“It is a riddle, wrapped in a mystery, inside an enigma; but perhaps there is a key.” Winston Churchill said these famous words in October 1939, and since then, almost everyone repeating them has left out the “key” part. Similarly, critics of an unusual proposal from SEC Commissioner Hester Peirce to create a safe harbor for issuing crypto tokens have focused on its problematic details, without asking whether there is a key to making it into actual policy. The proposal actually makes sense when assessed in the latter way.
How can the U.S. government allow crypto entrepreneurs to fund the development of innovative and potentially beneficial projects without becoming liable for violations of the securities laws?
Solving this riddle has occupied crypto startups, lawyers for crypto-based businesses, and the SEC staff since the surge of crypto token sales, often called Initial Coin Offerings (ICOs), in 2017. Crypto token sales have raised billions of dollars for startups despite resting on difficult legal ground under the U.S. securities laws.
Wrapped in a Mystery
U.S. securities laws have presented obstacles to crypto token sales since the July 2017 SEC Report of Investigation that assessed them using the now-familiar Howey test—once a mystery to the crypto community.
The July 2017 report established that the SEC will consider a crypto token to be a security if it is “an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others”—the Supreme Court’s test in its 1946 SEC v. W.J. Howey Co. decision. A crypto token meeting this test must be registered with the SEC or qualify for an exemption from the registration requirements, or else the SEC may find the issuer liable for violations of the Securities Act of 1933 and the Securities Exchange Act of 1934.
Startups have attempted various approaches to issuing crypto tokens without running afoul of the SEC. Many have conducted exempt offerings under Regulation A, exempted private placements to U.S. accredited investors under Regulation D, or exempted private placements to foreign investors under Regulation S. No-action relief was successfully obtained for the first time in April 2019.
Attempting to avoid the coverage of the Howey test and the registration requirements also has been a popular approach. Classifying crypto tokens as “utility tokens” rather than “security tokens” has been one way. Another way has been the Simple Agreement for Future Tokens (SAFT), an agreement for the later transfer of crypto tokens from a company to investors, in which the SAFT is considered to be a security that must be registered but the underlying crypto tokens are not.
SEC enforcement actions have re-established some of mystery around the Howey test by declaring some attempts to avoid its coverage to be unsuccessful. For example, in October 2019, the SEC blocked the sale of Telegram tokens (Grams) using a SAFT with a temporary restraining order after Telegram had already raised $1.7 billion, alleging in its complaint that the offer and sale of Grams using a SAFT was an unregistered sale of securities. Litigation in this matter is ongoing.
With her proposal for a safe harbor, Commissioner Peirce—widely nicknamed “CryptoMom” for her advocacy for blockchain and the crypto sector—attempts to unwrap the mystery around the original riddle. Announced in the Feb. 6 speech “Running on Empty: A Proposal to Fill the Gap Between Regulation and Decentralization,” the safe harbor proposal is styled as “Proposed Securities Rule 195—Time-limited Exemption for tokens”.
The safe harbor would provide an “initial development team” with a three-year grace period in which the offer and sale of its tokens would be exempt from the Securities Act of 1933, provided that it meets five conditions: (1) intends for the network on which its token functions to reach “network maturity” within three years of the date of the first token sale, and undertakes good faith and reasonable efforts to achieve that goal; (2) discloses key information on a freely accessible public website; (3) offers and sells the token for the purpose of facilitating access to, participation in, or development of the network; (4) undertakes good faith and reasonable efforts to create liquidity for users; and (5) files a notice of reliance on the SEC’s EDGAR system.
The antifraud authority of the SEC would not be affected by the safe harbor. SEC enforcement actions would continue to punish and deter fraud in connection with token sales.
Emphasizing that the safe harbor concept remains a work in progress, Commissioner Peirce encouraged public comments on how to improve Proposed Securities Rule 195 in her Feb. 6 speech and subsequent interviews, saying, “Give me a call, send me an email, stop by my office, provide feedback at the SEC’s FinHub webpage or post your comments online.”
Inside an Enigma
The safe harbor proposal has received praise from the crypto community and criticism from many legal commentators. Critics have said that the proposal lacks specificity regarding crucial terms; that it would have little impact on the development of emerging security token markets; and that it might not be worth the effort,given the odds against adoption. However, these specific critiques choose to ignore the elephant in the room: The proposal is an enigma.
Why the safe harbor proposal exists at all is not clear.
One SEC Commissioner taking the initiative to write a proposed rule without any legislative mandate, outside of the normal SEC staff rulemaking process, and without any apparent support from the other Commissioners is highly unusual. Commissioner Peirce acknowledged this in the conclusion to her Feb. 6 speech, saying, “Now that I have outlined a safe harbor, I suspect some of you are asking, ‘Who cares?’ I get the point. I am one of five Commissioners. I cannot write rules unilaterally.”
Commissioner Peirce has provided little insight into how the safe harbor proposal could become an adopted safe harbor rule. “It does not hurt to get the ball rolling,” and “People change their minds,” she said, along with Bruce Springsteen’s lyric, “You can’t start a fire without a spark.” But without a path to adoption, a more appropriate 1980s song lyric would be from David Byrne of Talking Heads (not John Byrne of AMLRightSource or Preston Byrne of Anderson Kill): “We’re on the road to nowhere.”
The safe harbor proposal has not had any apparent influence on related regulatory rulemakings. On March 4, the SEC announced proposed amendments to Regulation A, Regulation D, and other rules to simplify exempt offerings, and there was no mention of the safe harbor proposal—not even in Commissioner Peirce’s statement suggesting additional changes to the rules.
Nor has the safe harbor proposal had any apparent influence on related enforcement actions. The SEC closely followed the proposal with an enforcement action in which Enigma MPC agreed on Feb. 19 to pay a $500,000 fine to end allegations of raising $45 million in a token sale that was an unregistered securities offering.
To state the obvious, in the Enigma MPC case, the SEC seems to have declared the safe harbor proposal to be an enigma.
Commissioner Peirce’s term ends in June, leaving little time for her to persuade the other Commissioners who will remain for years after she departs. Chairman Jay Clayton’s term runs for another year, and Commissioners Elad Roisman’s and Allison Herren Lee’s will last until 2022 and 2023, respectively. (One of the five Commissioner seats is currently vacant.) Unless the proposal inspires the others to act soon, or to act after its author departs, it will end up as a thought experiment rather than a regulatory action.
But Perhaps There Is a Key
Winston Churchill ended his famous saying with the words, “But perhaps there is a key. That key is Russian national interest.” Removing the “Russian” reference leaves what may be the key to the safe harbor proposal becoming a reality: national interest, as determined by Congress rather than the SEC.
SEC decisions on crypto assets have had their basis in the securities laws as interpreted by the Supreme Court in Howey, not in the ideologies or whims of the commissioners. Congress deciding that a safe harbor is in the national interest and including it in legislation would require the SEC to adopt it.
Such an act could be aimed specifically at crypto assets, like the introduced but unpassed Token Taxonomy Act of 2019. Or it could be part of a bill to encourage startup companies more generally—perhaps a JOBS Act 4.0. (Yes, there have already been three (!) “JOBS Acts”–the original JOBS Act of 2012; the Fixing America’s Surface Transportation Act of 2015, often called JOBS Act 2.0; and an unpassed JOBS Act 3.0 of 2018.)
There is no public indication that the safe harbor proposal is intended to develop into legislation rather than a regulation. But the possibility is likely to have occurred to Commissioner Peirce, who formerly served as Senior Counsel on the Senate Banking Committee after working as an SEC staff attorney on regulatory rulemakings that often took years to complete. (Disclosure: I worked on such prolonged rulemakings in the same SEC staff office as Commissioner Peirce in 2001–2005.)
We will see, up to the end of Commissioner Peirce’s term in June and possibly beyond, whether her safe harbor proposal ends up as a regulatory rulemaking debated within SEC headquarters or as part of legislation debated in the Capitol, only a few blocks away. Such a move could surprise observers who have focused narrowly on the details of developments without seeing the broader picture at multiple agencies and branches of government.