A THREE YEAR REPRIEVE FROM THE SECURITIES ACT FOR CRYPTO OFFERINGS?
SEC Commissioner Hester Peirce presented a draft safe harbor proposal for digital token offerings Thursday, and while attorneys have commended the draft, they say there is much work to be done with the commission to fill in gaps in the proposed rule’s structure.
Proposed Securities Act Rule 195 would give a company launching digital tokens a three-year exemption from the Securities Act of 1933 to develop a sufficiently decentralized network. The expectation is that after the safe harbor period is complete, a company would have had time to develop its network to a point of maturity where the tokens no longer fit the definition of a security.
The proposal would also create exemptions under the Securities Exchange Act of 1934, allowing exchanges to facilitate transactions of digital assets that were sold pursuant to Rule 195, and provide important market liquidity. Such exchanges would be exempt from the definitions of “exchange,” “broker” and “dealer” under the Exchange Act only with respect to tokens offered under Rule 195.
“This proposal reflects, and we’re very fortunate for this, that Commissioner Peirce has been listening to the concerns of the industry,” Joshua Ashley Klayman, global technology co-head at Linklaters LLP and U.S. head of the firm’s fintech group, told Law360. “And we’re very lucky that the regulators, in general, have been keeping their ears open, keeping their eyes open and trying to help us find a way forward.”
HOW FAR WE’VE COME
The U.S. Securities and Exchange Commission has faced wave after wave of criticism from the cryptocurrency industry over its approach to digital tokens since it released guidance in 2017 that took the form of a report on a German group known as the DAO, which stands for decentralized autonomous organization, that used blockchain technology to raise about $150 million in 2016.
Although the SEC said it would not take any enforcement action against the group, it said the DAO’s tokens — which were sold online to U.S. investors — legally qualified as securities and urged entrepreneurs and investors to act with caution, adding that it would take a “facts and circumstances” approach to whether or not a particular digital token is a security.
Since then, there’s been an uptick in enforcement actions. Notably, in 2019, the agency brought a pair of closely watched actions against Kik Interactive Inc. and Telegram Group Inc. for unregistered offerings of digital tokens, which have the chance to head to trial.
Industry groups, including the Blockchain Association and the Chamber of Digital Commerce, have highlighted a lack of regulatory clarity in the SEC’s treatment of digital assets, noting the detriment that “regulation by enforcement” could cause to the industry as a whole.
Despite the proposed rule, former SEC Senior Counsel Philip Moustakis, who is now counsel at Seward & Kissel LLP, said it wouldn’t have any immediate impact on enforcement actions.
The SEC Division of Enforcement “doesn’t change course based on possible future changes in rules or regulations or the law,” he said. “By and large, enforcement is backward-looking, and the [initial coin offerings] that in the SEC’s view violated the federal securities laws when they were conducted are still the proper subject of enforcement action as far as the SEC would be concerned.”
Peirce has been among the most vocal SEC commissioners on the digital token front, publicly raising concerns over the lack of meaningful guidance. Her safe harbor proposal takes the conversation to a new level, attorneys told Law360.
“I think it’d be extremely helpful” if something along the lines of what Peirce proposed were to eventually become a promulgated rule, Latham & Watkins LLP partner Stephen Wink said. “There’s been this incredible overhang of uncertainty in this marketplace. And that’s really stifled innovation and it’s pushed innovation offshore. There are a lot of projects out there currently that need this sort of certainty to proceed.”
Peirce would still need to garner support from a majority of her colleagues on the commission, however, before the proposal can embark on the full rulemaking process, and whether or not she can do so remains unclear. Peirce said in her Thursday speech announcing the safe harbor proposal, and in an interview with Law360, that she aims to actively engage with interested parties to eventually present a workable model to her fellow commissioners.
Key Questions Remain
The preliminary notes to Rule 195 highlight one of the key issues surrounding the application of securities laws to digital tokens: that “a token may be offered and sold initially as a security … but that designation may change over time.” The notes also outline that the application of federal securities laws “frustrate” the ability of projects to “achieve maturity,” at which point a token can spin away from being a security and SEC oversight.
At the end of the three-year safe harbor period, a specific “initial development team” would need to determine the nature of its tokens, assessing “whether token transactions involve the offer or sale of a security,” according to Rule 195. Central to this assessment is the rule’s definition of “network maturity.”
Network maturity is reached when the network in question is either sufficiently decentralized or functional, according to the rule.
While Peirce wrote in the preliminary notes to Rule 195 that “Network Maturity is intended to provide clarity as to when a token transaction should no longer be considered a security transaction, as always, the analysts will require an evaluation of the particular facts and circumstances.”
The agency in April released extensive guidance, titled the “Framework for ‘Investment Contract’ Analysis of Digital Assets,” explaining that for a digital asset to be considered a security there must be an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others,” as determined by the U.S. Supreme Court’s 1946 Howey decision.
And, in a May speech, Peirce noted that despite the Howey test having four main factors, the framework outlined 38 different issues to consider, with various sub-points to those. She said the dozens of factors outlined in the framework could have a chilling effect on nonlawyers looking to enter the space.
While Peirce’s draft proposed rule would give a token issuer more time to consider how the framework applies to their token, it would not provide a bright-line test that could allow someone to definitively say their token is not a security, attorneys told Law360.
“I think it’s really clever,” Gary DeWaal, special counsel at Katten Muchin Rosenman LLP, said of Peirce’s safe harbor proposal. “Even though there’s a recognition that instruments can morph, the problem is there doesn’t seem to be a willingness to draw a bright line. Unless there’s a willingness to draw a bright line, it’s problematic.”
Wink shared a similar thought, suggesting that it would be helpful if the rule clarified “that networks and their tokens that fall within the definition [of network maturity] are either exempt from the definition of a security or otherwise exempt from the application of the various registration requirements of the securities laws.”
“The only bright line is three years from the date of the issuance,” Moustakis said. “Rather, it shifts the facts and circumstances analysis from day one to three years plus one day.”
Moustakis also said that more needs to be done on the definitions front, conceding that they are difficult to pin down.
Peirce told Law360 she was also very conscious that she will need input from lawyers and technologists who work in the industry.
“I need people … who know the technology to look at the definitions and say to me, Hester, these will not work. … By writing it with this word, instead of with this word, you basically made it useless for this group, or you’ve made it useful only for a subset,” she said.
“I welcome comments from people who know the law and the technology and kind of get the problem I’m trying to solve,” she added. “They understand the nuances of that problem.”