In a speech on February 6, 2020, US Securities and Exchange Commission (SEC) Commissioner Hester M. Peirce outlined a proposed safe harbor to address certain regulatory difficulties faced by individuals desiring to build functioning token networks.1 Market participants have sought additional certainty with regard to the circumstances under which a token sale does not constitute a securities offering, and this proposed safe harbor presents some interesting ideas in this regard.
The proposed safe harbor is designed to both achieve investor protection objectives and provide the regulatory flexibility to allow innovation in the token space.2 The safe harbor would provide a crypto network developer a three-year grace period from its first token sale, during which the network developer could facilitate participation in and the development of a functional or decentralized network, provided that certain conditions are satisfied. (See "Summary of Framework for Safe Harbor" below.)
Commissioner Peirce has demonstrated a strong interest in the crypto industry and has a history of advocating for a regulatory approach to crypto that does not stifle innovation.3 Before detailing her proposed safe harbor, she outlined her primary concerns regarding the current legal landscape for token network development. "Many crypto entrepreneurs are seeking to build decentralized networks4 in which a token serves as a means of exchange on, or provides access to a function of[,] the network. In the course of building out the network, [the crypto entrepreneurs] need to get the tokens into the hands of other people," Commissioner Peirce explained.5 With respect to regulation, she noted, "But these efforts can be stymied by concerns that such efforts may fall within the ambit of federal securities laws. The fear of running afoul of the securities laws is real. Given the SEC's enforcement activity in this area, these fears are not unfounded."6
Commissioner Peirce also explained that the SEC has historically analyzed token sales through the Howey test but noted there are issues with this approach.7 In Howey, the US Supreme Court defined an investment contract, which is one type of security under federal securities laws, as having four elements: (i) the investment of money, (ii) in a common enterprise, (iii) with an expectation of profits, (iv) that is solely from the efforts of others. Commissioner Peirce cited several issues with applying the Howey analysis to crypto, highlighting how the approach makes it "extremely difficult for a company to distribute a token . . . without running into a charge that the company is engaged in a securities offering."8 One example of an issue commentators have identified to Commissioner Peirce includes omitting the distinction between the token and the investment contract. Commissioner Peirce explained: "The 'contract, transaction, or scheme' by which the token is sold may constitute an investment contract; but, the object of the investment contract—the token—may not bear the hallmarks of a security."9 She added that conflating the two concepts has limited secondary market trading and has had "disastrous consequences for the ability of token networks to become functional."
In describing issues with the current approach, Commissioner Peirce noted that a "regulatory Catch 22" has been created. She explained that "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. The securities laws cannot be ignored, but neither can we as securities regulators ignore the conundrum our laws create."
Against this backdrop, Commissioner Peirce described the proposed safe harbor. The proposed safe harbor sets forth tests that are meant to serve as proxies for the considerations included in the Howey test and bring clarity on when a token transaction should be considered a securities transaction.
Summary of Framework for Safe Harbor
Under the contemplated safe harbor, the initial development team10 would have a three-year grace period from the date of the first token sale to develop and build a functional or decentralized network while exempted from the registration provisions of the federal securities laws.11 This grace period would be conditioned on the following:
- The initial development team must intend for the network on which the token functions to reach network maturity—defined as either decentralization or token functionality—within three years of the date of the first token sale and undertake good faith and reasonable efforts to achieve that goal.
- The initial development team would have to disclose key information on a freely accessible public website.
- The token would have to be offered and sold for the purpose of facilitating access to, participation on, or the development of the network.
- The initial development team would have to undertake good faith and reasonable efforts to create liquidity for users.
- The initial development team would have to file a notice of reliance on EDGAR within fifteen days of the date of the first token sale made in reliance on the safe harbor.
During the grace period, developers would be exempt from certain definitions under the Securities Exchange Act of 1934 (Exchange Act) applicable to exchanges (Section 3(a)(1)), brokers (Section 3(a)(4)) and dealers (Section 3(a)(5))12, and issuers would be exempt from the provisions of Section 12(g) of the Securities Act of 1933 (Securities Act), so long as the conditions of the safe harbor are met.
The contemplated safe harbor (i) is not available to an initial development team if at least one of its members is subject to disqualification as a bad actor under securities laws, (ii) reserves the SEC's antifraud authority with respect to token sales, and (iii) is available for tokens that "were previously sold in a registered offering or pursuant to a valid exemption under the Securities Act." Commissioner Peirce also noted that the safe harbor would preempt state securities laws but would still allow state antifraud actions.
Although Commissioner Peirce would need the support of her fellow commissioners to move her proposed safe harbor forward, it sets forth some interesting ideas to create more regulatory certainty for the development of functional or decentralized networks. It also provides some useful transparency into how at least one member of the SEC is thinking about this space.
Commissioner Peirce welcomes feedback on any aspect of her proposal, particularly the definitions and technical elements. Network developers and other market participants should consider providing feedback to help inform any regulatory movement that may come down the road. A safe harbor may not come in the near term (or at all). Nevertheless, it is important for the SEC and its staff to continue to hear from the industry about the issues faced by market participants. The feedback can help craft future guidance and/or rulemaking and assure that any such regulatory activity is sufficiently flexible to address this evolving space.
1. Running on Empty: A Proposal to Fill the Gap Between Regulation and Decentralization (Feb. 6, 2020) (Safe Harbor Proposal).
3. For instance, on May 9, 2019, Commissioner Peirce spoke at the Securities Enforcement Forum in East Palo Alto, California. She expressed concerns that the SEC had hindered the crypto industry by not providing clear regulation for it. Commissioner Peirce stated that "[i]t is not the SEC's overzealous action that has stifled the crypto industry, but its unwillingness to take meaningful action at all." How We Howey (May 9, 2019).
In his speech on June 14, 2018, William Hinman noted that "[i]f the network on which a token...is to function is sufficiently decentralized–where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts–the assets may not represent an investment contract." See William Hinman, Director, SEC Division of Corporate Finance, Remarks at the Yahoo Finance All Markets Summit: Crypto: Digital Asset Transactions: When Howey Met Gary (Plastic) (June 14, 2018). As described further herein, a factor of the Howey investment contract analysis is reliance on the efforts of others, and in decentralized networks this reliance is not reasonable.
5. Safe Harbor Proposal.
6. Id. For instance, the SEC sued Kik Interactive Inc. in June 2019 for allegedly conducting an offering of digital tokens to US investors without registering the offer or sale in compliance with US securities laws. SEC v. Kik Interactive Inc., Case No. 19-cv-5244 (S.D.N.Y. June 4, 2019). In October 2019, the SEC filed an emergency action and obtained a temporary restraining order to prevent Telegram Group Inc. from distributing digital tokens in US markets in an allegedly unlawful manner. SEC v. Telegram Group Inc. and TON Issuer Inc., 19 Civ. 9439 (PKC) (S.D.N.Y. Oct. 11, 2019).
7. SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
8. Safe Harbor Proposal.
10. "Initial Development Team" is defined as any "person, group of persons, or entity that provides the essential managerial efforts for the development of the network prior to reaching Network Maturity." "Network Maturity" is defined in the proposal as "the status of a decentralized or functional network that is achieved when the network is either: (i) [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 (ii) [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. The definition is not meant to preclude network alterations achieved through a predetermined procedure in the source code that uses a consensus mechanism and approval of network participants."
11. Commissioner Peirce notes that "once the network cannot be controlled or unilaterally changed by any single person, entity, or group of persons or entities under common control, the token that operates on that network will not look like a security. Even for a network that remains centralized—think of the networks outlined in the TurnKey Jet and Pocketful of Quarters no-action letters—once the tokens are actually in use to buy and sell the services for which they were intended, the securities laws will be clearly inapplicable."
12. The exemptions from the definitions of "exchange," "broker," or "dealer" under the Exchange Act are intended to alleviate existing regulatory uncertainty on the applicability of securities laws to the secondary trading of tokens.
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