On February 8, 2019, SEC Commissioner Hester Peirce delivered a speech at the symposium ”Protecting the Public While Fostering Innovation and Entrepreneurship: First Principles for Optimal Regulation.” Her remarks, entitled “Regulation: A View from Inside the Machine,” provide insight into how SEC regulators currently view certain technological innovations and how they interpret and apply the Howey test as to when something is an “investment contract,” and therefore a security, for purposes of the US federal securities laws. Commissioner Peirce began by noting the challenges that the SEC is facing with respect to new technologies such as blockchain and cryptocurrencies. As such, the SEC has been considering if these technologies fit into existing securities rules or instead if a new regulatory framework should be created. “If we act appropriately, we can enable innovation on this new frontier to proceed without compromising the objectives of our securities laws—protecting investors, facilitating capital formation, and ensuring fair, orderly, and efficient markets,” she stated.
In particular, Commissioner Peirce elaborated on the application of the Howey test to new technologies and products. She referenced a speech by the Director of Corporation Finance, William Hinman, multiple times and explained that the Howey test continues to inform the SEC’s approach to tokens, blockchain projects and digital assets. See our post from June 2018 discussing Director Hinman’s speech in depth. Agreeing with Hinman, she emphasized that “it is the nature of the transaction that determines whether an offering of securities has occurred, not the item being sold.” For example, if a token sale occurs where there is already an existing, functioning network, those tokens are not investment contracts and fall outside the definition of securities.
However, Commissioner Peirce emphasized that the application of the Howey test to tokens poses new dilemmas for the SEC. First, the decentralized nature of many token offerings make it difficult to fit such offerings into the SEC’s existing regulatory framework. In contrast to traditional securities offerings that have “issuers” or “promoters,” token offerings may have a number of unaffiliated people or no one to fulfill such roles. Second, Commissioner Peirce expressed her concern that the application of the Howey test to digital assets and token offerings will be “overly broad,” particularly under its “profits solely from the efforts of others” prong. Many courts have deviated from a strict application of “solely” under this prong, instead focusing on whether profits are derived “principally” from the efforts of others. Given the various players across a token project – including miners, developers and other consultants – Commissioner Peirce warned that “the SEC must take care not to cast the Howey net so wide that it swallows the ‘efforts of others’ prong entirely” and prevents legitimate projects from proceeding.
There are also the challenges posed by the current disclosure regime of a token project. For these projects, most of the important information and terms – arguably what could be considered the “material” information – including but not limited to, describing how the platform and token work (or intend to work), risks factors of participating in the project and governance structure (if any) are found in a white paper. However, the white paper is highly technical and may be difficult for even the most sophisticated investor to understand.
Commissioner Peirce also discussed regulation of the exchanges and other platforms on which these tokens trade and exchange-traded products based on bitcoin or other cryptocurrencies. Again, these platforms and products do not fit neatly into the regulatory framework governing exchanges and alternative trading systems. Through conversations with industry participants and further exploration into the workings of blockchain, digital assets and other token projects, the SEC intends to improve their understanding to find ways to address such dilemmas. As Commission Peirce highlighted “[w]e rightfully fault investors for jumping blindly at anything labeled crypto, but at times we seem to be equally impulsive in running away from anything labeled crypto.”
It is also possible, as Commissioner Peirce further noted, Congress itself could help resolve some of these dilemmas. As discussed in our post from January 2019, a bill has recently been introduced in the House to amend the federal securities laws to exempt certain digital assets from such laws.
Additionally, she stated that the SEC is working on supplemental guidance on the issue, and that there is a standing offer for no-action relief in connection with a particular token offering or project.
Finally, while the SEC has spoken indirectly through enforcement actions finding that certain token offerings fell under the federal securities laws, Commissioner Peirce explained that this was not her preferred regulatory method. As such, she encouraged people to engage in conversations with the SEC and help it approach new regulatory questions in a way that would encourage innovation and entrepreneurship.