Newly Proposed Safe Harbor Would Relax Regulations for Crypto Startups

One of the largest obstacles in the crypto space is that many felt stifled by government regulation at one time or another. Now, an exciting new development, if implemented, could lead to industry expansion and more mature tokenization projects in the future.

SEC Commissioner’s Proposed Plan

In a recent International Blockchain Congress speech, U.S. Securities and Exchange Commission (SEC) Commissioner Hester Peirce proposed a safe harbor from many of the federal securities laws and regulations for new token projects. As reported in a February CoinDesk article, during this proposed three-year grace period, which would commence at the time of the first token sale, each startup project would establish an “initial development team,” which would be allowed to build a community and network for the project. According to Pierce’s speech, in order to provide liquidity to users, the development teams would be required to “to seek a trading platform that can demonstrate compliance with all applicable federal and state law.” At the end of the three-year safe harbor, the development team would be required to figure out whether their tokenized transactions qualify as securities transactions subject to additional regulation.

"It is important to write rules that well-intentioned people can follow. When we see people struggling to find a way both to comply with the law and accomplish their laudable objectives, we need to ask ourselves whether the law should change to enable them to pursue their efforts in confidence that they are doing so legally," Commissioner Peirce stated in her speech. Current U.S. regulations hinder token distribution, which, in turn, hampers a network’s maturation and decentralization. Therefore, Commissioner Peirce referred to these rules as “a regulatory Catch 22.” 

Notably, Commissioner Peirce also clarified that the classification of any given token offering as a security may change over time if the asset matures. In this case, the term “network maturity” means that the network is operational and is “not controlled and is not reasonably likely to be controlled” by one single person or entity. Furthermore, to increase a token’s liquidity and allow for speculation, the development team may choose to pursue legal secondary trading markets. On a secondary market, one may trade securities after an issuer has sold them as initial public offerings on the primary market.

Typically, crypto startups must undergo securities evaluations, such as the Howey Test. Named for the 1946 U.S. Supreme Court case SEC v. W.J. Howey Co., the Howey Test is an assessment used to determine whether any given transaction qualifies as a particular type of security called an investment contract. The Howey test considers the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others as investment contracts qualifying as securities. According to the Howey analysis, many factors guide the determination of whether the purchaser of a digital asset is relying “on the efforts of others” as indicated. None of these factors is determinative on its own, however. The fewer of these factors a transaction satisfies, the less likely it is to qualify as a security. Examples include:

1. Whether an active participant (a third party or affiliated group of third parties) is responsible for developing, operating, or improving the network.

2. If the active participant performs essential tasks.

3. If the active participant “creates or supports a market for, or the price of, the digital asset.”

4. If the active participant continues to make decisions about the network or the digital asset.

If an unaffiliated, decentralized network of users performs the “essential tasks” mentioned above, then the transaction is less likely to qualify as a security.

Disclosures

To prevent fraud, Commissioner Peirce proposed some requirements. These include:

1.    Public notices

2.    Personal disclosures

3.    Source code disclosures

4.    Publicly accessible transaction and token sales histories

5.    Token economics and roadmap

These anti-fraud requirements would protect investors, along with SEC enforcement actions against bad actors. More specifically, as cited by CoinDesk, an issuer would disclose “the names and relevant experience, qualifications, attributes or skills” of each member, how many tokens they have, and how many they may earn through rewards programs. Furthermore, the transaction history would be located on a publicly accessible website, along with a description of how to search.

According to Commissioner Peirce, no one has yet issued a registered token offering in the U.S. In fact, projects utilizing the proposed safe harbor could utilize SEC registration exemptions under Regulation D of the Securities Act as an alternative. For example, under Rule 506(c) of Regulation D, although issuers of securities offerings may publicly advertise or otherwise generally solicit, they may only sell to accredited investors.