US regulators and federal legislators may be heeding the calls of crypto-enthusiasts for legal clarity regarding the status of digital assets and cryptocurrencies (collectively, tokens). On 10 April, the Securities and Exchange Commission (SEC) released an analytical framework for determining when a token constitutes a security. Last week, US federal legislators followed up by introducing two bills that are designed to "provide regulatory certainty for businesses, entrepreneurs, and regulators in the US' blockchain economy," the Token Taxonomy Act of 2019 (H.R. 2144) (TTA) and the Digital Taxonomy Act of 2019 (H.R. 2154) (DTA, and together with the TTA, the Bills).
Foggy regulation of tokens
In July 2017, the SEC published the "DAO Report", an investigative report asserting that token sales may be subject to US federal securities law. Since that time, regulators have issued broad guidance and enforcement actions that reinforce the notion that absent certain exemptions, most token offerings are securities offerings. Many in the blockchain community have responded with calls for a classification system that broadly differentiates between tokens with features similar to a security (e.g. those representing ownership interest) and those used to purchase goods or services through a platform (e.g. a “utility” or “consumer” token).
Unfortunately for those arguing for differentiation, current legal tests for determining whether an asset (including tokens) is a security do not draw categorical distinctions. Instead, they are fact-intensive inquiries designed to only reach a conclusion about a specific asset. As a result, companies seeking to sell utility tokens face difficult choices: comply with securities law and, as a result, only list their token on regulated exchanges; spend time pursuing a no-action letter from the SEC that may never come; or forgo access to US token marketplaces and offer their token elsewhere. Moreover, the design of many token networks may not be viable if complying with the US securities laws requires networks to register as securities intermediaries.
Recognising this dilemma, sponsors of the Bills noted that the Bills are intended to reconcile and clarify state initiatives, regulatory rulings, and judicial decisions in hopes of limiting the outflow of capital and innovation they believe "is fleeing the US market for the welcoming certainty of other jurisdictions".
A clear path forward?
If enacted, the TTA would amend the Securities Act of 1933 (Securities Act), the Securities Exchange Act of 1934 (Exchange Act), the Investment Advisers Act of 1940 (Advisers Act) and the Investment Company Act of 1940 (Company Act). Such enactment would potentially create a more permissive regulatory regime for selling, using and trading certain tokens. Additionally, the TTA would amend certain provisions of the Internal Revenue Code of 1986, which is not discussed in this article.
Definition of a "digital token"
The TTA proposes to amend the Securities Act (with corresponding amendments to the Exchange Act, Advisers Act and Company Act) to exclude digital tokens from the definition of a security. The TTA defines a digital token as a subset of a "digital unit". A digital unit represents economic, proprietary, or access rights that are stored in a computer-readable format, and digital tokens are a subset of digital units created through a decentralised, mathematically verified process, recorded on a distributed ledger, and tradeable peer-to-peer. Given the intent of the TTA and US federal securities laws, the definition of a digital token excludes assets representing "a financial interest in a company or partnership, including an ownership interest or revenue share". However, pre-mined digital units (those created in an initial allocation before the launch of the platform or network on which they may be used, and which the SEC has stated are likely to be securities) are included so long as later distributions of the digital units comply with the other definitional requirements. As written, the definition appears to cover an array of digital units, including those the SEC has informally indicated are not securities – bitcoin and ether – and many designed and marketed as utility tokens.
Digital token offerings
The TTA would also amend the Securities Act to create an exemption for transactions involving the offer and sale of digital units. Such transactions are exempt so long as the person offering or selling the digital unit had a "good faith belief" that the digital unit was a digital token. Although the phrase "good faith belief" is not expressly defined, its inclusion may provide comfort to sellers that have been hesitant to conduct offerings in the US due to uncertainty of enforcement. Importantly, however, the TTA provides that the exemption will be revoked if such person fails to publicly post notice and "take reasonable efforts to cease all sales and return all proceeds" within 90 days of receiving notice from the SEC that it has determined the digital unit to be a security. This essentially provides a veto right to the SEC for any token issuances purported to be made under a safe harbour.
Custody of digital units that constitute securities
Currently, security token trading in the US remains extremely limited while regulated market intermediaries await interpretive guidance on compliance with federal securities law. Namely, what must market intermediaries do to demonstrate adequate custody of their clients' digital units that constitute securities? The TTA would resolve this issue by requiring that the SEC amend the Exchange Act to indicate that satisfactory control by a securities intermediary is demonstrated by using public key cryptography to protect a digital unit and by following commercially reasonable cybersecurity practices that enable the regulated market intermediary to "solely be able to sign on behalf of such digital unit." While this amendment would answer the custody question at a high level, it does not specifically address how a custodian demonstrates its sole ability to sign on behalf of a digital unit.
Restrictions on state securities laws
Importantly, the TTA includes an amendment to the Securities Act that pre-empts state laws relating to the offer and sale of digital tokens. Such state laws include securities and money transmitter laws, which may require the registration of digital token offerings or sales (DTOs), prohibit or impose conditions on disclosure documents and notices required for DTOs or impose merit-based conditions or limits on DTOs. In order to ensure consumers are adequately protected, however, states would retain their investigatory and enforcement powers in this space. The inclusion of pre-emption is particularly notable because it was not included in the TTA's predecessor bill, which was introduced in 2018.
The Digital Taxonomy Act
Compared with the TTA, the DTA is much narrower in scope. The DTA would appropriate $25 million per year to the Federal Trade Commission (FTC) between 2020 and 2024 to prevent unfair and deceptive practices in digital token transactions. Additionally, the DTA would ask the FTC to provide an annual report to Congress outlining any actions it takes in furtherance of its digital token mandate along with legislative recommendations. The DTA and TTA are complementary, and neither would limit the Commodity Exchange Act.
SEC retains influential veto power
Although the TTA would provide a safe harbour for conducting DTOs in the US, this safe harbour does not appear all that safe. As noted above, a DTO must be rescinded if the SEC determines that the relevant digital unit was a security rather than a digital token. Given that the SEC's guidance to date indicates only a relatively narrow path for non-security tokens, it would be surprising for the SEC to stand by without exercising its effective veto power under the TTA to rescind DTOs. The agency's reasoning for issuing such a notice could be based on whether the DTO was marketed as an investment opportunity, if investors rather than network users purchase the digital unit, or on the basis of other factors cited in prior SEC guidance. With this veto power looming, it is difficult to see how token issuers could get comfortable taking advantage of the safe harbour. Rather, the market is more likely to rely on the same sort of facts-and-circumstance analysis that is applied today, which puts tokens other than some stable coins and payment tokens at greater risk of being deemed securities by the SEC. As a result, the TTA's utility may be limited unless the SEC's authority is scaled back.
Market response: mixed
Predictably, the Bills have been met with mixed reviews. The goal of bringing regulatory certainty is admirable, but the SEC's effective veto right over DTOs results in little additional certainty to the regulatory status of tokens or offerings thereof. Of course, the TTA would offer some positive changes, including the custody and tax provisions, as well as pre-emption of the panoply of state laws that apply to tokens. Notably, however, concerns have been expressed about the constitutionality and prudence of the TTA's pre-emption clause.
Overall, the sponsors of the Bills should be commended for their efforts, but also urged to address the issues outlined in this post in subsequent revisions of the Bills to increase the likelihood that the Bills will be enacted in a manner that will foster the growth of this innovative technology.
Note: full citations can be found in the published article on Latham & Watkins' Global FinTech & Payments Blog: www.fintechandpayments.com
|About the author|
Stephen Wink is a partner in the New York office of Latham & Watkins and a member of the financial institutions and fintech industry groups. Stephen is co-chair of the firm's blockchain and cryptocurrency task force. His practice focuses on advising a wide range of market players, including fintech companies, cryptocurrency issuers and platforms, investment banks, hedge funds, private equity firms, trading platforms, and other financial institutions.
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Morgan Brubaker is an associate in the Washington, DC office of Latham & Watkins and member of the firm's fintech industry group, technology transactions practice, and blockchain and cryptocurrency task force. Morgan advises public and private companies, financial institutions, private equity firms, and emerging companies on the structuring and negotiation of complex technology-related commercial transactions and acquisitions focusing on intellectual property exploitation, licensing, development, customisation, and commercialisation, as well as related data privacy and security matters.
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Cameron Kates is an associate in the New York office of Latham & Watkins and a member of the financial institutions and fintech industry groups and blockchain and cryptocurrency task force. Cameron represents financial institutions, fintech and emerging growth companies, and other market participants in public and private securities-related transactions, cryptocurrency offerings, intellectual property commercialization, mergers and acquisitions, and regulatory compliance matters. He also advises non-bank financial institutions on federal and state laws applicable in the US.
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Shaun Musuka is an associate in the London office of Latham & Watkins and a member of the capital markets practice. Shaun's practice includes representing investment banks, private equity firms, and companies in public and private debt and equity offerings and acquisition financing, with a particular emphasis on issuances of high yield debt securities and leveraged transactions.