SEC Safe Harbor for Crypto — Maybe Story
By Sergey Golubev (Сергей Голубев) on The Capital
The biggest US and worldwide challenge for the cryptocurrency world has historically been from the Securities Exchange Commission (SEC), which establishes regulations for companies that wish to be traded publicly on the stock market and to raise some funds. In recent years, the SEC stated periodically that while bitcoin (and ether) may not be security, many tokens are securities, and relevant regulations applying to normal stocks and IPOs would apply to them as well. Known how ICOs usually operate, this presents an obvious problem. This position by the SEC amounted to statement that most ICOs were, in fact, illegal security offerings. It also destroys efforts for truly decentralized networks to launch, because, in order for those networks to function, the tokens that power them must be distributed, and if team building the project can’t do that without running directives of regulator well, it’s easy to see the problem here.
The desire to avoid the SEC’s wrath has led most projects to ban US citizens from participating in ICOs, and some exchanges even refused Americans as customers that is open discrimination against US people. It’s no surprise then that many projects choose to relocate abroad to more crypto-friendly locations like Malta, Singapore, Switzerland, or Hong Kong. In many cases, the people behind those projects are actually American citizens, but the regulatory ambiguity is so deep, and the consequences of getting it wrong so risky that they won’t take the risk of running the project in their home jurisdiction. In order to avoid falling behind in the blockchain revolution, the United States will clearly need to make some changes. That’s why Commissioner Hester Peirce’s recent comments on providing a temporary “safe harbor” for new crypto projects was a pleasant surprise to many in the industry.
SEC Commissioner Hester Pierce proposed a token safe harbor for decentralized projects from aggressive review by the SEC. The SEC currently reviews practically any decentralized project from its earliest stages and often applies the same regulations that it applies to publicly traded securities. The extent of these regulatory measures and review makes it harder for developers to experiment and flesh out their decentralized networks, which may eventually not fall under the definition of a security. The proposal would create a three-year grace period where the SEC provides developers with more roads to grow their projects without stringent review. Projects in the grace period are still subject to some regulations, like data disclosure (source code, transaction history, etc.) and review for fraud and malpractice. Upon conclusion of the safe harbor period, developers must show that their projects are robust, active decentralized networks where tokens wouldn’t be considered traditional securities or they become subject to the same SEC regulations as publicly traded securities. The proposal represents an important step forward in fighting the legal uphill battle that blockchain technologies have often faced, and making it significantly easier for developers to experiment with various architectures without fear of aggressive review and regulation by the SEC.
SEC Commissioner Hester Peirce, colloquially known as “CryptoMom,” launched a proposal at the International Blockchain Congress in Chicago for a token safe harbor proposal for the SEC and decentralized finance projects. The motivation behind Peirce’s proposal comes from stringent and confusing SEC regulations and review. These processes tend to disincentivize people from pursuing the creation of various tokens and decentralized networks and adds more friction to the process of developing decentralized networks and working out various problems and pain points in its architecture. Currently, the SEC aggressively tries to classify decentralized cryptocurrency projects as securities, which puts these projects through a strict review process because of legal regulations around how to trade securities publicly. Developers often work hard to build their architecture with characteristics to avoid the security classification, but often, in early stages, the SEC classifies their projects as securities nonetheless, subjecting many early-stage decentralized networks to the review process. The SEC Safe Harbor would essentially allow early stage decentralized projects (contingent on a few conditions) to be able to initially develop and grow without strict review by the SEC, making it significantly easier for such projects to move forward.
The proposal, formalized as Rule 195, gives some leeway to growing projects that hope to eventually become full-fledged decentralized networks that fall out of the conception of a “security” under the SEC definition. To qualify for the safe harbor, projects must meet a certain number of requirements. Developers must show that their project is evolving into an active, decentralized network where token transactions would not be considered securities transactions. They also are subject to a plethora of reporting and disclosures, including source code and transaction data, information on the token mining & minting process, and clear explanations of token governance (how supply is regulated, procedures for burning, consensus protocols, etc.).
The projected time for the safe harbor is three years, where developers have more leeway to play around with their network architecture without needing to worry about aggressive SEC review. During this grace period, projects would function as SAFTs, or Simple Agreements for Future Tokens, where the tokens are not yet considered securities. To qualify as a SAFT, projects must also create significant liquidity in the market and allow purchasers to resell tokens to third-parties. After the three years, developers must show a decentralized network that falls out of the conception of SEC securities (as determined by the Howie Test) or must be subject to scrutiny under SEC security standards and laws.
The safe harbor would not allow any projects that have already been disqualified as bad actors through SEC review; it would also maintain the SEC’s power and jurisdiction over antifraud cases, meaning that developers found guilty of lying about their tokens could still be tried by the SEC for fraud activity. The vast majority of the crypto community has been thrilled by Peirce’s proposal. Catherine Coley, CEO of Binance, claimed that it could be the “most groundbreaking development for the U.S. cryptocurrency market to date.” Proponents argue that the safe harbor will lead to a much smoother growth curve for decentralized networks and also give developers the space they need to explore various paths and possibly fail in their development process, while still maintaining the benefits of SEC review. The proposal represents a huge step forward in allowing developers to differentiate their projects from conventional, publicly traded securities, and also giving more federal & legal credibility to cryptocurrency projects across the country. Legal recognition and adaptation have always been an uphill battle for decentralized projects, and a safe harbor could be the first step in changing that.
The term “safe harbor” basically means a reduction in liability in some situations if certain criteria are met. There is a precedent for this concept; the SEC’s Rule 10b-18 was established in 1982 to make it easier for companies to buy back shares of their own stock, and reduce their liability as long as specific conditions were met. But that’s just one, very specific situation. In order to put crypto investors and developer’s minds at ease, a crypto-specific safe harbor rule will be needed.
That’s what Hester Peirce’s idea is designed to provide. Under this proposal, new projects would be given a 3 year grace period in which the SEC would take no action against them as long as five conditions are met (quoting from the source):
1. 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.
2. Second, the team would have to disclose key information on a freely accessible public website.
3. Third, the token must be offered and sold for the purpose of facilitating access to, participation on, or the development of the network.
4. Fourth, the team would have to undertake good faith and reasonable efforts to create liquidity for users.
5. Finally, the team would have to file a notice of reliance.
This proposed framework would give new projects some breathing room where they can do their work without fear of being fined, arrested or having their offices raided. It would also provide a reasonable amount of time to actually build viable decentralized networks, and require them to be fully transparent with users online (while many projects do try to do this by publishing roadmaps and white papers, there are no actual laws requiring them to do so). This obviously filer out the bogus projects that have no intention of building a workable, decentralized product. For investors, this would essentially legalize token sales in the United States as long as these specific criteria are met. While some in the crypto community does have a certain anarchic libertarian aversion to government scrutiny, these new regulations may not be such a bad thing, given that a vast number of ICOs turned out to be fraudulent during the pre-2018 “Wild West” era of cryptocurrency.
Although crypto community has questions for SEC’s Safe Harbor concept as well. The proposed safe harbor would give digital token projects three years to demonstrate that the tokens they issue are not securities, and therefore should not be subject to the SEC’s securities regulations. The hotly anticipated proposals were met with approval from many in the crypto community. However, a week on, many prominent names in the sector have had time to deep-dive into Peirce’s proposals and have now raised a range of concerns. “Thinking more about Hester Peirce’s proposal for a token safe harbor, which really does advance the ball re US SEC issues,” wrote Caitlin Long on Twitter, a Wyoming-based blockchain expert. The open problem that there are issues that still need to be addressed — the basic one is whether the tokens are presumed securities during the safe harbor or not.
During a speech in Chicago last week, Peirce discussed the problem at hand. Many crypto entrepreneurs are seeking to build decentralised networks in which a token serves as a means of exchange on, or provides access to, a function of the network. In the course of building out the network, they need to get the tokens into the hands of other people. But these efforts can be stymied by concerns that such efforts may fall within the ambit of federal securities laws, adding the fear of running afoul of the securities laws is real. Given the SEC’s enforcement activity in this area, these fears are not really unfounded. As it stands, entrepreneurs looking to issue tokens can be hesitant to do so in fear of breaching the SEC’s stringent regulatory regime.
“We have created a regulatory catch-22,” said Peirce. That means that Would-be networks cannot get their tokens into people’s hands because their tokens are potentially subject to the securities laws. The laws cannot be ignored, but neither can SEC, as securities regulators ignore the conundrum our laws create. It’s a case of investors causing issue for the very entrepreneurs they are investing in. Most investors buying tokens when they are first available are not in fact immediately acquiring them for a ‘consumptive’ purpose. They believe that, over time, the related network will grow and they will be able to sell the tokens for a profit. But what of third parties who want to use the tokens for their intended purpose, and what about exchanges that want to provide access to tokens? If adopted, the safe harbor proposal will address these secondary sale transactions by persons not affiliated with the initial development team. There is no policy reason why such asset sales should comply with the securities laws.
Let’s suggest the proposals are positive, but points out some issues: the proposal opens at least two problems — the custody question, and creates problems for issuers outside the US. Many countries recognize that tokens aren’t necessarily securities, but if the US thinks they are, then other countries may follow. This proposal moves the ball, but there’s still a big catch-22 preventing the security token industry from flourishing in the US. But, on the other hand, if the tokens aren’t presumed securities during the three-year grace period, then they’re property. In the US, individual states, not the SEC, have jurisdiction over property — meaning the SEC would need to cooperate with each state for the proposal to work. This matters a lot because property and securities are treated differently under commercial law (different negotiability, different ways of perfecting security interest, etc.). Others made similar points.
The first thing that struck crypto community was the tone of mission statement implied. This looks like ‘how do we make workable token sales that allow networks to develop?’ not ‘how do we apply the securities laws to issuers of instruments?’ Is this a policy shift? Some commentators have questioned if the safe harbor proposal is a ratification of the Simple Agreement for Future Tokens (SAFT) framework. SAFT is an investment contract offered by cryptocurrency developers to accredited investors (in 2017), which is considered a security and therefore is compliant with securities regulations. It was first created to help new cryptocurrency entrepreneurs raise money without breaching financial regulations; specifically, the regulations that govern if the investment is a security or not. Some expected Peirce’s safe harbor to be a formal ratification or extension of the SAFT model. Others suggest it is not. That this is not an extension of the SAFT framework at all. It is like a dramatic new approach to regulating token issuance desire.
‘’The SAFT framework looks downright conservative next to this”, wrote Marco Santori, president and chief legal officer of digital asset platform Blockchain.com. For many, this proposal is far superior to the SAFT framework. It exempts from the registration requirements not only resales of tokens, but also primary issuance. By and large, under the SAFT framework that became standard in 2017/18, primary issuance of tokens in the US could only be to accredited investors. In contrast, this safe harbor proposal permits initial sales to the public right out of the gate; it gives retail the same early access as venture capital funds.
According to Jeffrey Amico, counsel at tech venture capital firm Andreessen Horowitz, if the safe harbor passes, “it would not only be very positive news for new token launches, but also for existing SAFTs that are sitting in regulatory limbo”. These points show that the proposals need to be worked out in details — far from unusual for this type of regulatory change. In her speech, Peirce suggested that her office would be open to discussion. Hopefully, there is one point on which we can all agree: if you are in this space, it is critical to understand the arguments on both sides and to have an informed view on them. The safe harbor proposal is the beginning of an important dialogue on this topic, if you do not take into account the hysteria in the global economy around the coronavirus.
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Sergey Golubev (Сергей Голубев)
EU structural funds, ICO/STO/IEO projects, NGO & investment projects, project management, comprehensive support for business
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