SEC Commissioner Hester Peirce earlier this month proposed a draft SEC Rule 195 as a safe-harbor for developmental token offerings, providing a registration exemption for three years to allow the token’s network to achieve “maturity.”

Proposed Rule 195.

In proposing the Rule, Commissioner Peirce stressed that it is a developmental concept and welcomed direct input.  She also said it might work better as a no-action position.

The Rule would provide a three-year non-exclusive exemption to allow Initial Development Teams (“IDT”) an “incubator” period during which a token “wrapped in an investment contract” would be exempt from ’33 Act registration, while the IDT develops a sufficiently decentralized (or “mature”) network.  A mature network is one developed to the point that token purchasers “no longer reasonably expect a person or group to carry out the essential managerial or entrepreneurial efforts” to generate profit.  The Rule would require the IDT (and the SEC) to reassess the “facts and circumstances” at the end of the exemption period to determine if a Howey investment-contract conclusion no longer is warranted.

In return for the exemption, the IDT would be required to disclose key project information publicly, act in good faith and register their reliance on the exemption:

The initial development team would have to meet certain conditions, which I will lay out briefly before addressing several in more depth.  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.  Second, the team would have to disclose key information on a freely accessible public website.  Third, the token must be offered and sold for the purpose of facilitating access to, participation on, or the development of the network.  Fourth, the team would have to undertake good faith and reasonable efforts to create liquidity for users.  Finally, the team would have to file a notice of reliance.

The proposal also includes Exchange Act exemptions to allow exchanges to facilitate transactions and provide liquidity.  Notably, the exemption would not extend to the anti-fraud provisions in Sections 12(a)(2) and 17 of the ’33 Act.

Peirce’s “Why” - Running on Empty.

Proposing the Rule, Commissioner Peirce told of a college road trip when she pulled into a New Jersey gas station in a downpour.  Despite the notice of a law preventing customers from pumping their own gas, the attendant clearly expected her to do it because he would not come out in the rain.

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.

Of the SEC’s position, Peirce said:

We have created a regulatory Catch 22.  Would-be networks cannot get their tokens out into people’s hands because their tokens are potentially subject to the securities laws.  However, would-be networks cannot mature into a functional or decentralized network that is not dependent upon a single person or group to carry out the essential managerial or entrepreneurial efforts unless the tokens are distributed to and freely transferable among potential users, developers, and participants of the network.  The securities laws cannot be ignored, but neither can we as securities regulators ignore the conundrum our laws create.

Commissioner Peirce’s address, Running on Empty: A Proposal to Fill the Gap Between Regulation and Decentralization (Feb. 6, 2020, at Chicago, IL), is here.

Getting to Renegade Pandas

The SEC’s seminal statement on tokens was its Section 21(a) Report, The DAO, Rel. 34-81207 (SEC July 25, 2017), here.  In The DAO, the SEC applied the Howey analysis to conclude that tokens offerings were a form of “investment-contract” security.

The next year, Corporate Finance Director William Hinman suggested that when a digital asset once offered as security (investment contract) later might become part of a sufficiently decentralized network such that one would conclude a purchaser was not reasonably relying on the managerial or entrepreneurial efforts of others.  Digital Asset Transactions:  When Howey Met Gary (Plastic), Remarks at the Yahoo Finance All Markets Summit: Crypto (San Francisco, CA, June 14, 2018), here.

The SEC’s no-action positions over the period recognized that purely utilitarian tokens within a developed network were not “securities.”  See, e.g., TurnKey Jet (April 3, 2019), here and Pocketful of Quarters (July 25, 2019), here.

That tension between the need to develop networks while issuing tokens to develop them appears in the Court’s opinions in SEC v. Blockvest, No. 18-cv-2287 (USDC SDCA Nov. 27, 2018).  In that case, involving a token offering and attempts to develop the token network, the Court first denied the SEC’s motion for a preliminary injunction on the limited-scope “beta” version. Id.,  2018 U.S. Dist. LEXIS 200773 (S.D. Cal. Nov. 27, 2018).  The Court later reversed itself on reconsideration and granted the injunction based upon false representations to prospective public purchasers beyond “friends and family.”  Id., 2019 U.S. Dist. LEXIS 24446 (S.D. Cal. Feb. 14, 2019).  See also here. 

The SEC aggregated its prior token guidance and enforcement positions in its mid-2019 “Framework,” here.

Peirce discussed her disappointment that the SEC’s positions seemed to inhibit innovation and first floated her safe-harbor concept in her “Renegade Pandas” speech in Singapore on July 30, 2019.  See here.