SEC Cmr. Hester Peirce’s Token Safe Harbor Proposal 2.0: First Impressions

Barbara Piro works as a Legal Corporate Specialist at an Italian gaming company based in Rome. She is also a RegTrax Contributor for the United States.

On April 13, 2021, US Security and Exchange (SEC) Commissioner Hester M. Peirce, who has truly earned her “CryptoMom” moniker, released an amended version of her safe harbor proposal for blockchain tokens. Her original version, entitled “Proposed Securities Act Rule 195: Time-limited exemption for Tokens” was previously published in February 2020. Since then, Cmr. Peirce has sought out comments and feedback from the crypto community. This Version 2.0, released both as an SEC Public Statement and as a Github repo, incorporates the suggestions made over the past year.

According to this new proposal, an Initial Development Team—defined as “any person, group of persons, or entity that provides the essential managerial efforts for the development of the network … and makes the initial filing of a notice of reliance”—will have three years to establish their network as “functional or decentralized” in order to receive an exemption from federal securities registration, assuming they are able to meet certain additional conditions. This sort of regulatory sandbox is aimed at fostering the development of a mature network for the exchange of tokens while simultaneously ensuring that the transactions are conducted in a safe and responsible manner.

After three years, the Initial Development Team will be required to analyze the state of the network and, accordingly, determine whether or not “the network has matured [into] a functioning or decentralized network.” This assessment would have significant consequences, since the sale of tokens that are usable on a fully mature network, for example, may not constitute securities transactions. Without this safe harbor, the SEC has indicated that many US token sales (with the exception of those that operate under other compliant structures, e.g., Regulation A offerings) are in violation of US securities law.

To better understand the implications of the “Token Safe Harbor Proposal 2.0”, it is worth analyzing a few definitions provided by Cmr. Peirce’s updated document. First of all, it is essential to establish what a token is, as well as flesh out its defining features. This latest Safe Harbor proposal defines a token as:

“a digital representation of value or rights 

(i) that has a transaction history that: 

(A) is recorded on a distributed ledger, blockchain, or other digital data structure; 

(B) has transactions confirmed through an independently verifiable process; and 

(C) cannot be modified;

(ii) that is capable of being transferred between persons without an intermediary party; and

(iii) that does not represent a financial interest in a company, partnership, or fund, including an ownership or debt interest, revenue share, entitlement to any interest or dividend payment”. 

One interesting question concerns the intended scope of these distributed ledger technologies, as they represent the backbone of the definition provided. For example, does this cover private or consortium blockchains? At what point do transactions become unable to be modified?

Another useful definition is that of “Network Maturity,” which will ideally give structure to the status of a decentralized or functional network when it is either clearly not, or not likely to be, “economically or operationally controlled or unilaterally changed by any single person, entity, or group of persons or entities under common control.” An additional safeguard come in the form of an exception carved out that disallows networks in which the Initial Development Team controls either 20% of the supply or 20% of the means of reaching consensus from relying on this particular definition to show maturity. If a network cannot show itself to have reached maturity under the prior definition, it can still attempt to show itself to be functional “as demonstrated by the holders’ use of Tokens for the transmission and storage of value on the network, the participation in an application running on the network, or otherwise in a manner consistent with the utility of the network.” As suggested by Commissioner Peirce, determining the status of the network will require a factual analysis which will be crucial to achieve the main objective of this safe harbor proposal: establishing when token transactions should no longer be considered security transactions.

Also of particular interest to both lawyers and token companies is the newly-introduced requirement of an exit report: a document that will have to be filed after three years from the date the notice of reliance (which can also be found in Version 1) is submitted. This exit report is intended primarily to determine whether the network was able to reach network maturity either via decentralization or functionality, or if not, how the Initial Development Team intends to proceed (although, in all likelihood, the next step is registration with the SEC). If a claim of maturity is to be advanced, an analysis by outside counsel—including certain descriptions and explanations of the characteristics of the network—will have to be provided. In the case of a decentralized network, the report will include salient information such as the metric(s) used to argue for decentralization (looking at network dimensions such as voting power, development efforts, etc.), and a discussion on how the Initial Development Team’s role has changed. If the token project is claiming that their network is now functional, on the other hand, the report asks for descriptions of use and details on how the team intends to restrict marketing efforts to encourage consumptive engagement, rather than purchases for purely speculative reasons. Notwithstanding the unquestionable relevance of the introduction of the concept of the exit report, it would be useful to specify who may file the exit report after the expiration of the three-year period.

All things considered, the structure put forward in this proposal offers a significant—if still theoretical—boon to token projects, as well as legal professionals, technologists, and the public. If enacted, Commissioner Peirce’s “Token Safe Harbor Proposal 2.0” would be a tremendous step towards greater regulatory clarity for the blockchain space.

Barbara Piro works as a Legal Corporate Specialist at an Italian gaming company based in Rome. She is also a RegTrax Contributor for the United States.