Introduction

The rise of digital assets and cryptocurrency quickly transformed into a significant area for corporate and securities lawyers, following the SEC’s 2017 Section 21(a) DAO report, which concluded that cryptocurrencies are typically securities under the Howey Test. Since then, the regulatory landscape has been continuously evolving, with numerous enforcement actions and guidance issued by the SEC. The complexity surrounding digital tokens, particularly in distinguishing between securities and utility tokens, has left both innovators and practitioners navigating uncharted waters.

Cryptocurrency as a Security: The Regulatory Challenge

Since the DAO report, the SEC has reinforced that most cryptocurrency tokens, especially those issued for capital raising, are classified as securities. However, while capital raising might be clear, the broader regulatory treatment of digital tokens, especially those fundamental to decentralized applications, has remained ambiguous. For instance, tokens that help facilitate decentralized networks raise questions about their initial classification as securities and their future transition into utility tokens.

The SEC’s enforcement actions, including the temporary injunction against Telegram’s Gram token, underscored this challenge. Telegram’s token was widely perceived as a utility token, but the SEC considered it a security due to its initial use for fundraising. In contrast, Blockstack’s Regulation A offering of its token provided a different path for token issuances, emphasizing the importance of pre-offering compliance.

The Regulation A Approach and S-1 Constraints

Regulation A has emerged as a viable method for issuing digital tokens to the public, allowing pre-marketing and broad public communications. In contrast, traditional S-1 filings limit communication before the offering, making it an unsuitable route for most token issuances that rely heavily on pre-offering marketing and community building. Regulation A+ has enabled issuers like Blockstack to register tokens while allowing them to be used on decentralized networks, though concerns about transitioning from security to utility tokens remain.

The Secondary Trading Conundrum

Another major regulatory challenge involves the secondary trading of digital asset securities. According to the SEC, secondary trading of securities (including digital assets) requires a broker-dealer license, presenting a barrier to developing a robust secondary market for digital assets in the U.S. Nevertheless, digital tokens used within a decentralized network for their intended purpose may be treated differently from those being traded as securities.

Commissioner Hester Peirce’s Safe Harbor Proposal

SEC Commissioner Hester Peirce has become a vocal advocate for regulatory innovation in the digital asset space. Acknowledging the challenges faced by cryptocurrency projects, she proposed a safe harbor that would give digital asset projects a three-year grace period to develop and decentralize their networks, exempt from federal securities laws, provided certain conditions are met. This proposal aims to bridge the gap between the current regulatory framework and the practical realities of token-based networks.

Key Aspects of the Safe Harbor Proposal:

1. Three-Year Grace Period: Developers would have three years to facilitate participation in and development of a decentralized or functional network without fear of violating securities laws.
2. Disclosure Requirements: Projects would need to disclose critical information on a public website, such as the token's purpose, the development team's identities, and the governance mechanisms.
3. Good-Faith Efforts to Decentralize: Teams must demonstrate their intention to decentralize the network or make the token functional within three years.
4. Liquidity for Users: Developers are encouraged to create secondary trading markets for token liquidity, but these markets must comply with federal and state laws.
5. Filing with the SEC: Developers must file a notice on EDGAR within 15 days of the first token sale, signaling reliance on the safe harbor.

Legal Implications and Challenges

While Commissioner Peirce’s proposal addresses some of the regulatory concerns surrounding token projects, it still faces challenges. For instance, achieving “decentralization” within three years is subjective and could lead to uncertainty. Additionally, the reliance on self-regulation and public disclosure introduces potential risks, such as inadequate investor protection. The proposal also does not preclude anti-fraud enforcement, meaning that even under the safe harbor, projects must adhere to the SEC’s anti-fraud provisions.

Conclusion

Commissioner Peirce’s safe harbor proposal is a significant step toward regulatory clarity for digital asset projects, especially those that aim to develop decentralized networks. However, it remains to be seen whether this proposal will gain traction within the SEC or the broader regulatory community. As the cryptocurrency industry continues to evolve, a balance between innovation and investor protection must be struck. The regulatory framework for digital assets is still in its infancy, and there is hope that proposals like Peirce’s will pave the way for a more defined, practical, and supportive regulatory environment for blockchain-based projects.