In a speech to the International Blockchain Congress on February 6, 2020, Securities and Exchange (“SEC”) Commissioner Hester Peirce, sometime referred to as “Crypto Mom,” proposed a three-year safe harbor for virtual currency token projects. The safe harbor would exempt (i) the offer and sale of tokens from the provisions of the Securities Act of 1933, other than the antifraud provisions, (ii) the tokens from registration under the Securities Exchange Act of 1934 and (iii) persons engaged in certain token transactions from the definitions of “exchange,” “broker” and “dealer” under the Securities and Exchange Act.
To date, the SEC’s policy has been to enforce (perhaps selectively) against virtual currency companies that have raised funds through token sales that have appeared to violate US federal securities laws. Many of these companies have argued that while their sale of tokens may seem like securities offerings at first, the ultimate intent is to create a decentralized network where the tokens can be used in exchange for a service or product and not merely as an investment. Our post on the test the SEC uses to determine what is considered to be a security may be accessed here.
Peirce described the current “regulatory Catch 22” that has arisen – “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 [that is the hallmark of securities] unless the tokens are distributed to and freely transferable among potential users, developers and participants of the network.” Peirce’s proposal would give these companies a three-year grace period to achieve such network decentralization.
This is also not the first time the SEC has grappled with this issue. As discussed in our post from June 2018, SEC Director of Corporation Finance William Hinman described how the virtual currency Ether may have originally started as a security but in later years the network evolved and Ether was decentralized enough that it could no longer be considered a security.
Peirce’s proposal includes a set of strict requirements that would have to be met in order for a token issuer to rely on the safe harbor. The requirements include 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 team would have to disclose key information on a freely accessible public website including:
- the source code and transaction history
- total number of tokens to be created, the number to be issued in the initial allocation and the release schedule of the tokens
- information regarding how tokens are generated and mined
- process for validating transactions and the consensus mechanism
- governance mechanisms for implementing changes to the protocol
- the plan and timeline of development of the network
- how many tokens each member of the development team owns and disclosure when they sell more than 5% of their tokens
- The token must be offered and sold for the purpose of facilitating access to, participation on, or the development of the network.
- The team would have to undertake good faith and reasonable efforts to create liquidity for users.
- The team would have to file a notice of reliance on the SEC EDGAR database.
It is noteworthy that the proposed safe harbor includes a conduct standard of “good faith and reasonable efforts.” The team does not have any fiduciary duty to the token holders, although anti-fraud rules still would apply.
Despite many of the safe harbor’s required disclosures lining up with what is disclosed anyway in countless token project whitepapers, potentially problematic for nascent token projects is the requirement to publish source code that could be considered proprietary and confidential, especially during the competitive development timeframe that the safe harbor is intended to protect.
While Peirce’s safe harbor proposal may be a great step for the SEC in providing more regulatory clarity in the digital asset space, there is still a long road ahead for any type of proposal to eventually become a final rule. As Peirce herself states, the final rule, if any, after deliberation and comment by the SEC and industry participants, may look nothing like what she has laid out in this speech.
Norton Rose Fulbright has a useful database of FinTech materials for those who are interested in learning more about the subject.