Those building projects that use a crypto token often complain that U.S. law is holding them back. They argue ominously that if the U.S. doesn’t get with the program, Americans will be left behind, the rest of the world will benefit from the advances that this tech promises and we will get bupkis.
As a lawyer who represents software developers — crypto and otherwise — I’m sympathetic to the complaints.
Still, lurking beneath the white papers and utopian claims, this question often bubbles up: why do you actually, technically need a capped number of pre-mined tokens if not to enrich yourself and some lucky early investors? In other words, the token is often a needless bolt-on that is added as an excuse to raise capital to build the thing that the token will run on and in the hearts and minds of the investors (because let’s face it, that’s what they are), it would be really swell if the thing was listed on Kraken and Binance.
This isn't a moral issue, in my mind – it's a legal and policy issue. If someone wants to exchange their hard-earned dollars for Beep Beep Boop Token, that doesn't violate any commandment I'm aware of and doesn't offend my sensibilities.
But it might violate human law if not done right. Right now, the U.S. regulatory landscape here is challenging for token sellers. So far, the only clarity we’ve gotten from the SEC about token sales is that prepaid air mile tokens are fine and the same for similarly structured gaming tokens. These no-action letter responses tell us what we already know, really – a consumptive token that can be bought once a platform is fully functional and can be used there and not traded on secondary markets; not a security, probably.
There’s the SEC’s framework document, which summarizes the law, sort of, but if you’ve ever tried to apply it to an existing project you know that doing so leaves you with pages of pretzel prose and logic and about as much clarity as when you started. This isn’t the fault of the well-intentioned SEC staff who put the thing together (and who were basically begged to do this by industry participants).
The problem lies in trying to fit the round, slightly oxymoronic peg of “decentralized governance” into the square hole of U.S. securities law. So...what’s the solution?
On the one hand, I loathe telling people to avoid the United States. On the other hand, if you are building a crypto project, have to have a token that will be traded on secondary markets and are selling it before the network is functional, and can’t be bothered to comply with U.S. securities laws, avoiding the U.S. is often really quite advisable. (There’s also the not small issue of registering with states, which people frequently forget too). And don’t get me started on Bank Secrecy Act compliance, which adds a whole ‘nother layer of cost and complexity.
On the other hand (I have three hands), it's unclear why this one area of technological development needs its own special place and protection in our securities regime. Is crypto entitled to and does it need special pleading, or do special rules end up making new problems?
It’s with these thoughts in mind that I read with great interest SEC Commissioner Hester Peirce’s “Running on Empty: A Proposal to Fill the Gap Between Regulation and Decentralization’”. It’s a very well written and thoughtful speech, that ends with a proposal for a “safe harbor” under the securities act for token sales. At the same time, it's unclear if it solves problems or potentially create more, at least in its present form.
Peirce explains her underlying motivation as an attempt to give well-intentioned technology innovators a way to develop their projects while not running afoul of the law. She explains that: "It is important to write rules that well-intentioned people can follow. When we see people struggling to find a way both to comply with the law and accomplish their laudable objectives, we need to ask ourselves whether the law should change to enable them to pursue their efforts in confidence that they are doing so legally."
Peirce's proposal frames the technical problem as a network bootstrapping issue:
"...in order for a network to mature into a functional or decentralized network that is not dependent upon a single person or group to carry out the essential managerial or entrepreneurial efforts, the tokens must be distributed to and freely tradeable by potential users, programmers, and participants in the network. Additionally, secondary trading of the tokens typically provides essential liquidity for the users of the network and aids in the development of the network. The application of the federal securities laws to these transactions frustrates the network’s ability to achieve maturity and prevents the transformation of the token sold as a security to a non-security token functioning on the network."
To resolve this, Peirce proposes a three year safe harbor period where an “Initial Development Team” can issue a token and create a decentralized network subject to an exemption from securities laws registration. To assure purchaser protection, some disclosures are required and sellers are still subject to the anti-fraud protections of U.S. Securities laws.
And to be eligible for the exemption, you have to satisfy four requirements. First, “network maturity” has to be achieved in three years. This is a defined term:
"is the status of a decentralized or functional network that is achieved when the network is either: