By Soyoung Ho
In a speech last week, SEC Commissioner Hester Peirce unveiled her own proposal that would create a three-year “safe harbor” for the offer and sale of certain crypto tokens if they meet certain conditions.
Peirce’s safe harbor is focused on one aspect of the crypto asset industry: a company is trying to build a decentralized network in which a token is used to provide access to a function of the network. In building the network, companies distribute the tokens. But in doing so, their efforts may be regulated under federal securities laws. Safe harbor means that an entity will not be held liable for not following certain securities laws provisions.
This is not an SEC proposal. For any rulemaking to go forward, the commissioners must vote to approve it first. “I am one of five Commissioners. I cannot write rules unilaterally,” Peirce said at the International Blockchain Congress 2020 in Chicago on February 6. But “it does not hurt to get the ball rolling. People change their minds.”
Her proposal comes as the market for digital tokens and assets has been growing, and the SEC has been trying to set clear rules of the road for crypto markets. The commission said it would regulate digital assets if they function like an investment contract under securities laws. But Peirce said regulations need to be clearer because there are a lot of gray areas in digital markets. She also does not want regulation to stifle innovation.
In April 2019, the SEC issued staff interpretive guidance that lays out the framework for analyzing whether certain digital assets fall under the category of an investment contract. The staff guidance discusses the 1946 Supreme Court decision in SEC v. W. J. Howey, which dealt with the sale of units of a citrus grove development in Florida. The high court found that an investment contract exists when money is invested in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.
The framework says that the so-called Howey test applies to any contract, scheme, or transaction regardless of whether it has any of the characteristics of typical securities. And the securities laws require all offers and sales of securities, including those involving digital assets, to either be registered with the commission or to qualify for an exemption from registration. The registration statement must be complete and not be materially misleading. (See Guidance Published to Help Determine if Digital Assets Are Securities in the April 5, 2019, edition of Accounting & Compliance Alert.)
In her remarks, Peirce said applying the Howey analysis to crypto tokens is not easy. For example, the contract or transaction by which the token is sold may constitute an investment contract, but the token may not bear the hallmarks of a security.
“Conflating the two concepts has limited secondary trading and has had disastrous consequences for the ability of token networks to become functional,” Peirce said. “Also of concern, suggesting that tokens will increase in value, combined with securing secondary market trading, can trigger a conclusion that those tokens are being sold pursuant to an investment contract. There are circumstances in which the security label fits, but, in other cases, promises made about tokens increasing in value are nothing more than expressions of the hope that a network will succeed and be used by lots of people.”
The safe harbor would provide network developers with a three-year grace period during which they develop a functional or decentralized network without registering with the SEC.
To take advantage of the safe harbor, among other conditions:
- developers would have to disclose key information on a freely accessible public website;
- the token must be offered and sold for the purpose of facilitating access to, participation on, or the development of the network;
- developers would have to undertake good faith and reasonable efforts to create liquidity for users; and
- developers would have to file a notice of reliance.
The crypto industry welcomed Peirce’s initiative.
“The safe harbor framework is an important next step to help innovation thrive, and we welcome the clarity it could provide,” Katie Biber, General Counsel of institutional crypto custodian Anchorage, said. “We urge the Commission to move promptly to adopt it and to consider other innovative ways to increase investor choice in the digital asset space.”
Andy Bromberg, cofounder and president of CoinList, said her proposal is good not only for the blockchain industry but also the United States. CoinList is a platform where digital assets companies manage their token sales.
“Under the previous ambiguous regime, some of the top crypto projects moved overseas or prohibited Americans from purchasing tokens,” Bromberg said. “Now, economic benefits from this industry can once again accrue to the United States, and U.S. purchasers can benefit from this world-changing technology.”
However, Reuben Yap, project steward for privacy-first digital currency Zcoin, questioned whether a three-year exemption period is sufficient.
“What happens if after the three-year safe harbor period, the token hasn’t achieved sufficient network maturity?” he said. “The vast majority of projects have not, and even those where it is arguable, took longer than three years. There exists a huge disincentive to then rule it as a security due to the chaos that can ensue. In a way, many feel that EOS, which raised $4.1 billion, got off lightly with a $24 million fine only because of this. It is also questionable whether any network can gain sufficient decentralization after only three years.”
In the meantime, Steven Lofchie, a partner with Cadwalader, Wickersham & Taft LLP, wrote in a memo that if the SEC were to pursue her proposal, it would need to be refined and impose additional conditions such as periodic statements of cash flow and dollar limits on the amount of tokens that could be sold to retail investors.
This article originally appeared in the February 11, 2020 edition of Accounting & Compliance Alert, available on Checkpoint.
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