SEC Commissioner Peirce has proposed a three-year safe harbor for qualifying token projects, but regulatory clarity remains elusive.
SEC Commissioner Hester Peirce has been a perennial advocate of innovation in the financial services and digital asset space. Continuing that tradition, she unveiled a Token Safe Harbor Proposal in a speech at the International Blockchain Congress on February 6, 2020. The proposal would allow for a time-limited exemption for token-based projects that seek to raise capital to develop decentralized networks. The exemption would permit fledgling networks to operate unburdened by the onerous registration provisions of the US federal securities laws.
Provided that certain standards and disclosure requirements were met, the three-year grace period would ostensibly allow token developers to pursue “sufficient” decentralization of their network from the time of first token sale, such that purchasers of the token would no longer reasonably expect that that token value was being driven by a person or group via managerial or entrepreneurial efforts. Sufficient decentralization has become the holy grail of initial coin offerings (ICOs) ever since the SEC’s Strategic Hub for Innovation and Financial Technology released a framework for assessing whether a blockchain-issued token or digital asset constitutes an investment contract (i.e., security) under the Howey test. (See New SEC Token Guidance: This Is Howey Do It and Crypto — The Pursuit of Sufficient Decentralization.)
Three-Year Grace Period, or Kicking the Can Down the Road?
Despite the proposal’s boldness, it does have some shortcomings that would limit its utility to stakeholders. While the proposal defines the achievement of “network maturity,” which is helpful, it does not specifically create a bright line that tokens on such networks will not be deemed securities. According to the proposal, network maturity is found 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
The proposal also includes a harrowing disclaimer that could overshadow the entire effort: “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 question looms — what would happen at the end of three years? Without regulatory clarity on this point, how much value could really be squeezed out of this grace period? Would that sort of “regulatory overhang” stifle innovation as it has the entire ICO market? It seems that an easy fix would be to enshrine the definition of network maturity as a bright line that is beyond the reach of the securities laws.
Of course, Commissioner Peirce is to be commended for her courage in putting forth the proposal. The road from proposal to rulemaking is a long and winding one. Nonetheless, there is real hope that if the Commissioner’s proposal were to be adopted, along with a true safe harbor for network maturity, it could be a great boon to the industry.