Davis Polk has submitted a comment letter to the SEC on proposed Regulation Crypto Assets, or Reg CA. Davis Polk partners Joe Hall and Zach Zweihorn and counsel Justin Levine and Amy Starr contributed to the letter.

Reg CA would give crypto asset developers a tailored way to raise capital. It includes:

  • a startup exemption for offerings of up to $5 million over four years;
  • a two-tier fundraising exemption for offerings of up to $75 million in any 12-month period;
  • disclosure requirements designed for crypto assets;
  • a safe harbor under which an asset could be deemed no longer subject to an investment contract; and
  • preemption of state registration requirements.

The lawyers write in support of the proposal’s objective of establishing predictable rules for crypto asset markets.

The principal concern is the role the proposal gives to the Howey test, and above all to the phrase “essential managerial efforts.” The proposal makes that phrase the test for entering the regime, for leaving it and for the status of every secondary-market transaction in between. The letter agrees that Howey applies for deciding whether a developer’s sales outside Reg CA involve an investment contract. But the flexibility that makes Howey valuable for post-hoc adjudication of novel transactions makes it a poor operating condition for a market-wide regime. A developer that chooses Reg CA should have an objective path to compliance. Independent market participants should be able to trade in reliance on the public filing record, without making their own Howey determinations. 

The SEC can provide both using authority it already has. The safe harbor would be built from exemptions, not from a declaration that tokens are not securities. Securities Act Section 28, Exchange Act Section 36 and the parallel provisions of the Investment Company and Advisers Acts authorize this kind of class-wide relief. The SEC took a similar approach when Dodd-Frank brought security-based swaps within the definition of “security.”

A conclusion, not a standard

The reason Howey is ill-suited for this regime is that “essential managerial efforts” names the result of a legal analysis. It does not tell a developer which commitments will turn its token sales into investment contracts, which changes will alter that or when its obligations end. As noted in the letter, the phrase “works as a conclusion, but it cannot serve as the operating condition for a market-wide regime.” The proposing release itself acknowledges that “it can be difficult to apply the Howey test to crypto assets.”

Yet the phrase appears nearly 80 times in the proposing release, and it would govern every point where the framework matters:

  • Entering the regime. To use either exemption, a developer must in effect conclude that its offering involves an investment contract. A developer that believes none ever existed has no express protection against its filings being treated as an admission that one did.
  • Disclosure. Offering documents and periodic reports must describe the promised “essential managerial efforts” and the developer’s progress, under antifraud liability.
  • Leaving the regime. The developer must certify that all of those efforts have been completed or permanently ceased.
  • Trading. Trading platforms, brokers, dealers and asset managers cannot rely on that certification. The release says the SEC could later challenge it and other parties could still argue the asset is a security. An inaccurate certification, “either intentionally or otherwise,” could mean the investment contract never ended. Every intermediary must therefore reach its own conclusion, with no protection if it is second-guessed.

The problem is also one of durability. After the Senate declined to advance the Clarity Act on September 15, Reg CA is likely to be the main federal framework for crypto asset offerings for some time. A framework built on a nebulous, undefined term can be narrowed or reversed by a future Commission, or by a court that reads Howey differently. Conditions written as the objective terms of an exemption would rest on firmer footing.

This is also not how the securities laws usually treat a class of instruments once it matures. The SEC resolved disputes over certain annuities with a criteria-based safe harbor. Congress defined security-based swaps by statute. The Supreme Court has declined to force notes and stock through Howey. The proposing release itself shows that crypto assets can be defined as a class. Howey should keep its traditional role as a catchall for arrangements designed to evade objective rules, but it should not be the rule for an entire asset class.

Fungible tokens cannot carry their history

Even if the term were clear, the proposal would face a second problem. Under the SEC’s approach, an investment contract “travels” with a token into the secondary market until the asset separates from the developer’s promises. As a result, some units of a crypto asset are treated as subject to an investment contract while identical units are not. Units of the same token could have been sold in a fundraising, mined, airdropped, earned as network rewards or issued offshore. Once they are pooled on an exchange, no one can tell them apart. 

Howey itself shows why this matters. The Supreme Court held that the citrus groves and service contracts in that case were investment contracts, not that the oranges were securities. A produce dealer never had to ask whether an orange came from a Howey grove. Under the proposal’s framework, it would. As the letter argues: “Securities regulation should follow the investment arrangement. It should not follow the orange indefinitely through the produce market.”

We recognize that a token is not an orange: its value often depends on the developer’s continuing work. But depending on someone else’s efforts has never been enough, by itself, to make the resale of a non-security asset a securities transaction. Condominium units and smartphones depend on their makers too. That dependence also affects every unit equally, so it cannot explain treating identical units differently. Where dependence is real, the answer is disclosure and developer accountability, not a test of each unit’s origin that no venue, broker or dealer can apply. The traveling theory is also not limited to crypto. It would conceivably reach resales of any good sold with promises of managerial efforts, without any of Reg CA’s relief.

Recommendations

In the letter, Davis Polk recommends that the SEC keep the proposal’s structure while replacing its Howey-based conditions with objective ones:

  • Separate the offering exemptions from Howey. Make the startup and fundraising exemptions available for a developer’s sales of an eligible crypto asset, without requiring the developer to conclude that those sales involve an investment contract.
  • Make clear that relying on Reg CA is not an admission. Using an exemption or the safe harbor should not be treated as admitting that any transaction involved a security. Developers should be able to rely on them as a precaution, and the certifications in the proposed forms should be revised to match.
  • Protect secondary trading from the start. Exempt trades by anyone outside the developer group, and the platforms and intermediaries that handle them, from the securities laws’ registration and other requirements that depend on an asset’s security status. This protection would start with the developer’s first startup-exemption filing or fundraising-exemption qualification and last while its filings are current. Developers whose tokens already circulate should be able to opt in going forward by filing the required disclosure.
  • Let third parties rely on the public record. Anyone outside the developer group should be able to rely on the filing record unless it actually knows the record is materially false or misleading. If a developer fails to comply, the SEC should suspend the protection publicly and going forward. Everyone who traded the asset should not retroactively become a violator.
  • Replace the completion-or-cessation test with an objective exit. End the developer’s reporting when verifiable conditions are met. Examples include developer-group holdings and voting power falling below set thresholds and the developer giving up specified control powers. Protection would then continue without further filings, unless an objective trigger, such as a new capital-raising sale, requires reporting to resume.
  • Require disclosure of commitments, not legal labels. Instead of asking developers to describe their “essential managerial efforts,” require disclosure of the work promised, who will do it, the resources available, the milestones and progress against them. That disclosure should be filed on EDGAR, including under the startup exemption.
  • Line up the relief across statutes and State law. Provide matching relief under the Investment Company Act and the Investment Advisers Act. Base state preemption on the same public filing record, to the extent Section 18 of the Securities Act allows.
  • Remove the Tier 2 cap. The SEC has acknowledged that registration and traditional exemptions fit these offerings poorly, so a developer that needs to raise more than $75 million has nowhere else to go. The rules should instead scale disclosure and reporting to the size of the offering, while keeping SEC qualification, audited financial statements, ongoing reporting and investor limits.

Read the letter

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