On February 6, 2020, SEC Commissioner Hester Peirce gave a speech in which she proposed a regulatory solution for crypto entrepreneurs through new Securities Act Rule 195 and several related Exchange Act rules. The proposed rules would create a three-year safe harbor during which token projects that meet certain requirements could enjoy exemption from SEC registration and other requirements. Peirce explained that network creators currently may eschew certain token projects that temporarily, while in development, might trigger application of the securities laws − even though, once fully mature, the ultimate token products might not constitute securities. To encourage innovation, the proposed laws would provide the time-limited exemption from registration to allow creators to develop their networks to “maturity,” ie, either decentralization or functionality, at which point the underlying tokens may have transcended classification as securities and thus application of SEC regulation, allowing for certain token transactions without required registration as a broker-dealer or exchange. Commissioner Peirce’s proposed rules have received significant attention, with some speculating that such rules could stimulate the US market for digital assets. Below we summarize the impetus for Commissioner Peirce’s proposed rules, the rules themselves, and their possible fate and impact.
For a bit of background, Commissioner Peirce was appointed by President Trump to fill a Republican seat on the SEC. She has been critical of regulatory expansion, including in the cryptocurrency space. She has also opined that regulation has stymied innovation in the digital asset industry.
Commissioner Peirce announced her proposed rules during a February 6, 2020, speech to the International Blockchain Congress. She emphasized that “[i]t is important to write rules that well-intentioned people can follow” and to “address the regulatory difficulties faced by people who want to build functioning networks.” Consistent with her prior positions, she reiterated her belief that US securities laws and regulations currently stand in the way of well-intentioned blockchain-based innovation.
The Commissioner then outlined the specific problem that Securities Act Rule 195 and its accompanying Exchange Act rules seek to address. Specifically, the SEC has suggested that it has jurisdiction to regulate the distribution of tokens on blockchain networks unless and until those networks become sufficiently decentralized or functional. But building such networks may require maturation and development time, and during this time, these networks may lack sufficient decentralization and functionality to avoid regulation of the tokens as securities. This may cause token developers to eschew innovation of ultimately non-securities products for fear of interim regulation by the SEC.
Proposed Securities Act Rule 195’s safe harbor, would provide network developers with a three-year grace period to create and develop a functional or decentralized network, during which the assets would enjoy exemption from the registration provisions of the Securities Act (although not its antifraud provisions). The proposed Exchange Act rules would exempt tokens from the Exchange Act’s registration requirements and persons engaged in certain token transactions from the Exchange Act’s definitions of “exchange,” “broker,” and “dealer.”
To qualify for the safe harbor, developers would have to meet at least five conditions. First, developers must intend for the network on which the tokens function to reach network maturity − defined as either decentralization or token functionality − within three years of the first token sale. In her speech, Commissioner Peirce reiterated her view (which finds support in SEC actions and commentary over recent years) that tokens do not constitute securities if they exist on a fully decentralized network or are in actual use for exchanging goods or services. Second, developers would have to disclose certain key information on a public website to reduce information asymmetry between developers and users. Required disclosures would include information such as the network rules (eg, how will tokens be generated, how many tokens the network will generate and when) and development plan. Third, the token offer and sale must be intended to facilitate access to, participation on, or development of the network. Commissioner Peirce noted that this requirement would help prevent developers from issuing securities masquerading as tokens. Fourth, developers must endeavor to create liquidity for users. Commissioner Peirce acknowledged that the SEC has viewed secondary trading as an indication of a securities offering. But, she explained, developing a decentralized or functional network may require secondary trading, for example, to distribute the token to people who will actually use it. Fifth, developers must file a notice of reliance on the safe harbor with the SEC.
While prognostication is always difficult, if adopted, Rule 195 would likely encourage additional token project development. Legitimate developers would have a far more certain path forward than currently exists.
But as Commissioner Peirce acknowledged, Rule 195’s future is uncertain. She is only one of five SEC Commissioners and, as she noted, her views may differ from those of the SEC or other commissioners. Furthermore, she added that the views she expressed in her speech “are not fully formed in [her] own mind and may not reflect [her] own opinions in the months to come.” In addition, Commissioner Peirce’s term expires in June 2020, and if her ideas do not gain traction with the other Commissioners and she leaves the Commission, a potential safe harbor may not move forward. Finally, like other agencies, the SEC has a lengthy formal rulemaking process. Currently, a potential blockchain safe harbor is not on the SEC’s rulemaking agenda. Even if it is added to the agency’s rulemaking agenda, the time from development of a proposed rule for public comment to Commission approval of a final rule can take years, if it ever occurs.
Despite the uncertainties, Rule 195 represents a bold proposal concerning digital asset regulation. At a minimum, Commissioner Peirce has started the regulatory discussion in a manner that should be hard to ignore. Importantly, she has invited direct engagement on her proposal with calls, emails, meetings or feedback on FinHub (the SEC’s Strategic Hub for Innovation and Financial Technology.) We urge industry participants to accept her invitation to help develop reasonable regulation.