SEC Commissioner Hester M. Peirce proposed establishing a three-year safe harbor from the securities laws, other than the anti-fraud requirements, for the sale and trading of digital tokens that satisfy various conditions.
Ms. Peirce argued that the application of the so-called "Howey Test" to digital tokens has not worked as a matter of law, in that applying the Howey analysis to crypto has become over-inclusive, and has discouraged the development of worthwhile applications of distributed ledger technology.
Ms. Peirce proposed conditions that a token would be required to meet in order to benefit from the exemption. These include:
- the token does not represent a financial interest in an entity or any right to receive any ownership interest or the right to receive any financial return, whether in the form of a share of profits or revenue, or an interest-related return; and
- at the end of a three-year period, the network on which the
token is transferred has reached "Network Maturity,"
meaning that the token or the network on which it is used or traded
- "decentralized," meaning that it is not controlled and is unlikely to be controlled by any single person or by a group under common controls; or
- "functional," as demonstrated by the ability of token holders to use the tokens on the network.
Among the other conditions that the tokens would be required to meet are provisions intended to exclude "bad actors" from involvement in the token offering and limited public disclosure requirements. (All of the conditions to the proposed safe harbor are set out in the Appendix to Ms. Peirce's remarks.)
Qualifying token projects and their promoters would be exempt from Securities Act registration and Securities Exchange Act issuer registration requirements. In addition, firms acting as intermediaries with respect to the exempt tokens would not be required to register as a broker, dealer or exchange. The exemption would no longer be available if Network Maturity had not been achieved after three years.
Commentary Steven Lofchie
In proposing a safe harbor for digital tokens, Commissioner Peirce mentions two letters that the SEC staff had issued in which it took no-action positions as to whether a digital token was a "security." The first of these, Turnkey Jet, concerned a stablecoin that serves as a substitute for making payments through a credit card (see this related news story).
The second no-action letter, Pocketful of Quarters, is a genuine attempt by the SEC staff to grapple with the issue of the difference between a utility token that is intended to be used (and not purchased as an investment), and a "security." As discussed in more detail in a related news story, the conditions established by the staff letter are overly restrictive in certain ways (particularly, transferability) and set arbitrary limits on the uses that the developers of the product can make from their sale. In particular, the prohibition on using revenues from the sale of the product to further develop the product technology is simply not realistic: every technology product requires constant and ongoing development; it is hard to see how a prohibition on using revenue from the product's sales to further develop the product is workable.
Commissioner Peirce is quite right to call out the SEC on the need to develop a legal framework that will allow for the development of utility tokens (see also SEC Commission Peirce Criticizes SEC for Law of Clarity on Jurisdiction). The Commissioner is not merely carping here; she is putting forward a real proposal for comment. Interested persons should comment. (See instruction how to do so in Footnote 12 to the remarks.)
The proposal will likely need further development and the imposition of additional conditions. Commissioner Peirce might consider:
- expanding the definition of "Initial Development Team" to include not only those providing "significant managerial efforts" but also those who have provided funding for the project or will be paid either out of the revenues from the sales or by the promoter of the project (one reason for this would be to expand the number of persons who would be picked up by the "bad actor" disqualification);
- requiring that the promoter of the project file make available at a designated website periodic statements of income and expenses and statements of cash flow;
- requiring that the promoter of the project file make available at a designated website all marketing materials that are sent or made available to more than a single person; and
- imposing dollar limits on the amount of tokens that could be sold to retail investors, along the lines of what is permitted in crowdfunding projects.
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