In a speech given at a blockchain forum in Chicago last week, Commissioner Hester Peirce outlined her views on the regulatory uncertainty surrounding the development of blockchain and crypto. In turn, she proposed a framework for a safe harbor for token offerings. The proposed safe harbor would give token issuers an opportunity to issue tokens to the general public without the need to register as an issuer of securities– although they would still be subject to the anti-fraud provisions of the U.S. securities laws. Issuers would only need to meet certain limited requirements in order to rely on the safe harbor.
Safe Harbor Framework for Digital Assets
According to Commissioner Peirce, in order to rely on the safe harbor network based on the five following requirements:
The [issuer] 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.
The [issuer] would have to disclose key information on a freely accessible public website.
The token must be offered and sold for the purpose of facilitating access to, participation on, or the development of the network.
The [issuer] would have to undertake good faith and reasonable efforts to create liquidity for users.
The [issuer] would have to file a notice of reliance [on the safe harbor].
The proposed framework is clearly a work-in-progress, as Commissioner Peirce has conceded.
Open Issues with the Token Safe Harbor Proposal
A review of the “Token Safe Harbor Proposal” exposes more than a few issues.
While the the proposed framework requires a team to put forth a good faith effort to achieve decentralization within three years, how that is determined is not specified.
While there is a requirement to disclose certain key information on a freely accessible website, there is no apparent requirement to disclose all material information only through that website. Thus, information asymmetry is not entirely eliminated and the opportunity for insiders and tippees to trade on such information is still an issue. Arguably, one might be able to make an argument that the failure to disclose all material information to all purchasers at the same time constitutes securities fraud.
No specific standards are specified in terms of advertising to, or solicitation of, potential purchasers of the tokens– especially important given accusations of pump-and-dump schemes, insider trading, and just outright frauds in the nascent crypto industry.
There does not appear to be any limit to the amount of money that could potentially be raised– while we want to permit token ecosystems to develop, the safe harbor should not be a way to raise money for the mere enrichment of insiders outside of the primary goal.
There is missing a general framework of checks-and-balances or belts-and-suspenders that would permit the crypto industry to police itself. Although the proposed safe harbor does not exempt any person from the anti-fraud provisions of the U.S. securities laws, that is usually a rule of last resort enforced by the regulators themselves rather than industry participants.
Regulation CF
Fortunately, I believe many of the answers to the open questions above may have already been addressed by the SEC. If we look to Regulation CF, the regulation permitting crowdfunded securities offerings, a roadmap governing token offerings is provided that substantially lessens the regulatory load on potential token issuers.
Regulation CF, the much maligned ugly stepsibling to Regulation A+, is particularly useful by analogy. Much like token offerings, Regulation CF seeks to lessen the burden on issuers and allow them access to non-accredited, “retail” investors in crowdfunded campaigns. Regulation CF includes:
limits maximum offering amounts (does anyone really need to raise $2 billion to create a functioning decentralized network or is there another reason?)
subjects investors/purchasers to income- or net worth-based limits
requires an offering disclosure document (like a token whitepaper)
mandates regular updates and annual reports (all things token issuers should be doing anyway)
requires the use of an independent auditor
limits promotion/advertising to professionals and mandates disclosure of fees and conflicts
outlines who can and cannot participate in the offering–i.e., bad actor exclusion
For critics who argue compliance with the Regulation CF regime defeats the purpose of the safe harbor proposed by Commissioner Peirce, I argue that we cannot entirely swing the other way either and have regulatory hiatus for three years. It is a matter of tradeoffs– token issuers have to bear some reasonable regulatory compliance costs especially if they raise a lot of money from token issuances. Moreover, the regulation can be structured to have differing tiers of compliance depending on the amount raised.
Proposal for Setting “Decentralization” Definition
The safe harbor proposal’s requirement to achieve decentralization within three years is a tricky issue to address. On the one hand, perhaps, a numerical cutoff should be established to determine whether a team has achieved decentralization. For example, if all available tokens issued and outstanding held by the team is less than 50%, then decentralization will have been achieved. But this might be too simplistic and doesn’t recognize that control can be exerted with even a minority holding where most other tokenholders are broadly held/distributed.
My suggestion here to Commissioner Peirce would be to consider the framework of the Investment Company Act of 1940 of requiring a majority of independent trustees to oversee shareholder assets and authorizing the hiring/firing of service providers in the case of investment companies. A similar framework could be adopted for token issuers such that decentralization has been achieved when not only does the team hold less than 50% of the issued and outstanding tokens, but also that a token project’s development is further overseen by an independent board that has a fiduciary responsibility to act in the best interests of all tokenholders.
Limiting Insider Trading in Tokens
One of the biggest complaints of the crypto space is the amount of insider trading and pumping and dumping on retail investors. Similarly, early institutional investors are granted tokens at cheap prices and then subsequently dump them on retail investors, thereby depressing the price of tokens and causing substantial losses.
In order for the safe harbor proposal’s requirement that teams create liquidity for the tokens, there needs to be restrictions that trading by insiders be restricted (whether by the team, affiliates of the team, or early institutional investors) during the safe harbor period.
In conclusion, Commissioner Peirce’s Token Safe Harbor Proposal is a welcome advancement to address the open needs in this nascent industry. However, there also remains a host of open issues that need to be addressed. As Commissioner Peirce stated in her speech, she is one of five SEC Commissioners and it takes a majority to advance the cause, but hopefully, as she also stated, this is a spark to open discussions.
