Crypto Reform Comes To Congress: Three-Year Safe Harbor Proposal For Distributing Pre-Network Maturity Digital Tokens | Farrell Fritz, PC

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Context: Crypto Catch 22

Followers of the SEC’s efforts to regulate digital tokens will recall the speech by former SEC Corp Fin Director William Hinman at the Yahoo Finance conference on June 14, 2018, in which he presented the now generally accepted proposal. according to which a digital asset could initially be considered a security while its network is under development but then evolves into a non-security where there is no longer a central company in which to invest 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, that is, where the network is decentralized or functional. See my blog post about it here.

According to Howey’s test, digital tokens offered and sold before the underlying network is decentralized or functional would likely be considered securities as long as buyers have a reasonable expectation that network developers make the management efforts. or business essentials needed to create value in tokens. . But for a network to become a decentralized or functional network that does not depend on a single person or group to carry out essential management or business efforts, tokens must be distributed and freely tradable by individuals. potential users, programmers and network participants. The problem with this Catch 22 crypto is that the application of federal securities laws to the distribution of tokens before “network maturity” thwarts the network’s ability to reach maturity and prevents tokens initially sold as security. to evolve in non-titles on the network.

Crypto Mom’s Safe Harbor

To address this issue, in March 2020, SEC Commissioner Hester Peirce (aka “Crypto Mom”) presented a proposal (which I blogged about here), revised in April 2021 as Safe Harbor 2.0, for create a three-year safe harbor during which developers would be allowed to distribute tokens to facilitate participation and development of a functional or decentralized network, exempt from the registration requirements of federal securities laws, both that certain disclosure and other conditions are met, including the filing of a trust notice in the safe harbor. Safe Harbor 2.0 offered three changes to the original. First, a requirement for a semi-annual update of the development disclosure plan. Second, a mandatory exit report at the end of the three-year grace period containing either an analysis by an outside lawyer as to why the network is decentralized or operational, or an announcement that the tokens will be registered under the Securities Exchange Act of 1934. And third, advice for decentralization analysis from outside lawyers in the form of factual and circumstantial benchmarks rather than a clear line test.

The Digital Token Clarity Act 2021

Crypto Mom’s Safe Harbor 2.0 was not passed by the SEC, but it now has a strong sponsor in Congress. On October 5, 2021, Cong. Patrick McHenry, a leading member of the Financial Services Committee and a leading advocate for capital market reform, 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 of the Securities Act of 1933 (referred to as “Token Safe Harbor”) for the offering and sale of a token if (i) the initial development team intends to for the network on which the token is operating to reach network maturity within three years of the first token sale, (ii) the token is offered and sold for the purpose of facilitating the access, participation or development of the network and (iii) the initial development team complies with certain disclosure and filing requirements.

Disclosure requirements

The disclosure provisions of the Act would require developers to disclose the source code on a publicly accessible website; the steps required to independently access, search and verify the history of network transactions; a description of the purpose of the network; the current status and schedule of network development to show how and when the initial development team intends to reach network maturity, with semi-annual updates; before token sales; identities of the initial development team and certain token holders; trading platforms on which the token is traded; transactions between related persons; and a warning that buying tokens involves a high degree of risk and potential loss of money.

Submission requirements

As is the case with Safe Harbor 2.0, the Act’s filing requirements would consist of a Safe Harbor Notice of Use and an Exit Report. The Safe Harbor Notice must be filed with the SEC prior to the date of the first token sold under the Safe Harbor. If a development team sold tokens before the Act came into effect but wishes to invoke the Safe Harbor, they can do so by filing the Notice of Appeal as soon as possible.

The exit report should generally be filed no later than the expiration of the third anniversary of the first token sale, the content of which would depend on the determination of the development team at this point as to whether the maturity of the network has been achieved, and whether for a decentralized or functional network.

If the development team determines that network maturity has been reached for a decentralized network, the output report should include a legal analysis which consists of a description of the extent to which decentralization has been achieved with respect to power. voting, development efforts and network participation. , as well as an explanation of how the development team’s pre-network maturity activities differ from the team’s ongoing involvement with the network.

If the development team determines that network maturity has been reached for a functioning network, the legal analysis should include a description of the use of tokens by holders and an explanation of how the marketing efforts of the network. ‘development team before the maturity of the network and the team’s continued efforts efforts will continue to focus on the consuming use of the token, and not on the appreciation of the price of the token.

If the initial development team determines that the maturity of the network has not been reached, the output report should include a description of the state of the network and the next steps that the development team intends to take. , as well as a statement acknowledging that the team will check in. tokens as a class of securities under Section 12 (g) of the Securities Exchange Act of 1934 within 120 days of filing the report.

Network maturity

The law defines “network maturity” as the status of a decentralized or functional network which is achieved by meeting the standard of control or functionality. According to the control standard, network maturity exists when the network is not economically or operationally controlled and it is not reasonably likely to be economically or operationally controlled or unilaterally changed by a single person, entity or group. of persons or entities under common control. Any network whose initial development team owns more than 20% of the tokens or more than 20% of the means to determine network consensus would not be eligible for network maturity. A network would be considered “functional” if tokens are used by token holders for the transmission and storage of value on the network, for participation in an application running on the network, or otherwise in a compatible manner. with the utility of the network.

Final thoughts

The Digital Token Clarity Bill of 2021 gives Congress the opportunity to responsibly bring greater clarity to crypto developers who are looking for ways to fund their network development and reach market maturity. network without unreasonable regulatory barriers. When it comes to the overall determination of whether or not the network has reached maturity, the Act takes a facts and circumstances approach rather than a clear line test, which is probably the right approach. It remains to be seen whether the Act will gain traction on the Hill.

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