SEC Commissioner Peirce has revived and refreshed her proposed three-year safe harbor for qualifying token projects, but some unresolved ambiguities remain.
US Securities and Exchange Commission (SEC) Commissioner Hester Peirce, a longtime and vocal advocate for innovation in financial services, has not shied away from engaging with and supporting the fledgling digital asset ecosystem. One of the milestones along this path has been the unveiling of her Token Safe Harbor Proposal on February 6, 2020, in a speech at the International Blockchain Congress. (See Taking the Scarlet Out of the Letters I-C-O.) Now, following up on a promise to refresh the proposal in light of feedback received in the past year from “the crypto community, securities lawyers, and members of the public,” Commissioner Peirce has published Token Safe Harbor Proposal 2.0 (Proposal 2.0).
The original Safe Harbor Proposal, as well as Proposal 2.0, provide a time-limited exemption for token-based projects that seek to raise capital to develop decentralized networks. Proposal 2.0 would also allow fledgling networks to operate unburdened by the onerous registration provisions of the US federal securities laws until they reached network maturity (defined as either decentralization or token functionality). Provided that certain standards and disclosure requirements are met, a three-year grace period would be granted to allow token developers to pursue “sufficient” decentralization of their network from the time of the first token sale. As a result, purchasers of the token would no longer reasonably expect that that token value was being driven by a person or group via managerial or entrepreneurial efforts.
What’s New in Proposal 2.0
According to Commissioner Peirce, Proposal 2.0 “is not a bright-line test, but rather attempts to strike a balance between providing a manageable number of useful guideposts while maintaining sufficient flexibility for the facts and circumstances of each network to be considered in the analysis.”
Proposal 2.0 updates the original Safe Harbor Proposal in a few key respects, including the following:
- Companies must provide updates to the SEC every six months (until the end of the three-year period, or a determination that network maturity has been reached) on the required “plan of development” disclosure. This disclosure is defined as the current state and timeline for the development of the network to show how and when the initial development team intends to achieve network maturity.
- Network maturity is still defined binarily as either functionality or decentralization; however:
- Decentralization now requires that the initial development team must not own more than 20% of the relevant network’s tokens, or own more than 20% of the means of determining network consensus.
- Functionality is “demonstrated by the holders’ use of Tokens for the transmission and storage of value on the network, the participation in an application running on the network, or otherwise in a manner consistent with the utility of the network.”
- Disclosure requirements on a freely accessible public website now include:
- A hyperlink to a block explorer, a web-based tool that allows an individual to search for information on a blockchain (for more information, see Latham’s Book of Jargon® — Cryptocurrency & Blockchain Technology)
- A description of any material transaction, or any proposed material transaction, in which the initial development team is a participant and in which any related person had or will have a direct or indirect material interest
- A statement that the purchase of tokens involves a high degree of risk and potential financial loss
- An exit report requirement now requires development teams to engage outside counsel at the end of the three-year grace period to analyze whether their network has reached maturity. The analysis must describe the extent to which functionality or decentralization has been reached across a number of dimensions.
- The analysis must provide a description of the extent to which decentralization has been reached across a number of dimensions, including voting power, development efforts, and network participation. If applicable, the description should include:
- Examples of material engagement on network development and governance matters by parties unaffiliated with the initial development team
- Explanations of quantitative measurements of decentralization
- The analysis must provide an explanation of how the initial development team’s pre-network maturity activities are distinguishable from its ongoing involvement with the network. The explanation should:
- Discuss the extent to which the initial development team’s continuing activities are more limited in nature and cannot reasonably be expected uniquely to drive an increase in the value of the tokens
- Confirm that the initial development team has no material information about the network that is not publicly available
- Describe the steps taken to communicate to the network the nature and scope of the initial development team’s continuing activities
- If network maturity has not been attained, the exit report must contain a statement that the initial development team will file a Form 10 to register the tokens as a class of securities within 120 days of the filing of the exit report, under Section 12(g) of the Securities Exchange Act of 1934.
- The exit report must be filed electronically with the SEC through the online EDGAR platform in accordance with Regulation S-T.
- A new grace period for trading platforms will exempt such platforms from the requirements of Section 6 of the Exchange Act due to activity related to the trading of tokens involving networks that have not reached maturity. This grace period will be granted on the condition that the trading platform prohibits such trading within six months of such determination.
- Proposal 2.0 deletes a good-faith provision, whereby development teams were expected to “undertake good faith and reasonable efforts” to achieve network maturity within three years of the date of the first sale of tokens and create liquidity for users.
- Proposal 2.0 deletes a provision whereby if development teams attempt to secure secondary trading of the token on a trading platform, the development team would “seek secondary trading platforms that can demonstrate compliance with all applicable federal and state law and regulations relating to money transmission, anti-money laundering, and consumer protection.”
Progress, but Unresolved Ambiguities Linger
Proposal 2.0 represents a significant step forward for the digital asset industry and would provide token holders with greater protection and transparency. It also provides valuable insight into how Commissioner Peirce believes decentralized networks should operate, including how development teams should scale back or change their contributions and how projects should interact with their communities. But despite these admirable improvements, Proposal 2.0 does not bridge some of the critical issues that defined the original proposal.
Namely, Proposal 2.0 does not create a bright-line test for “network maturity” whereby tokens on such networks will not be deemed securities (this is acknowledged by Commissioner Peirce in her statement). Although “decentralization” is more fleshed out than in the previous version (particularly the 20% thresholds noted above), law firms will still be challenged to deliver opinions with such scant guidance regarding the weighting of the various factors. Even with the analysis and attestation of competent outside counsel using the provided guideposts, the specter of enforcement will continue to loom where facts and circumstances are not framed by a bright-line standard. That specter is encapsulated in the disclaimer carried over into Proposal 2.0: “The definition of Network Maturity is intended to provide clarity as to when a Token transaction should no longer be considered a security transaction but the analysis with respect to any particular network will require an evaluation of the particular facts and circumstances” (this italicized text is new in Proposal 2.0).
In addition, the functional prong of the binary “network maturity” definition appears to be a hole that could subsume the decentralization prong. That is, if developers can avoid the securities laws by controlling a fully functioning project, why would they seek decentralization? While functionality is a necessary component of beating the Howey test, it is not clear why functionality alone — without decentralization — would be sufficient to shield a project from federal securities laws if the overall success of the project continues to rely on a central authority. A security token that is used for transmission and storage of value on a functional network, for example, would paradoxically appear to qualify for network maturity and the protection of the safe harbor even if it is managed by a central authority whose efforts to promote and continue to maintain the project are vital to its success and the value of the token. On the other hand, many governance tokens that provide holders with functional rights with respect to the governance of decentralized networks would satisfy both prongs of the safe harbor, and therefore deserve to be supported with the proposed regulatory certainty.
Lastly, while Proposal 2.0 does much to align the interests of token holders and development teams, it could leave token holders and development teams exposed to significant risk of economic harm, because it fails to address or seek to limit speculative trading of centralized project tokens on secondary markets. A potential remedy for this could be the addition of transferability restrictions correlated with the decentralization progress achieved by the project.
Commissioner Peirce continues to seek crowdsourced feedback, and to that end, posted Proposal 2.0 on an internet platform where tech developers can access open source software and collaborate on projects, the very same platform on which open source code lives for most token projects.
A Changing of the Guard at the SEC
Proposal 2.0 was released the day before Gary Gensler was confirmed by the Senate as the new chairman of the SEC. Chairman Gensler is widely expected to be attentive to the digital asset industry’s calls for regulatory progress in this space. In fact, during his Senate confirmation hearing, he told Congress that he would pursue new regulations for cryptocurrencies, which he described as a “catalyst for change.” While his approach will surely be underpinned by the SEC’s focus on investor protection, the industry would benefit from a well-defined framework. The industry is hopeful that Commissioner Peirce’s support, along with Chairman Gensler’s fresh perspective and mandate, will result in a breakout from the regulatory holding pattern.