Digital assets are relatively new compared to many other asset classes, and their regulatory framework has changed significantly over the years. Many jurisdictions and their regulatory entities have sought to provide an ideal environment for digital assets.
In a February 2020 speech, Hester M. Peirce, a commissioner of the U.S. Securities and Exchange Commission (SEC), proposed creating a safe harbour period for token sales. Under this plan, which was unveiled at the International Blockchain Congress, companies issuing digital tokens would have three years during which the network for their digital assets could become sufficiently decentralised.
If a digital token's network achieves a certain level of decentralisation, it would not qualify as a security under the Howey Test, the standard used by the SEC. Alternatively, if a digital asset did not become decentralised enough by the end of the safe-harbor period, the company that issued it would have to register with the SEC and abide by securities laws.
Peirce stated that many digital currency entrepreneurs are looking to build decentralised networks that make use of digital tokens. While fulfilling this objective requires putting tokens into the hands of users, distributing such digital assets could put these entrepreneurs at risk of breaching securities laws.
She elaborated in an opinion piece she wrote for CoinDesk. In the article, she noted that projects will probably not enjoy network effects until the point that their digital tokens are distributed to users, and these users have the ability to easily transfer them.
However, entrepreneurs may be hesitant to distribute digital tokens if selling these assets constitutes a securities offering. As a result, networks that leverage digital tokens may have a hard time achieving decentralisation.
Peirce's proposal would give "network developers" a three-year safe harbour as long as they meet specific requirements. By ensuring that those creating such networks provide adequate disclosure and follow federal securities laws' anti-fraud provisions, the following four requirements can help protect investors, according to Peirce's notes.
The first stipulation involves a so-called initial development team, which would be responsible for supervising the project's growth during its first years, as well as its objectives. "First, the team must intend for the network on which the token functions to reach network maturity—defined as either decentralization or token functionality—within three years of the date of the first token sale and undertake good faith and reasonable efforts to achieve that goal," the proposal stated.
The second requirement centers on disclosure, as those developing networks would need to reveal "key information on a freely accessible public website." Those responsible for creating the network would need to disclose "the names and relevant experience, qualifications, attributes, or skills of each person who is a member of the Initial Development Team."
They would also need to make the network's source code and transaction history publicly available. Additionally, the initial development team would need to provide details surrounding its network and its plans to bring it to maturity. They would have to reveal the following as well: the number of tokens each member owned, "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."
Peirce's proposal would require teams to "disclose any time that a member sells five percent or more of her originally held tokens over any period of time, which would help to guard against fraud."
The third requirement involves token functionality. The proposal states that "the token must be offered and sold for the purpose of facilitating access to, participation on, or the development of the network." In other words, the safe harbour was not designed for projects that are looking to sell debt or equities in the form of digital tokens.
A fourth requirement is an obligation to "undertake good faith and reasonable efforts" to provide liquidity for users. Also, network developers interested in obtaining the exemption would be obligated to file a "notice of reliance" with the SEC.
Safe Harbour Ending
At the conclusion of the three-year period, it would be up to an initial development team to conclude whether a specific token transaction qualifies as either the offer or sale of a security. Assuming the network has evolved to a point of significant maturity or functionality, transactions involving its tokens may not count as securities offerings.
In her CoinDesk opinion piece, Peirce elaborated by saying that a network would have reached significant maturity if "it is not controlled and is not reasonably likely to be controlled, or unilaterally changed, by any single person, group of persons, or entities under common control."
Peirce also clarified what she meant by functionality. For this to be achieved, users would be able to leverage tokens "in a manner consistent with the utility of the network."
Call For Comment
When announcing this proposal, Peirce left the door open so that industry participants and other interested parties could offer their two cents. "If we are going to do something like what I suggest today, I want to get it right," she stated. She added that "getting it right" means she needs people to "tell me what I have gotten right and what I have gotten wrong."
The proposal received a wide range of reactions, which varied from individuals voicing strong support to those who rejected it outright, according to Peirce's CoinDesk opinion piece. She said that the responses frequently fell into two categories.
Some pointed out there is no "bright-line test" for concluding that a token is in fact a security. Peirce reiterated that for a token to avoid being classified as a security, its network would have to be either significantly decentralised, meaning that it is not controlled by a single entity or group of entities, or functional, which means users can harness tokens "in a manner consistent with the utility of the network."
As for those who voiced concerns that her proposal would help create another raft of token sales, she stated that her suggestions were specifically created to make it more challenging for fraudulent projects to raise money and easier for legitimate projects to progress.
Preston Byrne, an attorney and columnist for CoinDesk, penned a highly critical response to Peirce's proposal. He noted that there is no clear standard for "decentralization." He added that in some cases, regulators have given differing treatment to projects that "appear technically indistinguishable."
"The SEC's 'decentralization' test, as currently used, and as proposed to be used in the future, is unquantifiable to the point of being unconstitutionally vague," claimed Byrne. He wrote that if industry participants like marketers and developers are unable to agree upon a uniform definition of a term, the government may have a very hard time doing so.
Peirce has put forward a very interesting proposal for network developers, which would give those holding token sales a three-year safe harbour to build out their network to the point where it is either sufficiently decentralised or functional.
To qualify for a safe harbour, the teams behind these projects would have to fulfill various requirements including disclosing their names, qualifications and information on their token holdings. They would also need to make the source code and transaction history of their network publicly available.
At the end of the three years, the initial development team would be able to determine whether a sale of their tokens represented a securities transaction.
Peirce has made a call for comment, which has resulted in varying responses. She stated during her initial speech that the proposal is a "work in progress," adding that she hopes "many other voices" will weigh in.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…