On February 6, 2020, SEC Commissioner Hester Peirce presented her proposal of a new regulatory scheme for legal ICOs in the United States (“Safe Harbor”).[1] To date, token issuers have struggled with the U.S. Securities and Exchange Commission (“SEC”) position of treating most tokens as investment contracts, and thus, as securities offerings under the notorious Howey test.[2] Under Commissioner Peirce’s proposal, certain tokens would not be treated as securities and could be sold to non-accredited investors in the U.S., provided that the disclosure and other requirements of the Safe Harbor are satisfied. Could this be the long-awaited path to legal ICOs in the U.S.? We have analyzed some of the key features of the proposal below.
Sink or swim in three years
The SEC has previously indicated in its Framework for “Investment Contract” Analysis of Digital Assets (“Framework”)[3] that the regulatory nature of a token can evolve over time, meaning that, a token that was considered to be a security at the time of its initial issuance, can evolve such that, at a later date, when the token’s network has become “sufficiently decentralized”[4] and the initial management or develop team is no longer performing essential functions for the token’s success, purchases and sales of the token are no longer considered to be purchases and sales of a security. This approach, although intended to provide the market a pathway forward for tokens, actually created a number of unanswered questions. Short of seeking no-action relief from the SEC the Framework left unanswered a clear means for determining the point in time that a token has actually evolved to non-security status. More importantly, the Framework started with the SEC’s existing view that virtually all tokens are securities. This created an unfortunate conundrum as to how a network can ever become sufficiently decentralized when tokens remain subject selling and trading restrictions imposed by securities laws and regulations that limit the ability to use the tokens in the decentralized way contemplated by the token founders in the first place. It is difficult, if not altogether impossible, to demonstrate the existence of a decentralized network if it is not possible to get tokens into the hands of potential users either through direct issuance or secondary trading.
The Safe Harbor proposed by Commissioner Peirce would allow a three-year grace period (“Grace Period”) within which the token network could be developed. Further, during the Grace Period, token sales would not be treated as the offer and sale of securities and trading platforms on which such tokens are traded would not be treated as exchanges or brokers or dealers under U.S. securities laws.[5] The Grace Period is intended to give the token’s development team a sufficient amount of time to implement a decentralized network for the token.
At the expiration of the Grace Period, the initial development team would be required to determine if the network has matured to a functioning or decentralized network. According to the Safe Harbor, “network maturity” will be achieved when it is either:
(i) not controlled and is not reasonably likely to be controlled or unilaterally changed by any single person, entity, or group of persons or entities under common control; or
(ii) functional, as demonstrated by the ability of holders to use tokens for the transmission and storage of value, to prove control over the tokens, to participate in an application running on the network, or in a manner consistent with the utility of the network.
In addition, the initial development team would have to undertake good faith and reasonable efforts during the Grace Period to create liquidity for users by securing secondary trading on token trading platforms. Commissioner Peirce recognized that while this may be counterintuitive with the SEC’s present position of viewing attempts to facilitate secondary trading as an indicia of a securities offering, she noted that secondary trading is necessary both to get tokens into the hands of users and to offer developers a way to exchange their tokens for fiat or crypto currency.
Disclose, disclose, disclose
A major concern for the SEC with respect to token sales has been investor protection and the asymmetry of information between the initial development team and the public. To rely on the Safe Harbor, the initial development team will have to make certain public disclosures covering among other things, the source code; token economics, including token supply, generation, distribution and governance; the network development plan; the development team, their experience and their anticipated token holdings; trading platforms for the tokens to the extent known; and notices of sales of more than 5% of originally held tokens by members of the initial development team. The Safe Harbor would also require that the initial developers provide ongoing disclosures of any material changes.
To attest that the disclosure and other requirements of the Safe Harbor are met, the initial development team would need to file a Notice of Reliance with the SEC within 15 days of the initial token sales.
Game opener
The Safe Harbor could possibly provide a win-win-win clarity for developers, token holders, and the SEC if adopted as portrayed by Commissioner Peirce. However, the SEC has five Commissioners whom to date have been infamous for not tolerating any leeway from securities laws for the blockchain industry and tolerating “regulation through enforcement.” We will wait to see if Commissioner Peirce’s Safe Harbor will become a game changer. For now it remains a massive game opener.
“Those who say it cannot be done, should not interrupt those doing it.”
A Chinese proverb
[1] https://www.sec.gov/news/speech/peirce-remarks-blockress-2020-02-06.
[2] SEC v. W. J. Howey Co., 328 U.S. 293 (1946).
[3] https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.
[4] https://www.sec.gov/news/speech/speech-hinman-061418.
[5] Token sales would continue to be subject to the antifraud provisions of the securities laws.
