SEC Commissioner Hester Peirce recently proposed a set of regulatory solutions for U.S. token issuers through Securities Act Rule 195 and coinciding Exchange Act rules. The proposed rules create a “safe harbor” for token projects that meet certain criteria, providing an exemption from the registration requirements of the Securities Act of 1933 and the Securities Exchange Act of 1934 for a three-year period. During this grace period, qualifying token projects would be able to develop their networks to the point of “network maturity” (ie. Decentralization) without having to navigate through securities laws in the process. At the end of the exemption period, the SEC would evaluate the facts and circumstances surrounding the project to determine if a securities exemption is warranted or not.
Regarding some of the issues token projects currently face, Commissioner Peirce said:
“We have created a regulatory Catch 22. 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 unless the tokens are distributed to and freely transferable among potential users, developers, and participants of the network. The securities laws cannot be ignored, but neither can we as securities regulators ignore the conundrum our laws create.”
See, Running on Empty: A Proposal to Fill the Gap Between Regulation and Decentralization, Commissioner Hester Peirce, February 6, 2020.
Specifically, the safe harbor would exempt (1) the offer and sale of tokens from certain provisions of the Securities Act and (2) the tokens from registration under the Exchange Act. Additionally, it would exempt persons engaged in certain token transactions from the definitions of “exchange,” “broker,” and “dealer” under the 1934 Act, providing an opportunity for token trading platforms to offer trading of qualifying tokens without pursuing costly federal and state licenses.
To qualify for the safe harbor, the project will need to satisfy five conditions:
- Three-Year Time Limit – Developers must intend for the network on which the token will function to reach maturity within three years of the first token sale.
- Public Disclosures – Developers must disclose certain information on a publicly accessible website.
- Consumptive Use – The token must be offered and sold for the purpose of facilitating access, participation or development of the network.
- Liquidity Creation Efforts – The initial development team must intend to and will undertake good faith and reasonable efforts to create secondary trading of the tokens on a trading platform.
- Notice Filing – Developers are to file a notice of reliance on the safe harbor with the SEC.
The proposed rules attempt to clarify to the elusive concept of what constitutes a sufficiently decentralized project in the eyes of the SEC, something network developers and token issuers have aimed to achieve with little guidance. Under the proposed law, the term “Network Maturity” means the status of a decentralized or functional network that is achieved when the network is either:
- 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
- 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.
This definition is not meant to preclude network alterations achieved through a predetermined procedure in the source code that uses a consensus mechanism and approval of network participants. This definition of “Network Maturity” can provide clarity as to when a token transaction should no longer be considered a security transaction but, as always, the analysis will require an evaluation of the particular facts and circumstances.
Importantly, the statements made by token issuers will still be subject to the anti-fraud provisions of the Securities Act, so developers should engage legal counsel to review their purchase and sale agreements, marketing materials, and statements made to potential purchasers to ensure compliance with the anti-fraud provisions of the securities laws. If implemented as proposed, the safe harbor would require public disclosures regarding the material aspects of the network, such as the source code and transaction history, the initial token allocation, token release schedule, token generation and mining procedures, validation and consensus mechanism, and other important information which many blockchain developers tend to disclose to prove the efficacy of a project and encourage user adoption. Therefore, token issuers would do well to prepare preparing a marketing and disclosure plan and retain a record of all communications made to potential purchasers, a best practice utilized by securities issuers to comply with the anti-fraud rules.
Safe Harbor for Brokers, Dealers, and Exchanges
In a typical private offering of securities, brokers, dealers, and exchanges operate to provide liquidity for the token issuer and recruit investors. Recognizing the same services will be needed by token issuers, Commissioner Peirce proposed to include in the safe harbor exemptions for these third-parties that would play a crucial role in creating secondary trading markets for exempt tokens.
Proposed Exchange Act Rule 3a1-2. Exemption from the definition of “exchange” under Section 3(a)(1) of the Act.
An organization, association, or group of persons shall be exempt from the definition of the term “exchange” to the extent such organization, association, or group of persons constitutes, maintains, or provides a market place or facilitates bringing together purchasers and sellers of tokens satisfying the conditions of Rule 195 of the Securities Act, or otherwise performs with respect to such tokens the functions commonly performed by a stock exchange as that term is generally understood.
Proposed Exchange Act Rule 3a4-2. Exemption from the definition of “broker” for a person engaged in a token transaction.
A person is exempt from the definition of the term “broker” to the extent it engages in the business of effecting transactions in tokens satisfying the conditions of Rule 195 of the Securities Act of 1933 for the account of others.
Proposed Exchange Act Rule 3a5-4. Exemption from the definition of “dealer” for a person engaged in a token transaction.
A person is exempt from the definition of the term “dealer” to the extent it engages in the business of buying and selling tokens satisfying the conditions of Rule 195 of the Securities Act of 1933 for such person’s own account through a broker or otherwise.
Overall, Commissioner Pierce’s proposed rules are consistent with recent SEC commentary reflecting the view that tokens transmitted on a truly decentralized network or for the purpose of consumptive use will typically not constitute securities. If implemented, the rules will provide the opportunity for token issuers to build liquidity in a decentralized marketplace for network participants without dedicating precious capital to stringent compliance of offering securities in a private placement, an unachievable task under the current laws and regulations. While the future of Commissioner Peirce’s proposed rules remains uncertain, they represent an important step for the future of U.S. token issuers.
The author of this article is Tyler Harttraft, Esq., a partner at Bull Blockchain Law. Tyler represents token issuers, digital asset exchanges and other businesses specifically focused on projects related to blockchain technology, digital assets, and virtual currency activities. To schedule a consultation, you can email tyler@bullblockchainlaw.com.
