the initial groundwork, Commissioner Peirce’s next public foray into the topic of a potential token safe harbor came during a speech at the International Blockchain Congress in Chicago in February 2020, where she unveiled an actual proposal that would temporarily exempt blockchain tokens from federal securities registration requirements if certain criteria are met.
Commissioner Peirce acknowledged again the regulatory “conundrum” that existing securities laws create for developers, and she analogized to a time when she pulled into a gas station in New Jersey in the pouring rain during a college road trip. Despite the clear notice that state law prohibited customers from pumping their own gas, the attendant refused to venture out in the rain and instead presumably expected her to operate the pump:
“It is important to write rules that well-intentioned people can follow. When we see people struggling to find a way both to comply with the law and accomplish their laudable objectives, we need to ask ourselves whether the law should change to enable them to pursue their efforts in confidence that they are doing so legally.”
With that backdrop, she explained that the current regulatory regime creates a “Catch 22” for new token networks:
“Would-be networks cannot get their tokens out into people’s hands because their tokens are potentially subject to the securities laws. However, would-be networks cannot mature into a functional or decentralized network that is not dependent upon a single person or group to carry out the essential managerial or entrepreneurial efforts unless the tokens are distributed to and freely transferable among potential users, developers, and participants of the network.”
Thus, her concept of a safe harbor proposal “recognizes the need to achieve the investor protection objectives of the securities laws, as well as the need to provide the regulatory flexibility that allows innovation to flourish.” The idea is to both retain protections for token purchasers “by requiring disclosures tailored to their needs” and preserving the application of anti-fraud provisions under the securities laws, while at the same time providing network entrepreneurs “sufficient time to build their networks before having to measure themselves against a decentralization or functionality yardstick.”
Proposed Safe Harbor (Rule 195)
The title of Commissioner Peirce’s proposal is: “Proposed Securities Act Rule 195 – Time-Limited Exemption for Tokens.” The preamble to Rule 195 outlines the basic purpose and operation of the proposed safe harbor, and addresses the question of “maturity” following the three-year grace period:
“[T]his safe harbor is intended to provide Initial Development Teams with a three-year time period within which they can facilitate participation in, and the development of, a functional or decentralized network, exempt from the registration provisions of the federal securities laws so long as the conditions are met. The safe harbor is also designed to protect token purchasers by requiring disclosures tailored to the needs of the purchasers and preserving the application of the anti-fraud provisions of the federal securities laws.
Upon the conclusion of the three-year period, the Initial Development Team must determine whether token transactions involve the offer or sale of a security. Token transactions may not constitute securities transactions if the network has matured to a functioning or decentralized network. The definition of Network Maturity is intended to provide clarity as to when a token transaction should no longer be considered a security transaction but, as always, the analysis will require an evaluation of the particular facts and circumstances.”
The proposal defines “Network Maturity” as a “decentralized or functional network,” which is achieved when the network is either (a) “[n]ot controlled and is not reasonably likely to be controlled or unilaterally changed by any single person, entity, or group of persons or entities under common control,” or (b) “[f]unctional, as demonstrated by the ability of holders to use tokens for the transmission and storage of value, to prove control over the tokens, to participate in an application running on the network, or in a manner consistent with the utility of the network.”
Rule 195 seeks to strike a balance between maintaining investor protection and facilitating blockchain innovation by “exempting (1) the offer and sale of tokens from the Securities Act of 1933, other than the anti-fraud provisions, (2) the tokens from registration under the Securities Exchange Act of 1934, and (3) persons engaged in certain token transactions from the definitions of ‘exchange,’ ‘broker,’ and ‘dealer’ under the 1934 Act.” However, before the proposed exemption would apply, network developers would need to satisfy five requirements:
- A good faith intention and effort to reach network maturity within three years of the date of the first token sale;
- The disclosure of key information (discussed below) on a publicly-accessible website;
- The token must be sold “for the purpose of facilitating access to, participation on, or the development of the network”;
- A good faith intention and effort to “create liquidity for users”; and
- The filing of a “notice of reliance” on the safe harbor within 15 days of the first token sale.
The disclosure requirement for Rule 195 would require developers to make the following information readily available online to the public:
- Network source code
- Network transaction history
- Token Economics (“[a] narrative description of the purpose of the network, the protocol, and its operation”)
- Development plan for the network
- Token sales and terms
- Initial Development Team and their token ownership
- Secondary trading platforms
- Ongoing sales of tokens by the Initial Development Team
Finally, the proposed Rule makes clear that the anti-fraud provisions—specifically, Section 12(a)(2) and Section 17 of the Securities Act of 1933—would still apply even when a token qualifies for the safe harbor. Commissioner Peirce emphasized that the safe harbor does not immunize developers and the sale of the tokens from federal or state anti-fraud actions, including the making of false, misleading, or incomplete disclosures regarding the tokens.
Clarifying the Contours
On March 2, 2020, Commissioner Peirce participated in a panel discussion in San Francisco on the state of blockchain and cryptocurrency and the emerging regulatory landscape. She reiterated that, while regulators have provided more clarity, there is still a long way to go for blockchain and cryptocurrency regulation, in part because of the struggle to deal with the significant variation across digital assets.
During the discussion, Commissioner Peirce addressed and clarified several aspects of her proposed safe harbor for tokens, including the following. First, regarding section (f) of the Rule 195, which provides for the potential application of the safe harbor to digital assets previously sold pursuant to an exemption, she explained that those who have already launched and distributed tokens would need to consider whether prior token sales were transacted pursuant to an exemption, which in turn could dictate whether they could rely on the proposed safe harbor for future token distribution.
Second, Commissioner Peirce raised the unique difficulties that come with certain token launches where tokens are wrapped in investment contracts, which may look like traditional offerings initially, but that may change when the tokens are used in the network and no longer resemble securities. Notably, while Commission Peirce conceded that it would be a stretch to argue that the securities laws should still apply under such circumstances, SEC Enforcement recently argued to the contrary in the SEC v. Telegram case pending in the Southern District of New York. In that case, the SEC asked the judge to view the sale of an investment contract and subsequent token distribution as “one transaction.”
Third, Commissioner Peirce acknowledged that the definition of what it means for a token network to be “decentralized” and to reach “maturity” needs more refinement. She believes that it will be easier to assess if a network meets that definition after having been in existence for the three-year exemption period.
Finally, regarding Rule 195’s required disclosures of Initial Development Teams and associated token ownership, Commissioner Peirce indicated that the type of individuals contemplated by the safe harbor is similar to those who would fall under Section 16 of the Securities Exchange Act of 1934. It is often as simple as asking “who is working on the project?” She stressed that one of the reasons for the disclosure requirement is to ensure that developers are not intentionally hiding team members who may have been previously arrested for securities fraud.
All Hands on Deck
Commissioner Peirce has acknowledged that, although the concept of the token safe harbor and the Rule 195 proposal are solely her own, she is only “one of five Commissioners” and hopes to “convince [her] colleagues to add consideration of such an approach to the SEC rulemaking agenda.” Accordingly, she penned a call for commentary and feedback from the blockchain, cryptocurrency, and legal communities “to weigh in and tell me what I have gotten right and what I have gotten wrong.”
The communities appear to be listening. While there has been broad support for the general concept of a safe harbor, there has already been a significant amount of analysis, feedback, and criticism, including an open letter with proposed modifications to the safe harbor.
It is impossible to predict, of course, whether the safe harbor will ever become a reality. But as Commissioner Peirce recognized at the outset of her public safe harbor journey, the renegade pandas in the blockchain and cryptocurrency spheres that operate outside of “conventional” regulatory regimes will continue to “make the life of a regulator especially interesting.” A token safe harbor may be a productive first step to give tokens a genuine chance to become seaworthy.
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Stay tuned to Steptoe’s Blockchain Blog for future updates as we continue to monitor the proposed safe harbor and any related regulatory developments.