March 15, 2021
by Macauley B. Venora

Two bipartisan bills were introduced last week before the 117th Congress that seek to further clarify the legal and regulatory framework governing digital assets and cryptocurrencies.

H.R. 1628, officially the third iteration of the Token Taxonomy Act, again proposes to exclude “digital tokens” from the definition of a security. The text of the 2021 version is virtually identical to its 2018 and 2019 predecessors, both of which stalled in the House Committees on Financial Services and Ways and Means. The second bill, H.R. 1602, titled the Eliminate Barriers to Innovation Act of 2021, would direct the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) to “jointly establish a working group” to provide legal and regulatory analysis and recommendations relating to digital assets.

The Token Taxonomy Act of 2021

The Token Taxonomy Act would define “digital token,” and amend the Securities Act of 1933 (Securities Act) to exclude digital tokens from the definition of a security. Certain conforming changes in other parts of the federal securities law would follow, such as Securities Act Section 4—Exempted Transactions—and the definition of “bank” under the Securities Exchange Act of 1934 (Exchange Act), the Investment Advisers Act of 1940 (Advisers Act), and the Investment Company Act of 1940 (Investment Company Act).

For decades, financial markets participants and regulators have relied on the Howey test to determine whether certain products are securities and thus required to be registered under Section 5 of the Securities Act. Digital tokens, however, with their reliance on technology and decentralization, arguably do not fit as neatly under the Howey test as do more traditional financial products.  With a decentralized token that may or may not have some utility, it is often unclear whether a purchaser of the token is relying on the entrepreneurial efforts of others to profit from his or her purchase of the token, one of the prongs of the Howey test. Relying on the Howey test, the SEC has brought numerous enforcement actions alleging the unlawful sale of unregistered securities for token-based offerings. The Token Taxonomy Act’s proposed definition of “digital token” is a first step toward regulatory clarity for the crypto industry, and, at a minimum, would provide the SEC and digital token issuers with a new law regarding whether certain digital products require Section 5 registration as a security.

Securities Act of 1933

The bill proposes to amend Section 2(a) of the Securities Act to add subsection (20) which would define the term “digital token” to mean a digital unit:

(A) that is created:

(i) in response to the verification or collection of proposed transactions;

(ii) pursuant to rules for the digital unit’s creation and supply that cannot be altered by any single person or persons under common control; or

(iii) as an initial allocation of digital units that will otherwise be created in accordance with clause (i) or (ii);

(B) that has a transaction history that:

(i) is recorded in a distributed, digital ledger or digital data structure in which consensus is achieved through a mathematically verifiable process; and

(ii) after consensus is reached, resists modification or tampering by any single person or group of persons under common control;

(C) that is capable of being transferred between persons without an intermediate custodian; and

(D) that is not a representation of a financial interest in a company or partnership, including an ownership interest or revenue share.

The bill also would amend Section 2(a) to add subsection (21), which would define “digital unit” to mean: “a representation of economic, proprietary, or access rights that is stored in a computer-readable format.”

The most notable aspect of the bill is its proposal to exclude “digital token” from the definition of security under Section 2(a)(1). Consistent with that, the bill would create a new exemption under Section 4(a), the subsection that lists certain transactions that are exempt from the registration requirements in Section 5.  A newly added subsection (8) would exclude the following from Section 5:

            Transactions involving the offer, promotion, or sale of a digital unit if:

          (A) the person offering, promoting, or selling the digital unit has a reasonable and good faith belief that such digital unit is a digital token; and

          (B) within ninety days following a written notification from the Commission to such person that such digital unit has been determined by the Commission to be a security, posts public notice of such notification and takes reasonable efforts to cease all sales and return all proceeds from any sales of such digital unit, excluding funds reasonably spent on the development of technology associated with the digital unit.

Section 4(a)(8) as proposed would allow for persons “offering, promoting, or selling” a digital unit to rely on a “good faith belief” that the digital unit is in fact a digital token and not a Section 5 security. Notably, this safe harbor provision is not included in any of the other exempted transactions listed under Section 4(a).

Finally, the bill proposes to give preempting effect to the amendments over any state law that attempts to directly or indirectly require, limit, or impose any conditions of the offer, promotion, or sale of digital tokens.

Securities Exchange Act of 1934, Investment Advisers Act of 1940 & Investment Company Act of 1940

The bill also proposes conforming amendments to the Exchange Act, the Advisers Act, and the Investment Company Act (the “Acts”).  The amendments would similarly exclude “digital token” from the definition of security in each of the Acts. Digital token, as it is proposed to be used in the Acts, would have the same meaning as digital token in the proposed definition under Section 2(a) of the Securities Act.

Additionally, the bill proposes to amend the definition of “bank” in the Acts to include “trust companies” which “provide custodial services.”

Miscellaneous Amendments

The bill also would require the Commission to amend Rule 15c3-3 under the Exchange Act to provide that the requirement for a “satisfactory control location” for a digital unit can be satisfied by “protecting the digital unit using public key cryptography and by following commercially reasonable cybersecurity practices to maintain the privacy and accessibility of sufficient private key material to solely be able to sign on behalf of such digital unit.”

Finally, the bill would amend certain rules under the Internal Revenue Code relating to the taxation of virtual currencies. These include ensuring IRA investments in virtual currencies are not treated as distributions and making certain exchanges of virtual currencies tax-exempt.

Eliminate Barriers to Innovation Act of 2021

The Eliminate Barriers to Innovation Act of 2021 directs the SEC and CFTC to jointly establish a digital asset working group (the “Working Group”). The Working Group would be established to provide analysis and recommendations aimed at clarifying and improving the current regulatory framework, specifically the primary and secondary markets for digital assets. If enacted, the Working Group will be required to submit a report that contains the following:

  • An analysis of the legal and regulatory framework and related developments relating to digital assets including the impact that lack of clarity in regulation has on the primary and secondary markets for digital assets, as well as how the US regulatory framework and certain developments in other countries impact the competitive position of the US; and
  • Recommendations for the creation, maintenance and improvement of primary and secondary markets for digital assets; for standards concerning custody, private key management, cybersecurity and business continuity; and for best practices to reduce fraud and manipulation, improve investor protections, and assist in compliance with anti-money laundering obligations under the Bank Secrecy Act.

The Working Group would terminate one-year after the bill’s enactment, with an option to jointly extend for up to one year. Upon the expiration of the extension, the Working Group would be required to submit a new report with updates to the analysis and recommendations provided in the first report.

The bill would require that the Working Group be comprised of the following:

  • An equal number of SEC and CFTC employees;
  • Representatives appointed by the SEC and CFTC from the following:
    • Financial technology companies providing digital asset products or services;
    • Financial firms under the jurisdiction of the SEC and CFTC;
    • Institutions engaged in academic research or advocacy relating to digital assets;
    • Small business engaged in financial technology;
    • Investor protection organizations; and
    • Institutions that support historically-underserved businesses.  

While the Working Group may ultimately provide useful analysis and recommendations that aid in establishing a more practical regulatory framework for digital assets, the timeframe envisioned by this bill does not fully square with the pace at which crypto innovation is taking place both domestically and overseas.