The application of the U.S. securities laws to blockchain tokens has been a controversial subject, with the Securities and Exchange Commission (SEC) taking an aggressive posture. On February 6, 2020, SEC Commissioner Hester Peirce proposed a non-exclusive safe harbor from certain of those laws for sales and other distributions of certain blockchain tokens (sometimes called token generation events, airdrops, SAFTs, ICOs or IEOs), as well as secondary trading in such tokens.
Token sales became a popular tool in 2016-17 for blockchain projects to seek initial traction for their network or platform by selling the digital item native to the platform (colloquially known as a “token”). Projects sold tokens to achieve the primary benefits of jump-starting use of their platforms by putting tokens in users’ hands and providing a source of revenue or funding for the continued development of the platforms. A vibrant secondary trading market in tokens has developed through exchanges and peer-to-peer.
Despite good intentions, token sales also were a vehicle for the unscrupulous. Bad actors did what they always do: exploit people by fraudulently stealing their money with extravagant promises they had no intention of fulfilling. This unfortunate situation distressed the many good actors in the blockchain community, but, more importantly, it quite rightly raised the hackles of regulators such as the SEC. The SEC, some have argued, went overboard in its response by seeming to characterize virtually all token sales as the offer and sale of a security. On the other hand, the SEC wanted to stop fraudulent activity, so it began a tough campaign of public statements and enforcement for the right reason: investor protection.
The result of the SEC’s actions has been confusion about the U.S. securities law analysis, particularly with respect to the definition of the term “investment contract,” an asset listed as a type of security under the federal securities laws. The term received its first definitive treatment in the so-called Howey case, a U.S. Supreme Court decision in 1946 that created the test for when a “contract, transaction or scheme” is an investment contract and therefore subject to the full slate of securities laws around the offer, sale and secondary trading of securities in connection with that contract. Everyone involved with blockchain knows the test, and Howey is arguably the most well-known Supreme Court case in the tech community, which no law student from 1946 to 2016 would have predicted.
Questions from the community include: (1) when must a token sale comply with public offering rules; (2) must miners register as broker-dealers because they record transactions in the token on the blockchain; (3) is every movement of a token on a blockchain a securities transaction subject to securities fraud claims, even if for blockchain operations; (4) what disclosures are required, by whom, and in connection with which sales or movements of tokens; and (5) must you have certain licenses to hold tokens or transact on behalf of another person?
Commissioner Peirce deserves applause for listening to all sides of the debate and coming up with an excellent proposal. The full SEC should adopt a permanent rule that adds her proposed safe harbor to the many others that already apply in a variety of situations under the securities laws. Here are five non-partisan reasons for supporting Commissioner Peirce’s proposal:
1. Just because something is an investment does not mean it is an investment contract or other type of security.
This basic notion has been lost in the token sale craze, and the law is the poorer for it. We know that under U.S. law not all investments are securities because, as evidenced by the Commodity Exchange Act and the rules promulgated thereunder, Congress clearly distinguished between securities and commodities and created two different sets of laws enforced by two entirely separate commissions (the SEC for securities and the CFTC for commodity futures and derivatives). This distinction survived Gramm-Leach-Bliley, Sarbanes Oxley, and Dodd Frank, and courts have acknowledge it.
The distinction also makes common sense. It would strain credulity (to use a phrase litigators are fond of) to consider investments in art, collectibles, or rare books securities. The SEC has never argued to the contrary.
The safe harbor proposal recognizes that there are types of investments other than securities and items – like many types of blockchain tokens – that are not investments at all. As the proposal recognizes, it is sometimes hard to tell. Rather than draw ever finer distinctions that are difficult to apply or enforce, the proposal creates a middle way, just as other securities-law provisions have. For example, the safe harbor in Rule 144 says a seller of securities will not be considered an underwriter due to the lapse of time, Regulation ATS defines when a trading system is not an exchange, and Regulation D determines when a securities offering constitutes a private sale not subject to registration
2. A blockchain token can be anything because it is digital.
In the virtual world, everything is digital: a digital representation of either a tangible item (something from the physical world like gold or coffee mugs or an automobile) or an intangible item (the product of human imagination like stock in a company or a software license or user search history). Intangible items are easier to create digitally because they merely represent something that might have existed on paper. Tangible items need to be linked to their digital representation through some sort of promise to hold or deliver the physical thing. But in all cases, the representation can exist digitally on any type of database, including a blockchain ledger. Proponents view blockchain ledgers or databases as inherently superior to other forms of databases due to their ability to create digital uniqueness, which prevents forgery of digital items.
The point is that, if we do not understand the functions and features of the digital item, then we cannot understand its value, how it is used, or how to classify it legally or regulate it. The safe harbor allows us to simplify the regulatory approach under securities laws. It does not prevent anyone from saying that their token is not a security based on the token’s functions and features, but it does allow both regulators and participants to get a project moving while still protecting (through disclosure requirements and anti-fraud provisions) for purchasers of tokens.
3. Too many terms used in an investment contract analysis are not easily or consistently defined.
Since the latter half of 2016, several ambiguous terms have emerged in debates about when a token or a token sale does not meet the Howey test. Perhaps most popular has been the concept of “sufficient decentralization.” The idea was that a sufficiently decentralized blockchain did not meet the “efforts of others” prong of Howey because there was no central authority whose efforts were responsible for the expectation of profits. Exactly what constitutes sufficient decentralization has never been clear, and there is no generally accepted definition in the technology or blockchain worlds. The phrase seems to imply that all tokens created by centralized blockchains would be securities, which defies logic for reasons stated above and because all other database technologies were centralized, and no one argued that the assets sitting on them, like bank loans, books and music, or hospital records, were by definition securities because of the manner in which they were sold.
Another troubling concept was that any “fundraising” is a securities offering, and because token sales raise funds for the seller, they are securities. Yet fundraising could mean anything, including sales of goods or services that raise revenue for a company.
A final example is “initial coin offering.” “Initial” seemed to imply “first,” but often the term ICO was used to refer to a second, third, or fourth sale or generation of tokens. “Coin” seemed to imply some type of currency, but many tokens either did not have any currency-like function, or it was limited to a particular context or purpose. Finally, “offering” suggested a sale of tokens while many were generated without a sale or pursuant to a sale.
4. Blockchain technology may change the world but that doesn’t mean it should change the law.
While blockchain may have an impact on law and regulation, fundamental legal constructs should still apply. A pair of shoes on blockchain is still a pair of shoes; a stock on blockchain is still a stock. The laws of physics are not suspended and nor should most other laws.
The proposed safe harbor would not suspend existing laws but seeks to accommodate different interpretations of laws and finds common ground through a clear compliance framework. It leverages several time-tested mechanisms of investor protection (a disclosure regime and liability for fraud), provides for new projects and tokens while allowing existing ones to become compliant, and brings the rigor and standardization of securities laws without creating undue complexity or stifling innovation.
5. The safe harbor provides certainty and ease of application while not allowing for fraud.
The safe harbor proposal would create definitions for key terms, clear time frames for action, comprehensible disclosure and filing requirements, and investor protection both from disclosure and the threat of enforcement and class actions. Perfection can be the enemy of good, and there is a lot that is good about certainty, clarity, relative simplicity, and the flexibility to proceed with other approaches (the safe harbor is non-exclusive) and enforcement against fraudulent activity.
This post comes to us from Lee A. Schneider, co-host with Troy Paredes of the Appetite for Disruption podcast, contributing editor for the Chambers and Partners Fintech Practice Guide, and general counsel of blockchain developer block.one. A version was posted on afdfintech.com. He has written this article in his personal capacity, and it does not necessarily reflect the views of Paredes, Chambers, or block.one or its directors, officers, or employees.