SEC Commissioner Hester M. Peirce, nicknamed “Crypto Mom,” has made a proposal for the temporary deregulation of digital assets to advance innovation and allow for unimpeded decentralization of blockchain networks. Ms. Peirce made the proposal in a speech on February 6, 2020.
The world of digital assets and cryptocurrency literally became an overnight business sector for corporate and securities lawyers, shifting from the pure technology sector with the SEC’s announcement that a cryptocurrency is a security in its Section 21(a) Report on the DAO investigation. Since then, there has been a multitude of enforcement proceedings, repeated disseminations of new guidance and many speeches by some of the top brass at the SEC, each evolving the regulatory landscape. Although I wasn’t focused on digital assets before that, upon reading the DAO report, I wasn’t surprised. It seemed clear to me that the capital raising efforts through cryptocurrencies were investment contracts within the meaning of SEC v. W. J. Howey Co.
However, although capital raising seems clear, the breadth of the SEC’s jurisdiction and involvement are much less so. Not all token issuances and digital assets are used for capital raising, but rather these digital assets are fundamental to the operations of decentralized applications. Amazing new networks are being built and traditional applications are being disrupted at every turn. However, the ability to publicly issue the digital tokens that drive these networks continues to challenge the best practitioners, with all avenues leading back to some form of registration. The SEC’s temporary injunction against Telegram and its Grams digital token, the one token everyone firmly believed was a pure utility, together with the successful Regulation A offering of Blockstack’s token, has made Regulation A the clear choice for a public token issuance.
In theory, an S-1 would work as well, though to date no one has tried and likely will not do so in the short term. The issue with an S-1 is testing the waters and gun jumping (see HERE). Public communication in advance of an S-1 is strictly limited whereas most token offerings rely heavily on pre-marketing. Regulation A broadly allows pre-offering marketing, offers and communications (see HERE).
Currently, those who operate in the digital asset space must carefully navigate rough, uncharted waters while doing everything possible to comply with federal regulations. Although Regulation A+ works for the public issuance of a token, the issue of transitioning from a security to a utility a Hester Peirce Proposal For Treatment Oft this point requires a leap of faith. The SEC has been clear that when a network becomes decentralized enough, a token can cease to be a security. The question remains: how can a token that begins as a security, be utilized and traded freely in a network, in its utilitarian purpose, such to allow the network to grow in decentralization?
The SEC has also been clear that the secondary trading of securities, including digital assets, requires a broker-dealer license (see, for example, HERE). Currently there is no active secondary trading market for digital asset securities in the U.S., though we are getting closer. However, secondary trading is different than use in a network for a token’s intended purpose.
Although there is no written guidance or pronouncement from the SEC Division of Trading and Markets, it appears that the SEC will allow a token that is a security to be used in a network without compliance with the registration or exemption provisions of the federal securities laws. The basis for this conclusion is the clearance of Blockstack’s Regulation A offering, which announces that the token can be used on the network and informal calls with FinHUB (see HERE) and digital asset legal practitioners. This does not provide the sort of comfort that a business investing millions of dollars into technology wants to rely upon.
That is one huge gap in the digital asset regulatory framework, but many more exist, leading Commissioner Peirce to throw out the first of what will probably be several proposals that hopefully bring us to a working structure.
Commissioner Peirce’s Proposal
Ms. Peirce begins by pointing out what I and every other practitioner have pointed out while trying to traverse the law’s application to digital assets, and that is that compliance with the law while furthering the meritorious digital asset technology is an unwinnable struggle. Ms. Peirce states, “[W]hether it is issuing tokens to be used in a network, launching an exchange-traded product based on bitcoin, providing custody for crypto assets, operating a broker-dealer that handles crypto transactions, or setting up an alternative trading system where people can trade crypto assets, our securities laws stand in the way of innovation.”
Although the issues are widespread, Ms. Peirce focuses on the issue of getting tokens into the hands of potential network users without violating securities laws. Where a token is a security, the ability to grow a network and utilize a token within the network is unreasonably hampered.
Furthermore, although many tokens may be bundled in such a way as to create an investment contract under Howey, she thinks the SEC has gone too far in its analysis. The mere fact that a token is marketed as potentially increasing in value should not make it a security. If that were the case, quality handbags, designer sneakers, fine art and good wines would all be securities under the purview of the SEC.
The options available for digital asset technology innovators are limited. A network could simply open source the code and allow mining to create the initial tokens. A network could also take its chances and conclude that a token is not a security and proceed with the issuance, although that did not work out well for Telegram. The option most networks have chosen is to either avoid the U.S. altogether or rely on Regulation D and/or Regulation S for token issuances, and recently Regulation A for a more public issuance.
The safe harbor proposed by Commissioner Peirce is designed for projects looking to build a decentralized network. The safe harbor is admittedly in a draft form. Commissioner Peirce hopes for active public input as well as involvement within the SEC to help take her draft and formulate a workable plan that is either a rule or a no-action position, but that the market can rely on in moving forward.
The safe harbor would provide network developers with a three-year grace period within which they could facilitate participation in and the development of a functional or decentralized network, exempt from the federal securities laws as long as certain conditions are satisfied. In particular, (i) the offer and sale of tokens would be exempted from the provisions of the Securities Act of 1933 (“Securities Act”) other than the anti-fraud provisions; (ii) tokens would be exempt from registration under the Securities Exchange Act of 1934 (“Exchange Act”); and (iii) persons engaged in certain token transactions would be exempt from the definitions of “exchange,” “broker,” and “dealer” under the Exchange Act.
In order to qualify for the safe harbor, several conditions must be met including: (i) the development team must intend the network to reach maturity, either through full decentralization or token functionality, within three years of the date of the first token sale, and act in good faith to meet that goal. I note that good faith is a hard standard to prove; (ii) the team must disclose key information on a freely accessible public website; (iii) the token must be offered and sold for the purpose of facilitating access to, participation on, or the development of the network; (iv) the team must take reasonable efforts to create liquidity for users; and (v) the team would have to file a notice of reliance on the safe harbor on EDGAR within 15 days of the first token sale.
Determining decentralization requires an analysis of whether the network is not controlled and is not reasonably likely to be controlled, or unilaterally changed, by any single person, group of persons, or entities under common control. Functionality would be when holders can use the tokens for the transmission and storage of value or to participate in an application running on the network.
The key information that would need to be disclosed on a public website includes (i) the source code; (ii) transaction history; (iii) purpose and mechanics of the network (including the launch and supply process, number of tokens in initial allocation, total number of tokens to be created, release schedule for the tokens and total number of tokens outstanding); (iv) information about how tokens are generated or minted, the process for burning tokens, the process for validating transactions and the consensus mechanism; (v) the governance mechanisms for implementing changes to the protocol; (vi) the plan of development, including the current state and timeline for achieving maturity; (vii) financing plans, including prior token sales; (viii) the names and relevant experience, qualifications, attributes, or skills of each person that is a member of the team; (ix) the number of tokens owned by each member of the team, a description of any limitations or restrictions on the transferability of tokens held by such persons, and a description of the team members’ rights to receive tokens in the future; (x) the sale by any member of 5% or more of his or her originally held tokens; and (xi) any secondary markets on which the tokens trade. Disclosures would need to be updated to reflect any material changes.
The requirement to make good-faith efforts to create liquidity for users could include a secondary trading market. In that case, the team would be required to utilize a trading platform that can demonstrate compliance with all applicable federal and state law, as well as regulations relating to money transmission, anti-money laundering, and consumer protection. Although I find this requirement perplexing, Commissioner Peirce believes it will help facilitate the distribution of the tokens such that they can flow back to a utility use on the network.
As mentioned, the safe harbor would not include the anti-fraud provisions of the securities laws. In addition, the safe harbor would be subject to the bad actor rules, such that it could not be used if any member of a team fell within the bad actor provisions (see HERE). The safe harbor would pre-empt state securities laws, but as with other pre-emptions, it would not include the state anti-fraud provisions.
The safe-harbor would be retroactive in that it would apply to tokens previously issued in registered or exempt offerings to allow for the free use of the token to build the network, and secondary sales.
Although as Commissioner Peirce notes, it has to start somewhere, it is a given in the industry that the proposal as written will not likely gain traction. It is simply too anti-regulation for any regulator’s and perhaps even industry participant’s liking. However, it does lay the framework to open the conversation and start towards a workable solution. Certainly, the current plan to let tokens registered as securities, be used as utilities, until we say otherwise, is not any better. The industry needs a workable solution, and I am glad an SEC Commissioner is taking a step forward.
Further Reading on DLT/Blockchain and ICOs
For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.
For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.
For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.
For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.
For an update on state-distributed ledger technology and blockchain regulations, see HERE.
For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.
For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal’s op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.
For a review of the CFTC’s role and position on cryptocurrencies, see HERE.
For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.
To learn about SAFTs and the issues with the SAFT investment structure, see HERE.
To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.
For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty and the need for even further guidance in this space, see HERE.
For a discussion of William Hinman’s speech related to ether and bitcoin and guidance in cryptocurrencies in general, see HERE.
For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.
For a review of Wyoming’s blockchain legislation, see HERE.
For a review of FINRA’s request for public comment on FinTech in general and blockchain, see HERE.
For my three-part case study on securities tokens, including a discussion of bounty programs and dividend or airdrop offerings, see HERE; HERE and HERE.
For a summary of three recent speeches by SEC Commissioner Hester Peirce, including her views on crypto and blockchain, and the SEC’s denial of a crypto-related fund or ETF, see HERE.
For a review of SEC enforcement-driven guidance on digital asset issuances and trading, see HERE.
For information on the SEC’s FinTech hub, see HERE.
For the SEC’s most recent analysis matrix for digital assets and application of the Howey Test, see HERE.
For FinCEN’s most recent guidance related to cryptocurrency, see HERE.
For a discussion on the enforceability of smart contracts, see HERE.
For a summary of the SEC and FINRA’s joint statement related to the custody of digital assets, see HERE.
For a review of the SEC, FinCEN and CFTC joint statement on digital assets, see HERE.