An open letter to SEC Commissioner Peirce on token safe harbors

Gabriel Shapiro is a Silicon-Valley-based attorney specializing in complex corporate and blockchain-based transactions. 

Dear Commissioner Peirce,

I am a California attorney who has been active in representing technology clients in complex transactions for over ten years. After eight years primarily devoted to mergers & acquisitions transactions at the Silicon Valley branches of Dewey & LeBoeuf, Weil Gotshal and Hogan Lovells, I began focusing my work on clients building blockchain technology.

Since then, I have also been very active in writing on the intersection of law and decentralized systems[1], and, among other things, played a significant role in crafting Wyoming’s 2019 corporations code amendments[2] and a security token protocol for Ethereum[3].

I read with interest your recent “Token Safe Harbor Proposal” dated February 6, 2020, and have a number of thoughts thereon that I am eager to share.

In the open-source spirit of blockchain technologies, I will be posting this letter publicly at or about the same time as I send it. However, should you be so gracious as to respond, I will hold your response and all follow-up correspondence in confidence unless you consent to publication. 

The Commission Understands Blockchain And Is Poised To Provide Clarity

The Staff’s doctrine of “sufficient decentralization,” first articulated in William Hinman’s speech “Digital Asset Transactions: When Howey Met Gary (Plastic)” represents a watershed moment in the history of U.S. securities laws, and evidences the Commission’s deep study and understanding of decentralized blockchain technologies. When a blockchain network is “sufficiently decentralized,” it becomes, in effect, a public commons, and the protections of securities laws are thus neither necessary nor desirable. 

Likewise, I applaud and embrace your leadership in driving regulators and legislators to provide developers and investors with greater ex ante regulatory certainty to guide their efforts. The Commission can and should clarify the circumstances in which a blockchain network is sufficiently decentralized. Your proposed safe harbor is an important step toward this goal. 

Because of the important work you, Director Hinman and others have done to lead the way, the Commission is poised to craft a policy that balances the concerns of protecting ordinary markets against an appreciation for the unique promises and nature of blockchain technology. 

Iterating On The Safe Harbor

With this letter I aim to further the goals of your safe harbor while also suggesting some variations that I believe would align it further with traditional U.S. securities doctrine.

U.S. securities laws have evolved in accordance with a time-honored tradition of elevating substance over form. In that spirit, the safe harbor is premised on a technology-neutral determination of when a security is associated with or represented by a token. The safe harbor does not deny that tokens may represent securities, but provides blockchain developers with a specific roadmap for securities law compliance without incentivizing market participants to prefer token-based financings to traditional ones. 

A revised version of the safe harbor is available here. I believe this proposal should be considered. The remainder of this letter explains the most important features of the revised safe harbor and explains the reasoning behind each feature. 

Under this approach, the initial development team may utilize traditional exemptions such as Rule 506(c) or a qualified Tier II Regulation A+ offering to initially sell any pre-mined tokens. While the network is on the path to sufficient decentralization, the tokens may trade as securities on a peer-to-peer basis through decentralized exchanges, on appropriately registered centralized cryptosecurities exchanges or on foreign exchanges which exclude U.S. persons and are based in jurisdictions which do not treat the tokens as securities. Section 12(g) reporting is tolled by modifying Regulation A+ so that it no longer requires the use of a transfer agent for equity securities. 

Before “Sufficient Decentralization", Open Network Tokens Typically Represent Securities 

Before we delve into the details of the safe harbor, it is first important to establish a shared frame of reference for our securities laws as applied to tokens.

For the sake of brevity, I have refrained from a lengthy and citation-heavy discussion in the style of a law review article or memorandum of points and authorities. Of course, I would be happy to provide more detail at a later date. 

1. Nature of Open Network Tokens

In a recent enforcement action, the SEC described how open network tokens may function as “the representation of the holder’s right to the value underlying it, the mechanism for the [token purchasers] to realize their profit.”[4] I endorse this perspective. 

Purchasers do not primarily think of open network tokens as being similar to real estate, consumer products, software licenses or perishable goods such as whiskey or oranges. Nor are such tokens the “object” of an investment scheme, only momentarily twisted into serving an investment purpose against their normal nature.[5] 

Rather, open network tokens—finite in supply and specific to a deployed instance of a software protocol—are mechanisms for sharing in the value of an open network and are designed to appreciate indefinitely as other participants work to make the network more valuable.[6] Such tokens represent a major financial innovation—a method of investing in an ownerless digital commons—and are best understood when considered on their own terms rather than reasoning by analogy. 

The purchase of open network tokens in material amounts will nearly always be primarily or exclusively for investment. We need only ask whether the network is controlled by a relatively small group of affiliated persons (in which case such investment is a securities transaction) or whether the network is decentralized (in which case the securities laws do not apply). 

2. Open Network Tokens As Investment Contracts

When such a token is purchased, whether directly from the development team or in secondary transactions, by a person who has a reasonable expectation of profiting predominantly from the efforts of the initial development team, and there is (by virtue of the initial development team’s continuing economic control or functional control of the network) a common enterprise, our securities laws entail that an investment contract between the development team and the purchaser exists as a matter of law. The contents of the investment contract are the promises made by the initial development team to undertake efforts that implicate the Howey test. The promises may be implied, as with a whitepaper setting forth a vision of the thriving token economy, or they may be explicit, as embodied in a written contract in which the initial development team agrees to build and promote such a network. 

In an extreme case, a development team may have been very careful to refrain from making any promises, express or implied. The development team may even have expressly disclaimed all promises and undertakings, and may have secured from initial token purchasers a representation that such purchasers have not received and are not relying on any promises from the initial development team.[7]

Nevertheless, the development team may still reasonably be expected to be the predominant driver of token profits based on circumstances relating to its operational or economic control of the network. Because our securities laws are non-waivable[8] and elevate substance over form with reference to the canons of construction applicable to remedial legislation[9], even in such “no-promise” circumstances, an investment contract may be deemed to exist between the token purchasers and the development team as a matter of law. 

3. Open Network Tokens As Stock or Other Securities

Our case law provides that the existence of more conventional securities may, where appropriate, be tested “in terms of their substance (the economic realities of the transaction), rather than their form.”[10] Thus, open network tokens may also constitute other types of securities beyond investment contracts.

For example, tokens on “proof-of-stake” networks share many characteristics of “stock”, including the right to receive dividend-like staking rewards, negotiability, pro rata voting rights and the capacity to appreciate in value.[11] Conceptually speaking, such open network tokens function very much like shares of “network equity”[12] or shares in a “decentralized autonomous corporation”.[13]

4. Some Open Network Tokens May Be Non-Securities at Genesis

Some open network tokens may not be securities even when the network first launches, because the Howey test is not satisfied and the policy concerns underlying the securities laws are not implicated. This will typically (but not always) occur when there has been no “ICO,” “IEO” or other sale of “pre-mined” tokens. This is not, however, because persons only receive tokens when the network is functional and a scintilla of functionality is sufficient to moot the securities laws. Rather, it is because such networks are “sufficiently decentralized” at genesis. 

For example, “fair-launched” networks like Grin essentially resemble a kind of general partnership in which token ownership confers a quasi-equity interest in the network, but the securities laws are not implicated because all participants have a highly informed, active managerial role and are not relying predominantly on the entrepreneurial efforts of any other person(s).[14]

Launches bearing similarities to that of ZCash, in which the network is developed, as it were, “on-spec” and the initial developers are paid a reward of tokens from each block, like miners, may also fall outside the ambit of the securities laws, assuming that the developers are very clear that such tokens are ‘payment for work done’ and act consistently with that position (i.e., are not continuing to promote and improve the network in a manner that would create Howey expectations). 

5. Purpose of the Safe Harbor

Regardless of whether open network tokens represent investment contracts, “stock” or other securities, as long as they do not coincidentally also represent unrelated equity or debt rights, the securities laws do not require that they be regulated as securities beyond the point of “sufficient decentralization” of the network.

At that point, there is no longer an issuer or other controlling person that could rationally satisfy the reporting requirements of our disclosure-based securities laws; moreover, most of the risks contemplated by the securities laws are no longer relevant. Although a profit motive (rather than a “consumptive” motive) still prevails, at that point the network is being operated rather like a general partnership in which each participant is relying only on its own efforts, or in any event is not relying predominantly on any other participant(s)’s efforts, to bootstrap the network and achieve profits. 

The primary purpose of the safe harbor is to thus define when this point—the point of “sufficient decentralization”—is reached. As such, it does not revise or suspend the securities laws, but rather turns “sufficient decentralization” from a gloss on the fourth prong of Howey into an objective test providing reasonable ex ante clarity for when the securities laws will cease to apply to an open network token. 

Overview of Revised Safe Harbor

1. Disclosure Statement

The initial development team’s disclosures regarding the project must be filed with the Commission and include specific contractual undertakings (covenants) for developing and promoting the blockchain technology and network. In effect, the Disclosure Statement must set forth the investment contract between the initial development team and the token buyers who are investing in reliance on the initial development team’s efforts. 

Requiring the initial development team to commit to specific contractual covenants has the benefit of providing token holders with concrete rights and enforceable expectations, while also enabling the initial development team to eventually demonstrate that it has honored its responsibilities. The initial development team may still preserve flexibility to experiment, learn and iterate in accordance with the principles of agile software development by building reasonable discretionary standards into the covenants and enabling token holders to approve material changes to the covenants with a token-based or other reasonable governance mechanism. 

2. Network Maturity

Network Maturity is achieved when the initial development team: 

• has performed in all material respects the investment contract associated with the tokens;
• does not economically control the network (owns less than 10% of tokens); and
• does not operationally control the network (owns less than 10% of the means of determining network consensus).

3. Network Maturity as Performance of the Investment Contract

The initial development team’s fulfillment in all material respects of its promises to token buyers is one important aspect of measuring Network Maturity.

To the extent that promises go unperformed, there may remain an investment contract associated with the tokens requiring them to be treated as securities.

Performance of the investment contract will tend to coincide with achievement of “sufficient decentralization”—after all, what the initial development team promised to build was a decentralized blockchain network!

4. Network Maturity as Lack of Economic Control

If the initial development team still owns a material percentage of tokens, token buyers may reasonably expect the team’s efforts to remain the predominant factor affecting token price. Armed with substantial network-specific expertise and a token war-chest, the initial development team has both the power and incentive to increase token value, and token buyers will seek to profit from the team’s efforts.

Thus, even in the absence of any promises, the Howey test can still be satisfied if the initial development team owns substantial tokens. 

Short-swing trading, insider trading and other manipulative or self-interested trading by a major token holder also threatens the economic integrity of the network. The initial development team’s power to engage in such economic attacks is a form of “economic control” that enables coercion of other network participants, unfairly swaying the outcome of contentious hard forks and other governance disputes. The securities laws are a bulwark against such manipulative and self-interested behavior by asymmetrically powerful network participants and should continue applying until the network is sufficiently decentralized. 

The threshold of 10% ownership of existing tokens has been selected to track Section 16’s percentage threshold for defining an “insider” of a public company. In theory, a lower threshold (5%) or a higher threshold could be selected (20%-50%). However, a safe harbor should likely err on the side of being conservative. 

5. Network Maturity as Lack of Operational Control

As you know, a blockchain network is operated on a peer-to-peer basis by computers running a software client which processes transactions in accordance with a set of consensus rules. The consensus rules determine which set of chained blocks is agreed by nodes to constitute the canonical blockchain for that network. 

Whether the power to determine consensus is based on hashrate, token stake, leader selection or a form of per capita voting, the power of each participant to contribute to consensus on a given network at a given time is measurable. We refer to this as the “consensus power” for a network. 

Ownership of substantial consensus power can be a form of operational control over a network. If the initial development team beneficially owns 10% or more of the consensus power of the network, the network may not be sufficiently decentralized, and securities laws may still apply. 

Operational control of the network creates incentives, expectations and potentials for abuse by the development team. The control of so much consensus power could enable the development team to strongly influence governance decisions, and potentially even to attack the blockchain network for its own benefit. Token buyers may reasonably expect that an initial development team with so much operational power will remain the predominant driver of future token profits, satisfying Howey and triggering the securities laws. 

Of course, in proof-of-stake networks, operational control and economic control may be the same, assuming the initial development team chooses to stake its tokens; in such cases, the tokens may be “stock” and the securities laws may be even more strongly implicated. 

6. DAPPs, DAOs, etc.

DAPPs, DAOs and other Open Networks which do not have their own exclusive blockchain should also be eligible for the safe harbor. The revised safe harbor a