By L-ZYS, crypto legal advisor (wings.ai, smithandcrown.com, ZAG-SW.com) & DAO enthusiastic from Israel — Not Addmited in the US
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How do you force a square to a triangle?
Do you want to make a DAO (Decentralized Autonomous Organization)? but you also should be worried your DAO tokens may be considered an investment contract — triggering all the requirements associated with securities. Disclosure, registration, limitations, liabilities that comes along with it could be burdensome, slow and even risky.
Entrepreneurs have to follow the law or risk legal exposure. Unregistered offerings of “securities” is illegal and punishable.
Determining whether something is a security is not as straightforward as some might think. For example, the US courts determined that selling a right in a citrus field constitutes an “investment contract.” This seminal case, SEC v. W. J. Howey Co., laid out a four-pronged test to see if something is a security or not ( the Howey test ). The test consequent regulatory compliance, if DAO crowdsale constitute an unregistered offering, would make launching a DAO more expensive, extensive, and full of broad fiduciary duties and liability risk.
But on the other hand — the same things that the regulation is trying to solve, are sometimes being addressed inherently in DAO’s structure! The most clear example is the reporting requirement of company’s financials of a publicly raising company is being fulfilled — as it’s recorded real-time on an open blockchain.
The underlying technology is also different than the traditional system of securities we have today. The goal of the SEC is to achieve a fair and stable market, but as we going to demonstrate, in the crypto-economy, regulators need to consider a different approach:
First, as mentioned, reporting requirements for securities were designed for traditional accounting systems (two entries with a human auditor), not a triple-entry system with cryptographic proofs.
The new JOBS Act Title 3 (similar to regulation around crowdsales, it’s also for small companies seeking funding from the public), requires starups to publish financials once a year; in contrast, blockchain accounting guarantees DAOs and their investors financial reporting all year long.
The Act also requires businesses to publish a business plan once a year; contrast, DAOs operate by pre-determined code which is open-source and could be modified (or forked) by users. The funds DAO directs are also published on the blockchain, and the by-laws themselves that determines the relationship between the DAO participants is coded. The execution of those bylaws and the DAO’s accounting don’t depend on familiar agents, like the CEO or an auditor (the status of humans in the edges or curators have never been debated in case law, and might be replaced anyhow using Formal Verification methods). Therefore Investors expectations, a big concern for lawmakers and regulators, are being uniquely met, perhaps for the first time in history, solely and directly by the DAOs code.
The SEC also tries to prevent asymmetric information between the issuer of a security and investors by having those reporting requirements. As we can see, with DAOs all of the relevant information exists online whether on github or on the blockchain explorer. That might raise the question if modern reporting requirements of paper filings are out of date to begin with. Millenials are used to getting information online through social networks — to decide where to eat (yelp), where to sleep (airbnb) and if their taxi driver is good for the job (uber). SEC’s prospectus requirement when issuing a security for example, is pre-structured document, long and full of capital letters, perhaps Bitcointalk.org announcements and Slack\Reddit discussions are more intuitive and informative for Millenials to understand their investor rights.
Overall these changes might actually improve market practices (perhaps even achieve a “perfect competition” status). General solicitation of securities might be an outdated in the internet\information era, and the discrimination in deal access between high net worth investors and others (accredited\non-accredited investors) classifies our society in ways that only expand the rich-poor gap.
Adding the facts that DAOs are jurisdiction-less and the concepts of miners, nodes and curators are not familiar in the current legal system, makes the SEC’s job to try and force a square into a triangle. A new regulation is needed, one that fits the new technology and and better supports entrepreneurs in the digital age.
Ticket to a fair, sweat equity and current regulation alternatives
When users are buying tokens to use rather than to invest, it makes it more of a consumer product: “when a purchaser is motivated by a desire to use or consume the item purchased . . . the securities laws do not apply” ( United Housing Foundation, Inc. v Foreman). Buying Ether to compute on the network for example, or any other anti-spam mechanism, makes digital assets more of a consumer product, protected by consumer laws rather than securities laws.
Albert Wenger, a partner in USV, compared a blockchain token to a ticket to a fair. The court stated that “in the instances where the instrument is novel, they will always disregard the form of a transaction and instead focus on the economic reality of the transaction” (aka, the Economic Reality Test), and DAOs that share revenues with holders and allow them to vote makes the “economic reality” look more confusing.
Exhaustible tokens are easier to distinguish as products. The token acts as proof it was consumed, while non-exhaustible token may be considered memberships or subscriptions. Some models (like Steem.it) even involve different kinds of tokens, but crowdselling one with no rights, and using it purchase another other, can still be seen as one integrated security offering.
But do revenue-sharing protocols makes economic sense at all — other than as a crowdsales incentive? Let’s take a look at the economic implications:
If Ethereum, for example would pay each holder “dividends” (maybe by splitting the block reward between miners and token holders), then the gas to execute a smart contract would prevent its user some financial benefit. Organizations normally re-invest profits for future growth (maybe until they are close to a monopoly, such as Apple), so perhaps the same logic could work in crypto-economics, where portion of revenues goes to bounty funds.
Bounty funds could also allow DAOs to avoid securities offering regulation because the revenue sharing is done according to user actions (as opposed to passive holding, that is, just owning the token). The Howey test requires the “effort of others”, and DAOs, which could be seen as some sort of partnership, are “member-managed” that way (as opposed to “manager-managed”), thus might not be considered securities ( Sync Labs LLC v Fusion-Manufacturing).
That way, the token being distributed is more like “sweat equity” than an investment vehicle and the transaction more like remuneration/compensation than investment (Comakery.com is an example of such model: people contribute to projects and earn tokens, that can recieve portion of the project’s revenue, similar to employee stock option plans). This structure is also a chance to improve wealth distribution, instead of venture capitalists writing all the checks and earning the rewards, a greater percentage of revenues would go to real contributors.
Another claim might be applicable to tokens which bear similarity to Promissory Notes, a short-term debt obligation that can be collateralized. Although the term “note” is specifically included in the statutory definition of a security, courts haven’t been bound to it if the ‘note’ bears a “family resemblance” (Reves v. Ernst & Young) to a list of instruments, such as notes secured by a mortgage on a home (therefore structuring revenue sharing tokens without any voting rights might look less like a traditional security, but could still be a security).
If a note is not on the list, then the test looks at things like investor expectations, the notes tradability, and also the presence of an alternative regulatory regime. If the later exist, it significantly reduces risk might render regulation under the Securities Act unnecessary. Court determined for example that financial products covered by ERISA is indeed sufficient enough for protection (so securities laws are needless).
Should the blockchain ecosystem also have an alternative dedicated regulation? And more interestingly — could the crypto community regulate itself with it’s own technology?
VB already offered decentralized courts as a form of alternative dispute resolution (ADR) and the Ethereum Foundation was in fact the regulatory agency that dealt with TheDAO hack. Markets tend to naturally regulate themselves, but a “Best Practice” approach is need for the blockchain ecosystem, using standards and coordinate in order to prove efficiency.
Maybe more of the SEC roles could be privatized to protocol foundations, or white hat hacker groups (for example looking for insider trading activity for bounties). Perhaps another entity is required similar to FINRA (self regulatory organization — SRO, that traditional securities participants operate) but suited for the internet realm: ICANN recently became an independent global domain registry and EFF are online freedom advocates. Perhaps an institute that take an example from both, would be a good fit for DAOs, while not crippling their innovative nature. In any case it might be more effective then having SEC (or another financial regulator) considering it's current financial enforcement results.
Advanced Class Materials: Enforcability, Challenges and a nice Conclusion
Enforcabilty — this is not a drill (just an experiment)
Enforcement ability is still questionable: by which jurisdiction should a court prosecute a jurisdiction-less entity (Kim dot com is an early example..)? How (and if) will enforcement agencies find liable globally scattered developers, miners, and nodes, who actually contribute to a decentralized experiment for the benefit of our society?
Also regulators’ enforcement priorities are sometimes unclear. It is puzzling that the SEC did not publish a clear opinion on the TheDAO’s tokens sale to US citizens. It could be that DAOs\revenue-sharing tokens still don’t affect market stability or harm everyday investors, who still don’t know how to buy blockchain assets.
CFTC chair have previously mentioned the technology still has to mature before regulating it. However CFTC might have a responsibility in the Bitfinex hack, when it (perhaps ignorantly) required full delivery of bitcoins, making the exchange change their security configuration, possibly opening a vulnerability for the hackers to use.
All that is left now, is to hope the SEC wouldn’t repeat the same mistake and over-regulate DAOs.
Challenges..!!###@@!
Crypto tokens and securities both represent rights in a value-transfer system, with the ability to transfer value within this system. However, currently crypto tokens are essentially a bearer instrument not using the traditional registered instruments for verification and recordkeeping. Trustless transfer of digital value is indeed a technological achievement, but also a big headache for KYC and AML compliance.
Bearer shares now are mostly obsolete. In 2007, Wyoming and Nevada abolished bearer shares, ending their status as the last two U.S. states to permit their use. Even British Virgin Islands (BVI), the most popular offshore jurisdiction disabled it, and Panama is in the process of doing so as well.
Crowdsales (and the world) are in trouble if ISIS or corrupted agents use tokens to launder funds. This is why KYC and AML protocols became so important in the cryptocurrency industry. Some are already tackling this onchain and others propose that KYC could be done when exchanging tokens to fiat (localbitcoin.com anyone?). Perhaps a lighter approach of KYC is more suitable here. KYC compliance isn’t required to post on Reddit, so the same logic might apply to the unfolding use cases of Internet of Value. Collecting less data on users while monitoring suspicious addresses is a challenge that needs to be addressed.
Another related compliance hurdle is identifying users for collecting tax payments. Blockchain networks might need to explore revenue sharing schemes for global non-profit causes, to smooth the transition from government responsibility of citizens to the internet\blockchains.
Onward to the DAOs generation!
It’s exciting to see how DAOs can disrupt finance and revolutionize how markets operate. TheDAO, was a unified “hive mind” VC\crowdfunding experiment, that could have leveled the playing field in venture financing (currently done almost entirely by huge investors like endowment funds). A future inclusive global pension fund, p2p insurance scheme and organizations using futarchy to decide on actions (gnosis, Augur, wings.ai and others are placing the corner stones) might change everything we thought we know of finance.
DAOs might still be theoretical, and introduce new risks (as TheDAO was hacked and wasn’t even fully autonomous), but securities regulation are also sometimes old and odd. As Bitcoin disrupted our definition of coin (not being exclusively issued by government), the next step for the blockchain economy is to disrupt securities and financial markets with innovative concepts that leads to real value.
Few basic tips for the DAO entrepreneur that plans a crowdsale (and made it all this way in this article): remember to communicate and have full transparency, do not over promise with the product’s goals. Don’t promise any ROI and clarify that it is an experiment. Be a diligent fiduciary of funds (Bruce Wanker sends hi), and don’t act in negligence to your duties.
And of course, consult a lawyer.
At least until true smart contracts come out..