Background: Crypto Catch 22
Followers of the SEC’s efforts to regulate digital tokens will recall former SEC Corp Fin Director William Hinman’s speech at the June 14, 2018 Yahoo Finance Conference in which he introduced the now generally accepted proposition that a digital asset could originally be deemed a security while its network is being developed but then evolve into a non-security where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created, i.e., where the network is decentralized or functional. See my blog post on this here.
Under the Howey test, digital tokens offered and sold before the underlying network is decentralized or functional would likely be deemed to be securities so long as purchasers reasonably expect the network’s developers to carry out the essential managerial or entrepreneurial efforts necessary to build value in the tokens. But for a network to mature into a decentralized or functional network not dependent upon a single person or group to carry out the essential managerial or entrepreneurial efforts, the tokens must be distributed to and freely tradeable by potential users, programmers and participants in the network. The problem with this crypto Catch 22 is that the application of the federal securities laws to the pre-“network maturity” distribution of tokens thwarts the network’s ability to achieve maturity and prevents tokens initially sold as a security from evolving into non-securities on the network.
Crypto Mom’s Safe Harbor
To address this problem, in March 2020 SEC Commissioner Hester Peirce (aka “Crypto Mom”) introduced a proposal (which I blogged about here), revised in April 2021 as Safe Harbor 2.0, to create a three-year safe harbor during which developers would be allowed to distribute tokens to facilitate participation in and development of a functional or decentralized network, exempt from the registration requirements of the federal securities laws, so long as certain disclosure and other conditions are met, including filing a notice of reliance on the safe harbor. Safe Harbor 2.0 proposed three changes to the original. First, a requirement for semi-annual updates to the plan of development disclosure. Second, a mandatory exit report at the end of the three-year grace period containing either an analysis by outside counsel explaining why the network is decentralized or functional, or an announcement that the tokens will be registered under the Securities Exchange Act of 1934. And third, guidance for outside counsel’s decentralization analysis in the form of facts and circumstances guideposts rather than a bright-line test.
The Clarity for Digital Tokens Act of 2021
Crypto Mom’s Safe Harbor 2.0 has not been adopted by the SEC, but it now has a powerful sponsor in Congress. On October 5, 2021, Cong. Patrick McHenry, ranking member on the Financial Services Committee and leading capital markets reform advocate, introduced a bill called the Clarity for Digital Tokens Act of 2021 which would effectively codify Commissioner Peirce’s Safe Harbor 2.0 proposal.
The Clarity for Digital Tokens Act would create an exemption from registration under a new Section 4B to the Securities Act of 1933 (to be called “Token Safe Harbor”) for the offer and sale of a token if (i) the initial development team intends for the network on which the token functions to reach network maturity within three years after the first token sale, (ii) the token is offered and sold for the purpose of facilitating access to, participation on or the development of the network and (iii) the initial development team complies with certain disclosure and filing requirements.
The Act’s disclosure provisions would require developers to disclose on a freely accessible public website the source code; the steps necessary to independently access, search and verify the network’s transaction history; a description of the purpose of the network; the current state and timeline for the development of the network to show how and when the initial development team intends to achieve network maturity, with semi-annual updates; prior token sales; identities of the initial development team and certain token holders; trading platforms on which the token trades; related person transactions; and a warning that the purchase of tokens involves a high degree of risk and potential loss of money.
As is the case with Safe Harbor 2.0, the Act’s filing requirements would consist of a notice of reliance on the safe harbor and an exit report. The notice of reliance on the safe harbor would need to be filed with the SEC prior to the date of the first token sold in reliance on the safe harbor. If a development team has sold tokens prior to the effectiveness of the Act but wants to avail itself of the safe harbor, it may do so by filing the notice of reliance as soon as practicable.
The exit report would generally need to be filed on or before the expiration of the three year anniversary of the first token sale, the contents of which would depend on the development team’s determination at that point as to whether network maturity has been achieved, and if so whether for a decentralized or functional network.
If the dev team determines that network maturity has been reached for a decentralized network, the exit report would need to include a legal analysis that consists of a description of the extent to which decentralization has been reached as to voting power, development efforts and network participation, as well as an explanation of how the dev team’s pre-network maturity activities are distinguishable from the team’s ongoing involvement with the network.
If the dev team determines that network maturity has been reached for a functional network, the legal analysis would need to include a description of the holders’ use of tokens and an explanation of how the dev team’s pre-network maturity marketing efforts and the team’s ongoing efforts will continue to be focused on the token’s consumptive use, and not on token price appreciation.
If alternatively the initial dev team determines that network maturity has not been reached, the exit report would need to include a description of the status of the network and the next steps the dev team intends to take, and a statement acknowledging that the team will register the tokens as a class of securities under Section 12(g) of the Securities Exchange Act of 1934 within 120 days after filing the report.
The Act defines “network maturity” as the status of a decentralized or functional network that is achieved by meeting the standard of either control or functionality. Under the control standard, network maturity exists when the network is not economically or operationally controlled and not reasonably likely to be economically or operationally controlled or unilaterally changed by any single person, entity or group of persons or entities under common control. Any network of which the initial development team owns more than 20% of the tokens or more than 20% of the means of determining network consensus would be not qualify for network maturity. A network would be determined to be “functional” if the tokens are used by token holders for transmission and storage of value on the network, for participation in an application running on the network, or otherwise in a manner consistent with the utility of the network.
The proposed Clarity for Digital Tokens Act of 2021 gives Congress an opportunity to bring greater clarity in a responsible manner to crypto developers seeking ways to finance the development of their network and achieve network maturity without unreasonable regulatory impediments. As to the overarching determination of whether or not network maturity has been achieved, the Act takes a facts and circumstances approach rather than a bright line test, which is probably the sensible approach. It remains to be seen whether the Act will gain traction on the Hill.