In New Jersey, it’s illegal to pump your own gas. Initially, she was relieved by this arcane law, but the gas attendant decided that given the weather, he would not pump her gas. Commissioner Pierce was faced with two choices: obey the law and become stranded in New Jersey--which was certain--or risk being arrested for breaking the law and pump her own gas.
Choosing between a scenario that was certain to happen and another scenario that may that had a remote possibility of happening, she decided to take the risk and pumped her own gas, breaking New Jersey law.
She observed that founders of certain blockchain companies were faced with the same type of dilemma. On the one hand, it’s illegal to offer and sell securities without registering with the SEC or finding an exemption from registration. On the other hand, tokens do not fall neatly under the current definition of a security.
The SEC has applied the Howey test to analyze whether a token is a security. Under the Howey test, a token is a security if buyer invests money in a common enterprise and reasonably expects profits from
the efforts of others.
In order to promote ICOs, promoters have emphasized their efforts to make the tokens more valuable. Additionally, the founding team must use initial efforts to create the ecosystem and the tokens before the ecosystem can become sufficiently decentralized and no longer rely on the efforts on the founding team.
Catch-22 Under Current Law
Under current law, if a promoter attempts to sell a token--for example, one that can eventually be used to purchase goods and services on an ecosystem--by emphasizing the efforts that they’ll make to increase the price of a token, they would risk violating the law under the Howey test because the buyer would buy the token, reasonably expecting the founding team to make their token more valuable. If the company offers the tokens as securities, the tokens would remain a security and be subject to securities laws, which prevents the tokens from being used for its intended purpose.
People do not buy securities to purchase goods, services or access rights. However, without capital, the founding team may not have sufficient capital to develop their tokens or their network. If tokens that are not meant to be securities are forced to be sold under a securities framework because it has a characteristic of a security at the time of sale, this may prevent the tokens from getting into the hands of the public. Distribution is necessary for the public to access, develop, and otherwise participate in a decentralized ecosystem. When an ecosystem is sufficiently decentralized, it no longer makes sense for a token to be a security because a buyer would not be relying on the efforts of the party selling the token to increase the token’s value. Rather, the increase in value would be based on the participants and developers in the network.
Commissioner Pierce’s Proposed Rule
To bridge the gap between the need to protect buyers and to encourage innovation, Commissioner Pierce proposed a 3 year safe harbor for offers and sales of tokens meeting certain characteristics. Under these new rules tokens and offers and sales of tokens meeting these characteristics are exempt from the securities laws. Persons promoting these tokens and exchanges would also be exempt.
Under the proposed rule, token sales would be exempt from the securities laws if the following criteria are met:
1. Three-Year Grace Period
The initial development team intends for the network to reach network maturity within 3 years. This means that three years after the first sale of a token, the network must be sufficiently decentralized or a functioning network that allows the token to be used for the exchange of goods or services. This means the network cannot be centrally controlled or the tokens can be used consistently for its intended purpose. A network can be centrally controlled as long as the tokens can be used for their intended purpose.
2. Public Disclosures
The team makes public disclosures of the following:
Transaction history (e.g., block explorer)
Mechanics of the network, including the launch and supply process, total number of tokens to be created and the total number of tokens outstanding, how tokens are generated, process for burning tokens, validating transactions, the consensus mechanism, and governance mechanisms for changing the protocol
The team’s development plan, including the current state of development, the timeline and roadmap to network maturity
Key people, including qualifications and experience
The number of tokens owned by each member of the team, including limits on transferability and the ability to receive tokens in the future
Any instance when a key member sells 5% or more of her originally held tokens
Any material changes in initial disclosures, including changes in token economics, the network’s functionality, or the development team
3. Token Characteristics
The tokens must be sold for particular purposes, such as to facilitate access, participation, or development in the network. Tokens that are equity or debt securities do not qualify under this safe harbor.
4. Token Liquidity
Team must attest that it intends to and will undertake good faith and reasonable efforts to provide liquidity for users. If tokens are placed on an exchange, the team has to vet them to ensure that they are complying with federal and state securities laws, regulations relating to money transmission, anti-money laundering, and consumer protection. In addition, the seller must disclose where the tokens can be traded.
5. Notice of Reliance
Finally, a seller relying on the proposed rule must file a notice of reliance with the SEC within 15 days of the first sale in reliance of the safe harbor.
Conditions to Using the Safe Harbor
The proposed safe harbor is not available to a team, where one of the members is a “bad actor” as defined under the securities laws. That means, if someone on your team has violated the securities laws, this safe harbor is not available for the sale of your tokens.
Additionally, the anti-fraud rules under the securities laws still apply. This means, you cannot lie to or mislead your buyers. This includes omitting material facts or omitting facts that could mislead your investors.
The proposed safe harbor would apply to tokens that registered under the Securities Act or were sold under an exemption. These teams may need the safe harbor to permit secondary trading or to distribute the tokens in the hands of users
The rule that Commissioner Pierce outlined is only a proposal and should not be attributed to the SEC. Her proposal is not the law and it cannot be relied on for current sales of tokens. Every offer and sale of a token must be analyzed under the currently existing securities framework.
Additionally, Commissioner Pierce is uncertain if the proposal would be codified as a rule or come in a no-action position. If the safe harbor comes in the form of a no-action position, the Commission would pledge not to take action against projects that meet the parameters set out in the no-action position. If it’s a rule, offers and sales of tokens that fit under the safe harbor are exempt from state law.
Comments are Welcome!
Commissioner Pierce set out the proposal as a rule for purposes of discussion and invites anyone with feedback to call her, swing by her office, or providing feedback through FinHub. From my experience interacting with regulators, they really mean this! So, if you have feedback, please provide them.
This article is provided for informational purposes only and should not be construed as legal advice. Read our disclaimer here.