SEC Commissioner Hester Peirce continues to be one of the most vocal persons in leadership positions at federal regulators who are promoting innovation in digital currency and the blockchain. On February 6th, she unveiled Proposed Securities Act Rule 195 – Time-limited Exemption for Tokens, a rule proposal for a safe harbor that would provide regulatory relief under the federal securities laws for developers attempting to build functioning token networks. Her proposal is a step in the right direction to address one of the greatest challenges token network projects face.
As explained by the Commissioner, in the course of building a functioning network, developers must get tokens into the hands of other persons. These efforts run the risk of violating the U.S. securities laws regulating offers and sales, and the trading of, investment contract securities under the Howey test. Thus, she stated, the SEC has created a “regulatory Catch 22.” The Proposed Rule addresses this issue head-on by providing a three-year period during which an Initial Development Team can build their network and distribute tokens to persons who will use the network without concern that these efforts will be deemed by the SEC to violate the securities laws.
Of course, the Proposed Rule, as conceded by Commissioner Peirce and as discussed below, is a work in progress, and a great deal of work is necessary to address outstanding issues. One overarching issue is the degree to which the Proposed Rule should be prescriptive and thereby decrease the need for development teams to seek no-action relief. However, if overly prescriptive, the Proposed Rule would not be flexible enough to accommodate evolving technological developments and the complex facts that will arise in each case.
The Proposed Rule Would Provide Subjective and Prescriptive Requirements
The Proposed Rule provides Initial Development Teams with a three-year safe harbor from the application of the securities laws, with the exception of its anti-fraud provisions. In order to be covered by the safe harbor, five conditions would have to be met:
- The Initial Development Team must intend for the network to reach “Network Maturity,” defined as either decentralization or token functionality – within three years of the first offer and sale of tokens and undertake good faith and reasonable efforts to achieve that goal;
- Detailed disclosures pertaining to the token project and the Initial Development Team must be made to the public;
- The token must be offered or sold for the purpose of facilitating access to, participation on, or the development of the network;
- The Initial Development Team must intend to and undertake good faith and reasonable efforts to create liquidity for users; and
- The Initial Development Team must file a Notice of Reliance with the SEC.
The safe harbor conditions incorporate elements that are both subjective and prescriptive. The first and third conditions are principle-based and highly subjective, and without further regulatory guidance or authoritative precedent, it is unclear how the SEC would determine if they are being complied with. Additional guidance regarding the definition of “Network Maturity,” particularly in the form of hypotheticals and Q&A’s, would help provide clarity. Thus far, there are few concrete examples, beyond Bitcoin and Ethereum – which appear to have passed the SEC’s muster – to which developers can refer to understand the considerations relied upon by the SEC in determining whether a token is not deemed to be a security.
The second and fifth requirements are prescriptive. The disclosure requirements are intended to address information asymmetries between token issuers and purchasers. However, given that the anti-fraud provisions of the securities laws remain in place, it is not self-evident that an overlay of specific disclosure requirements is necessary.
As proposed, the notice requirement presents potential challenges to Initial Development Teams, particularly in the case of its applicability to tokens previously sold in compliance with the securities laws. It is uncertain as to the remedial actions that would be required, and what fines or penalties might be imposed, if the requirements of the Proposed Rule are not satisfied in whole or in part. Also, what would happen at the end of the three-year period if a network has not reached Network Maturity, e.g., the Proposed Rule does not provide a mechanism whereby the development team can request an extension of the safe harbor period and how such a request would be processed.
Until it is Enacted, the Rule Will Not Provide Industry Relief
Since the Proposed Rule is not binding on the Commission, SEC enforcement actions can and will continue to be prosecuted without regard to the Proposed Rule; attempted compliance with the Proposed Rule will not serve as a defense to an enforcement action. At the same time, the elements of the Proposed Rule can and should inform discussions between the Staff and development teams. In this regard, the specific disclosure requirements of the second condition may, in the short term, have the greatest impact, as they might serve as a ready checklist for statements by development teams and counterparties in connection with the development of their networks.
As positive a development as is the Proposed Rule Proposal, it is only the preliminary proposal of one Commissioner and the adoption of a proposal such as this one is subject to a rigorous vetting process by the SEC. Therefore, its future is uncertain.