SEC Safe Harbor for Crypto

VeradiVerdict - Issue #71

  • SEC Commissioner Hester Pierce proposed a token safe harbor for decentralized projects from aggressive review by the SEC. The SEC currently reviews practically any decentralized project from its earliest stages and often applies the same regulations that it  applies to publicly-traded securities. 

  • The extent of these regulatory measures and review makes it harder for developers to experiment and flesh out their decentralized networks, which may eventually not fall under the definition of a security.

  • The proposal would create a three-year grace period where the SEC provides developers with more leeway to grow their projects without stringent review. Projects in the grace period are still subject to some regulations, like data disclosure (source code, transaction history, etc.) and review for fraud and malpractice.

  • Upon conclusion of the safe harbor period, developers must show that their projects are robust, active decentralized networks where tokens wouldn’t be considered traditional securities or they become subject to the same SEC regulations as publicly-traded securities. 

  • The proposal represents an important step forward in fighting the legal uphill battle that blockchain technologies have often faced, and making it significantly easier for developers to experiment with various architectures without fear of aggressive review and regulation by the SEC. 

What’s the deal with the SEC Safe Harbor Proposal?

SEC Commissioner Hester Peirce, colloquially known as “CryptoMom”, launched a proposal at the International Blockchain Congress in Chicago for a token safe harbor proposal for the SEC and decentralized finance projects. 

The motivation behind Peirce’s proposal comes from stringent and confusing SEC regulations and review. These processes tend to disincentivize people from pursuing the creation of various tokens and decentralized networks and adds more friction to the process of developing decentralized networks and working out various problems and pain points in its architecture. 

Currently, the SEC aggressively tries to classify decentralized cryptocurrency projects as securities, which puts these projects through a strict review process because of legal regulations around how to trade securities publicly. Developers often work hard to build their architecture with characteristics to avoid the security classification, but often, in early stages, the SEC classifies their projects as securities nonetheless, subjecting many early-stage decentralized networks to the review process.

The SEC Safe Harbor would essentially allow early-stage decentralized projects (contingent on a few conditions) to be able to initially develop and grow without strict review by the SEC, making it significantly easier for such projects to move forward.

What exactly does it mean?

The proposal, formalized as Rule 195, gives some leeway to growing projects that hope to eventually become full-fledged decentralized networks that fall out of the conception of a “security” under the SEC definition. To qualify for the safe harbor, projects must meet a certain number of requirements.

Developers must show that their project is evolving into an active, decentralized network where token transactions would not be considered securities transactions. They also are subject to a plethora of reporting and disclosures, including source code and transaction data, information on the token mining & minting process, and clear explanations of token governance (how supply is regulated, procedures for burning, consensus protocols, etc.). 

The projected time for the safe harbor is three years, where developers have more leeway to play around with their network architecture without needing to worry about aggressive SEC review. During this grace period, projects would function as SAFTs, or Simple Agreements for Future Tokens, where the tokens are not yet considered securities. To qualify as a SAFT, projects must also create significant liquidity in the market and allow purchasers to resell tokens to third-parties. After the three years, developers must show a decentralized network that falls out of the conception of SEC securities (as determined by the Howie Test), or must be subject to scrutiny under SEC security standards and laws.

The safe harbor would not allow any projects that have already been disqualified as bad actors through SEC review; it would also maintain the SEC’s power and jurisdiction over antifraud cases, meaning that developers found guilty of lying about their tokens could still be tried by the SEC for fraud.

What’s the broader impact on the community?

The vast majority of the crypto community has been thrilled by Peirce’s proposal. Catherine Coley, CEO of Binance, claimed that it could be the “most groundbreaking development for the U.S. cryptocurrency market to date.” Proponents argue that the safe harbor will lead to a much smoother growth curve for decentralized networks and also give developers the space they need to explore various paths and possibly fail in their development process, while still maintaining the benefits of SEC review.

The proposal represents a huge step forward in allowing developers to differentiate their projects from conventional, publicly-traded securities, and also giving more federal & legal credibility to cryptocurrency projects across the country. Legal recognition and adaptation has always been an uphill battle for decentralized projects, and a safe harbor could be the first step in changing that. 

Sources:
https://www.coindesk.com/on-the-frontlines-of-the-sec-safe-harbor-proposal-with-coinlist-ceo-andy-bromberg
https://www.sec.gov/news/speech/peirce-remarks-blockress-2020-02-06
https://cointelegraph.com/news/secs-cryptomom-proposes-safe-harbor-framework-for-token-projects
https://fortune.com/2020/02/06/ico-sec-cryptocurrency-proposal-investing/

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ADDITIONAL INFO

Hi, I’m Paul Veradittakit, a Partner at Pantera Capital, one of the oldest and largest institutional investors focused on investing in blockchain companies and cryptocurrencies. The firm invests in equity, pre-sales/IEO rounds, and cryptocurrencies on the secondary markets. I focus on early-stage investments and share my thoughts on what’s going on in the industry in this weekly newsletter.

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