SEC Commissioner Proposes “Safe Harbor” for Cryptocurrency Securities

On Feb. 6, 2020, Commissioner Hester M. Peirce proposed a safe harbor for security token offerings. This safe harbor will exempt cryptocurrency and blockchain from federal securities registration regulations provided they satisfy certain conditions. This has been received very well in the digital currency community which was starving for some attention from policy makers. But before we dive deeper into it, let’s understand what a token is:

According to the SEC, a token is a digital representation of value or rights

1. that has a transaction history and:
   1. is recorded on a distributed ledger, blockchain, or other digital data structure,
   2. has transactions confirmed through an independently verifiable process,
   3. resists modification or tampering of the transaction.
2. that is capable of being transferred between persons without an intermediary party; and
3. that does not represent a financial interest in a company, partnership, or fund, including an ownership or debt interest, revenue share, entitlement to any interest or dividend payment.

SAFE HARBOR

Ms Pierce said, “‘There is, I think, a way to address the uncertainty of the application of the securities laws to tokens.  The safe harbor I am laying out this morning 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.  Accordingly, the safe harbor protects token purchasers by requiring disclosures tailored to their needs, preserving the application of the anti-fraud provisions of the securities laws, and giving them an ability to participate in networks of interest to them.  The safe harbor also provides network entrepreneurs sufficient time to build their networks before having to measure themselves against a decentralization or functionality yardstick. “

Although it is not effective yet, the proposed Safe Harbor referenced in her message is a three-year grace period that will provide exemptions on:

1. the offer and sale of tokens from the provisions of the Securities Act of 1933, other than the anti-fraud provisions,
2. the tokens from registration under the Securities Exchange Act of 1934,
3. persons engaged in certain token transactions from the definitions of “exchange,” “broker,” and “dealer” under the 1934 Act.

This will facilitate participation in and the development of a functional or decentralized network so long as the following conditions are met:

1. The team must intend to reach network maturity, within three years of the date of the first token sale and undertake good faith and reasonable efforts to achieve that goal
   1. “Network maturity” here is defined as either decentralization or token functionality that is:
      1. 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
      2. 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.
2. The team would have to disclose key information on a freely accessible public website that must include:
   1. the source code,
   2. transaction history,
   3. purpose and mechanics of the network (including the launch and supply process, number of tokens in initial allocation, total number of tokens to be created, release schedule for the tokens and total number of tokens outstanding,
   4. information about how tokens are generated or minted, the process for burning tokens, the process for validating transactions and the consensus mechanism,
   5. the governance mechanisms for implementing changes to the protocol,
   6. the plan of development, including the current state and timeline for achieving maturity,
   7. financing plans, including prior token sales,
   8. the names and relevant experience, qualifications, attributes, or skills of each person that is a member of the team,
   9. the number of tokens owned by each member of the team, a description of any limitations or restrictions on the transferability of tokens held by such persons, and a description of the team members’ rights to receive tokens in the future,
   10. the sale by any member of 5% or more of his or her originally held tokens
   11. any secondary markets on which the tokens trade. Disclosures would need to be updated to reflect any material changes.
3. The token must be offered and sold for the purpose of facilitating access to, participation on, or the development of the network.
4. The team would have to undertake good faith and reasonable efforts to create liquidity for users. This means that the teams will have to seek secondary trading that can demonstrate compliance with all applicable federal and state law, as well as regulations relating to money transmission, anti-money laundering, and consumer protection. secondary trading is recognized as necessary both to get tokens into the hands of people that will use them and offer developers and people who provide services on the network a way to exchange their tokens for fiat or crypto currency.
5. Finally, the team would have to file a notice of reliance. The disclosure will have to be filed on EDGAR within fifteen days of the date of the first token sale

Points to remember

• Safe harbor would be available for tokens that were previously sold in a registered offering or pursuant to a valid exemption under the Securities Act.
• It will not be available to a team if one or more members of the team is subject to disqualification as a bad actor under the securities laws.
• The safe harbor would reserve the SEC’s antifraud authority with respect to token sales

Why the SEC commissioner proposed the change

Until now the SEC has scrutinized token sales as investment contracts based on the case SEC v. W. J. Howey Co. which obstructs crypto entrepreneurs from building decentralized networks in which a token serves as a means of exchange on, or provides access to a function of the network. Other examples of companies that went through SEC’s enforcement actions for creating and selling tokens are Telegram and Kik (two major messaging platforms).

Many token offerings have proceeded under exemptions from registration, typically Regulation D exemptions but with access to only accredited investors it is difficult for these projects to fully take off. In theory, an S-1 would work as well but it is restricted in advance public communication while these networks rely heavily on pre-marketing. Regulation A remains the choice of offering and comes with heavy cost. But even if the companies opt for it, once the token is a security, it must be traded as a security and The SEC has been clear that when a network becomes decentralized enough, a token can cease to be a security.

The SEC has also been clear that the secondary trading of securities, including digital assets, requires a broker-dealer license and currently there is no active secondary trading market for digital asset securities in the U.S.

Some projects have excluded U.S. investors to avoid being governed by the securities laws enforced by the SEC.

Conclusion

Ms. Pierce remarked, “I have concluded the SEC can do this. The SEC has broad exemptive authority under securities laws. After looking after it, it is not as different as I thought that it potentially could be. It is not without some questions and I am looking forward to getting some lawyers input on it.” She has invited any suggestions/feedback on the proposal and anyone willing can contact directly at CommissionerPeirce@sec.gov or connect with the FinHub.

Security Token Compliance

Colonial Stock Transfer can help you with your security token transfer agent and Edgar filing needs whether it be a Reg D, Reg A+, or other offering. We are here to help you navigate through these complexities and ensure compliance with the Safe Harbor guidelines.