It’s not often that an SEC Commissioner quotes Bruce Springsteen – not once, but twice – in a speech on securities regulation. But SEC Commissioner Hester Peirce did just that in a February 6, 2020 speech in which she unveiled her novel proposal for a digital asset safe harbor. The proposal would create a three-year securities regulatory grace period during which digital network developers could distribute digital tokens while building a decentralized or functional network, provided they engage in good faith efforts to achieve decentralization or functionality within three years, fulfill disclosure obligations, sell the tokens with a purpose of facilitating network access, participation or development, undertake reasonable efforts to create token liquidity and file a reliance notice with the SEC.

Commissioner Pierce’s proposal may be the most significant since Commissioner William Hinman’s speech at the June 14, 2018 Yahoo Finance Conference in which he set forth the now generally accepted proposition that a digital asset originally offered in a securities offering could later be sold in a manner that does not constitute an offering of a security, where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created, i.e., where the network is either decentralized or functional.

Commissioner Peirce opened her speech (after quoting the Boss) by describing what she referred to as a regulatory Catch 22. Digital token network developers fear distributing tokens until the network is either decentralized or fully functional because doing so would violate the Securities Act. But they can’t develop a centralized or fully functional network unless they widely distribute the tokens to many people. Developers’ enforcement concerns are well founded given the Commission’s digital token offering enforcement campaign over the last two years, and I’ve blogged about it extensively. See, for example, here, here, here and here for my most recent posts on digital token sale enforcement.

Commissioner Peirce’s proposal seeks to resolve the regulatory Catch 22 by bridging the gap between a blockchain network’s initial centralized phase (when the tokens would be deemed to be securities) and its hoped-for decentralized or fully functional stage. The safe harbor would provide network developers a three-year grace period to facilitate development of and participation in a decentralized network by exempting (i) the offer and sale of tokens from the provisions of the Securities Act of 1933, (ii) the tokens from registration under the Securities Exchange Act of 1934 (the “Exchange Act”), and (iii) persons engaged in certain token transactions from the definitions of “exchange,” “broker,” and “dealer” under the Exchange Act.

To qualify for the proposed safe harbor, digital token network developers would have to meet the following five conditions:

  1. Reasonable Development Efforts: The development team must intend for the network 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.
  2. Disclosure. Disclosure of material information on a freely accessible public website, including source code and transaction history, description of the purpose, protocol and operations of the network, plan of development, prior token sales, initial development team and certain token holders, any secondary trading platforms on which the token trades and any member token sales of five percent or more.
  3. Purpose of Token Sales. The tokens must be offered and sold for the purpose of facilitating access to, participation on or the development of the network. This condition is intended to clarify that the safe harbor is not appropriate for debt or equity securities masquerading as tokens.
  4. Token Liquidity. The development team must undertake good faith and reasonable efforts to create liquidity for token holders.
  5. Notice of Reliance. The development team must file a notice of reliance on EDGAR within 15 days following the date of the first token sale in reliance on the safe harbor.

The safe harbor is not intended to provide immunity from fraud and is subject to bad actor disqualification under the securities laws.

Previously, compliant token offerings have been conducted pursuant to offering exemptions under Rule 506(c) of Regulation D or under Regulation A+. As Commissioner Peirce notes, however, because Rule 506(c) requires that sales be made only to accredited investors and there aren’t enough accredited investors to go around, this poses a built-in impediment to building a decentralized network. As to the alternative, Regulation A+, Commissioner Peirce observes the costs of conducting such a “mini-IPO” can be prohibitive. And even if a development team has the financial resources to do so, once the token is a security it must trade as a security while a core benefit of a token network is its non-reliance on intermediaries — people transact directly with one another. Having to buy or sell tokens through a registered broker-dealer or on a registered exchange would impede the development of a thriving, decentralized crypto network.

Finally, the condition that the development team promote liquidity in the tokens may seem antithetical to the securities offering law doctrine that generally holds that attempts to facilitate secondary trading is one indicator of a securities offering. Commissioner Peirce recognizes this, but seeks to reconcile the apparent contradiction by positing that in the context of the safe harbor, secondary trading is necessary both to get tokens into the hands of people who will use them and to offer developers and network service providers a way to exchange their tokens for fiat or crypto currency.