SEC Commissioner Hester Peirce, nicknamed “Crypto Mom” by the blockchain community, has outlined a formal proposal to provide a three-year safe harbor for token projects.
Speaking at the International Blockchain Congress in Chicago on 6 February 2020, Commissioner Peirce, unveiled her plan, that if adopted, would grant project developers a three-year grace period where digital tokens are not classified as financial securities. The proposal would effectively shield projects from a raft of securities laws and provide the breathing room required to allow for the development of a decentralized network.
The proposal is of significant importance to blockchain development and digital asset exchange. It demonstrates a dramatic shift in the way digital assets derived from blockchain are currently regulated. In recent cases, the Securities Exchange Commission (SEC) has shown that they are ready and willing to act against blockchain projects that do not make the appropriate disclosures. High profile actions have resulted in Block.One receiving a $24 million penalty for its initial coin offering (ICO), the halting of Telegram’s $1.7 billion digital token offering and messaging app Kik being charged for conducting a $100 million ICO.
The SEC’s current approach has provoked criticism that current securities laws are constraining innovation. Carrying the risk that blockchain projects will move away from the United States and into ‘friendly’ jurisdictions such as Switzerland, Singapore and Hong Kong where blockchain progressive policies are in place. Safe Harbor can be seen as a crucial step in fostering blockchain innovation within the United States.
We take a closer look at the current regulatory framework and the key points of Commissioner Peirce’s proposal.
- Proposed three year grace period for token projects to decentralize.
- There will be a documentation process involving code disclosures.
- The proposal is designed to remedy the regulatory catch-22.
- Just a proposal at this stage.
Current Regulatory Framework
In the current regulatory framework, it is difficult to distribute blockchain tokens in the U.S. without falling foul of federal securities law. Being classified as a ‘security’ brings a whole range of implications. The SEC can determine whether the security can be sold to U.S investors and also requires investors to register their holdings. There have been no registered token offerings in the U.S. to date. Instead, developers have relied on limited exemptions under Regulation A (‘mini IPO’s) or Regulation D (limited private placement to accredited investors). However, these exemptions have proved to be cost-prohibitive and limited given the limited pool of accredited investors.
The Howey Test
In determining whether an offering is a ‘security’, the SEC applies the Howey test. In SEC v W.J. Howey & Co, the U.S Supreme Court set forth a long-standing precedent that an investment contract is a type of security under securities laws. Essentially, the question is whether an offering forms part of a speculative enterprise because it relies on the managerial efforts of others. While the Howey case involved the sale of orange groves along with a share of the farming operation, the test has since been applied to a range of other offerings involving whiskey, beavers, and cryptocurrency.
The problem arises as emerging technologies and digital assets like cryptocurrencies are notoriously difficult to categorize. The very nature of a cryptocurrency is that it is designed to be autonomous and distributed on a decentralized network. However, the network needs time to become decentralized.
On first launch, tokens are likely to meet the definition of an investment contract, in that investors are taking part in a speculative enterprise, satisfying the Howey test. However, once a network becomes decentralized in that, purchasers no longer expect the managerial efforts, the asset no longer becomes a security.
The conundrum stands – How are projects expected to establish a decentralized network when they can’t sell the tokens required to use the network?
It’s a regulatory catch-22. Tokens are not being distributed from fear of violating securities laws. But without the distribution of tokens, networks are prevented from fully maturing.
The safe harbor proposal is aimed to remedy the regulatory catch-22 that has stymied network development.
‘Safe Harbor’ Proposal
Commissioner Peirce’s draft proposal can be summarised as follows: Three-year grace period for token projects to decentralize that would exempt:
- The offer and sale of tokens from most of the Securities Act of 1933;
- Tokens from registration under the Securities Act of 1934; and
- Persons engaged in certain token transactions from the definitions of exchange, broker, and dealer under the 1934 Act.
The exemption period would start from the date of the first token sale. This gives developers sufficient time to attract participants and build a decentralized network before being subject to the SEC’s strict regulatory regime. By effectively moving the application of the Howey test to three years after the first sale, the reasoning is that the network has time to become functionally mature enough that the offer of subsequent tokens would not satisfy the Howey test.
Additional features of the proposal include:
To qualify for the exemption, developers will be required to provide the SEC with relevant disclosures on a freely accessible public website. Disclosures include the project’s source code, transaction history, token economics, and roadmap of all token sales.
Commissioner Peirce recognizes that secondary trading is necessary for building a decentralized network. There are good faith and reasonable effort requirements to create liquidity for users.
SEC Filing Requirement
Developers will need to file a notice of reliance on the Safe Harbor with the SEC within 15 days of the first sale of tokens.
Disqualification and Anti Fraud Protections
Those considered ‘bad actors’ under securities laws due to past actions are immediately disqualified from Safe Harbor exemptions. Safe Harbor does not provide immunity from fraud actions. The SEC, state regulators and consumers retain their rights of action under antifraud provisions.
For the moment the proposal is just that – a proposal, and has no legal effect. In any case, Commissioner Peirce’s position is a positive move towards supporting innovation. It is characteristic of the recent trend of using legislative and regulatory flexibility in attempting to fill the gaps created by the rapid disruption of emerging technologies.
You may read the full proposal here. Commissioner Peirce has welcomed feedback and there will be a time for public input during the SEC’s formal rule-making process. Given the significance of the proposal to blockchain development, investors, developers, and participants should consider their existing business models and actively engage in the rule-making process.