SEC Commissioner Peirce Updates Proposed Safe Harbor for Digital Token Sales | Practical Law

SEC Commissioner Peirce Updates Proposed Safe Harbor for Digital Token Sales | Practical Law

SEC Commissioner Hester Peirce updated her proposal for a digital token safe harbor, which would provide digital network developers with a three-year grace period to facilitate participation in and develop the platform with a registration exemption from federal securities laws.

SEC Commissioner Peirce Updates Proposed Safe Harbor for Digital Token Sales

Practical Law Legal Update w-030-5909 (Approx. 6 pages)

SEC Commissioner Peirce Updates Proposed Safe Harbor for Digital Token Sales

by Practical Law Corporate & Securities
Published on 15 Apr 2021USA (National/Federal)
SEC Commissioner Hester Peirce updated her proposal for a digital token safe harbor, which would provide digital network developers with a three-year grace period to facilitate participation in and develop the platform with a registration exemption from federal securities laws.
On April 13, 2021, SEC Commissioner Hester Peirce issued a statement announcing updates to her proposal for a digital token safe harbor (see Practice Note, SEC Regulation of Digital Assets: Peirce Proposed Safe Harbor for Digital Token Sales). The safe harbor would provide digital network developers with a three-year grace period to facilitate participation in and develop the platform with a registration exemption from federal securities laws. The proposal is solely Commissioner Peirce's own and not a formal SEC proposal, but Peirce hopes the SEC will consider how its rules can be modified to accommodate new technology in a responsible manner. In addition to her statement, Peirce also posted the safe harbor on GitHub, and invites the public to provide feedback on the updated proposal.

Background

In her speech announcing the original proposal last year, Peirce described the current status of tokens as a "regulatory Catch-22" where would-be networks are unable to distribute tokens because the tokens are potentially subject to US securities laws. However, the would-be networks are unable to mature into a functional or decentralized network that is not dependent on a single individual unless the tokens are distributed to and freely transferable among potential users, developers, and participants in the network.
Although the proposal would extend to centralized networks as well, the proposal is primarily directed to assist projects that are looking to build a decentralized network but are experiencing difficulty bridging the legal gap. The safe harbor is also intended to be available for tokens that were previously sold in a registered offering or pursuant to a valid exemption under the Securities Act. In these cases, a safe harbor may be necessary to permit secondary trading to occur and to distribute tokens more widely into the hands of potential users.
The updated proposal reflects feedback received from the crypto community, securities lawyers, and members of the public over the past year. Peirce notes the updated version makes three significant changes:
  • To enhance token purchaser protections, the safe harbor proposal would now require:
    • semi-annual updates to the plan of development disclosure; and
    • a block explorer (an online tool that allows users to view current and past transaction data on that blockchain).
  • To address concerns about the lack of clarity regarding what happens when the three-year grace period expires, the proposal now includes an exit-report requirement. The exit report would include either:
    • an analysis by outside counsel explaining why the network is decentralized or functional; or
    • an announcement that the tokens will be registered under the Exchange Act.
  • The exit report requirement also provides guidance on points that outside counsel's analysis should address when explaining why the network is decentralized.

Proposed Token Safe Harbor 2.0

The revised safe harbor proposal is designed to protect token purchasers by requiring tailored disclosures while preserving the application of the anti-fraud provisions of the federal securities laws to token distributions by initial development teams relying on the safe harbor.
For the purposes of the safe harbor, the term "token" is defined as a digital representation of value or rights:
  • That has a transaction history that:
    • is recorded on a distributed ledger, blockchain , or other digital data structure;
    • is confirmed through an independently verifiable process; and
    • cannot be modified.
  • That is capable of being transferred between persons without an intermediary.
  • That does not represent a financial interest in a company, partnership, or fund, including an ownership or debt interest, revenue share, or entitlement to any interest or dividend payment.
The safe harbor would provide network developers with a three-year grace period in order to provide time to facilitate participation in and the development of a functional or decentralized network by exempting:
  • The offer and sale of tokens from the provisions of the Securities Act, other than the antifraud provisions.
  • The tokens from registration under the Exchange Act.
  • Persons engaged in certain token transactions from the definitions of "exchange," "broker," and "dealer" under the Exchange Act.
To qualify for the safe harbor, the following conditions would need to be satisfied:
  • The initial development 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.
  • Before filing a notice of reliance on the safe harbor, initial disclosure of specified information must be provided on a freely accessible public website. Any material changes to the information must be provided on the same website as soon as practicable. Such disclosures include, but are not limited to:
    • source code and transaction history;
    • token economics, describing the purpose, protocol, and operations of the network (such disclosure must also include a hyperlink to a block explorer);
    • the plan of development;
    • prior token sales;
    • information on the initial development team and certain token holders;
    • any secondary trading platforms on which the token trades; and
    • any incidence in which a member sells five percent or more of her originally held tokens over any period of time.
    • a description of certain material related-person transactions.
    • a statement to token purchasers warning of the high degree of risk and potential loss of money.
  • Every six months after the notice of reliance has been filed, the initial development team must update the information on the plan of development required in the initial disclosures.
  • The token must be offered and sold for the purpose of facilitating access to, participation on, or the development of the network. This condition, along with the definition of token in the proposal, clarifies that the safe harbor is not appropriate for debt or equity securities that are posing as tokens.
  • The initial development team must file a notice of reliance on EDGAR within 15 days of the date of the first token sale in reliance on the safe harbor.
  • An exit report must be filed no later than three years from the date the notice of reliance was filed. As discussed above, among other information, the exit report requires either:
    • an analysis by outside counsel explaining why the network is decentralized or functional; or
    • an announcement that the tokens will be registered under the Exchange Act.
In addition, the proposed safe harbor would not be available for tokens of an initial development team if it or its individual members would be subject to disqualification as a bad actor under Rule 506(d) of Regulation D.
For further details on SEC regulation of digital assets, including digital tokens, see Practice Note, SEC Regulation of Digital Assets.