Overview
“Not only do we have the state-federal allocation of responsibility that I just mentioned, but we have multiple federal financial regulators. The SEC regulates only securities; other agencies regulate commodities, currencies, many derivatives, and bank products. Even the federal securities space is shared with a quasi-private regulator, the Financial Industry Regulatory Authority (FINRA), which regulates broker-dealers, and with other non-governmental regulators.”
The second, and perhaps most notable, aspect is the reality that “the definition of what constitutes a security is a bit nebulous”:“Unlike many other countries, we do not have an exclusive list of what counts as a ‘security.’ The term of course includes stock, bonds, debentures, notes, puts, calls, and other classic ‘security’ instruments, but it also includes ‘investment contracts.’ The courts have defined the investment contract category of securities by considering whether it encompasses particular assets presented in litigation. In the grandfather of these cases, SEC v. Howey, our Supreme Court established a test for determining whether something was an investment contract and therefore a security under our laws. Howey involved interests in an orange grove, so it is clear that an instrument need not look, smell, or taste like a traditional security in order to be deemed one by our laws. Under Howey, something—including something that is a digital asset—is a security if it involves an investment in a common enterprise with an expectation of profits derived solely through the efforts of others.”
Within this nebulous framework, Commissioner Peirce pondered how tokens required to be issued as securities might eventually transition to the point of decentralization where they cease to be securities. She subsequently posited certain preliminary pillars of a safe harbor exemption for tokens to help facilitate such a transition:- “[a] non-exclusive safe harbor for the offer and sale of certain tokens” that would “permit issuers to offer tokens under an alternative regime with robust requirements”;
- a “time-limited” exemption that would “guard against reliance on the safe harbor by projects without a workable plan to build operational networks”;
- permits trading in order to “get tokens in and out of the hands of developers and users”;
- “open digital token offerings to facilitate participation in open-source software development”; and
- disclosure requirements “important to purchasers of tokens intended for use in open-source networks” (for example, “providing clear disclosure of the assets’ functionality, including the mechanisms for changing holders’ rights and explaining how funds are to be used”).
“It is important to write rules that well-intentioned people can follow. When we see people struggling to find a way both to comply with the law and accomplish their laudable objectives, we need to ask ourselves whether the law should change to enable them to pursue their efforts in confidence that they are doing so legally.”
With that backdrop, she explained that the current regulatory regime creates a “Catch 22” for new token networks:“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.”
Thus, her concept of a safe harbor proposal “recognizes the need to achieve the investor protection objectives of the securities laws, as well as the need to provide the regulatory flexibility that allows innovation to flourish.” The idea is to both retain protections for token purchasers “by requiring disclosures tailored to their needs” and preserving the application of anti-fraud provisions under the securities laws, while at the same time providing network entrepreneurs “sufficient time to build their networks before having to measure themselves against a decentralization or functionality yardstick.” Proposed Safe Harbor (Rule 195) The title of Commissioner Peirce’s proposal is: “Proposed Securities Act Rule 195 – Time-Limited Exemption for Tokens.” The preamble to Rule 195 outlines the basic purpose and operation of the proposed safe harbor, and addresses the question of “maturity” following the three-year grace period:“[T]his safe harbor is intended to provide Initial Development Teams with a three-year time period within which they can facilitate participation in, and the development of, a functional or decentralized network, exempt from the registration provisions of the federal securities laws so long as the conditions are met. The safe harbor is also designed to protect token purchasers by requiring disclosures tailored to the needs of the purchasers and preserving the application of the anti-fraud provisions of the federal securities laws.
Upon the conclusion of the three-year period, the Initial Development Team must determine whether token transactions involve the offer or sale of a security. Token transactions may not constitute securities transactions if the network has matured to a functioning or decentralized network. The definition of Network Maturity is intended to 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.”
The proposal defines “Network Maturity” as a “decentralized or functional network,” which is achieved when the network is either (a) “[n]ot 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 (b) “[f]unctional, 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.” Rule 195 seeks to strike a balance between maintaining investor protection and facilitating blockchain innovation by “exempting (1) the offer and sale of tokens from the Securities Act of 1933, other than the anti-fraud provisions, (2) the tokens from registration under the Securities Exchange Act of 1934, and (3) persons engaged in certain token transactions from the definitions of ‘exchange,’ ‘broker,’ and ‘dealer’ under the 1934 Act.” However, before the proposed exemption would apply, network developers would need to satisfy five requirements:- A good faith intention and effort to reach network maturity within three years of the date of the first token sale;
- The disclosure of key information (discussed below) on a publicly-accessible website;
- The token must be sold “for the purpose of facilitating access to, participation on, or the development of the network”;
- A good faith intention and effort to “create liquidity for users”; and
- The filing of a “notice of reliance” on the safe harbor within 15 days of the first token sale.
- Network source code
- Network transaction history
- Token Economics (“[a] narrative description of the purpose of the network, the protocol, and its operation")
- Development plan for the network
- Token sales and terms
- Initial Development Team and their token ownership
- Secondary trading platforms
- Ongoing sales of tokens by the Initial Development Team
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Stay tuned to Steptoe’s Blockchain Blog for future updates as we continue to monitor the proposed safe harbor and any related regulatory developments.