DAO (Decentralized Autonomous Organizations) and Regulation

Originally published on Cryptos on the Rise.

A DAO (Decentralized Autonomous Organization) is a revolutionary change in the manner that people and businesses can organize.  Leveraging blockchain technology, it is a decentralized model of control and governance.  The essence of a DAO is transparency, clarity of rule, and process driven decisions – primarily utilizing smart contracts on distributed ledgers.  Once a DAO has been established, via a blockchain, participants take ownership of its token, which allow them to participate in the system.  Token holders can propose changes, and can vote on those changes, with the subsequent actions being taken, “leaderlessly”.  There are no CEOs, CFOs, CTOs, only code and community.

Close to 5,000 DAOs have been formed to date, expecting to grow exponentially.  Many involve pooling digital money together to purchase assets, both physical and digital.  ConstitutionDAO was established seven days prior to the auctioning of one of the eleven remaining copies of the US Constitution. The intent, to purchase and house it at a protected public location.  Participants in the DAO contributed money in ETH (Ethereum token) to the cause, raising $45 million.  Separately, the AssangeDAO raise $53 million for the criminal defense of Julian Assange.  These are quick and powerful ways form decentralized autonomous organizations.

Central to a DAO is transparency.  Anyone can see which individual (wallet address) owns tokens.  Tokens allow for people to vote on proposals.  Anyone can create a proposal.  Simply stated, and in an ideal setting, it is egalitarian.  Challenges to the model are its extremely democratic nature, i.e. voting on everything.  As a result, it can be overly deliberate and result in a slower process compared to a more centralized formed organization like a corporation.

With this nascent, but extremely powerful organizational structure, the regulatory landscape at the state level is nearly non-existent.  Wyoming, which has led the US on regulation for blockchain and cryptocurrency, recently codified rules for DAOs residing in the state. Therefore, a DAO could be created under the laws of the State of Wyoming. No other state enables this yet.  Further, there is a movement afoot for corporations in the cryptocurrency space to dissolve and become DAOs.  With potentially hawkish regulation on the horizon for cryptocurrency, DAOs, by their very nature, are code based, self-running, leaderless entities running via a decentralized network, which permits actions based on how users interact under brassbound, predefined rules. Theoretically, under the current regulatory landscape there is nothing the law can do about such an entity. The converted corporation to a DAO would no longer be in control of the platform, which reverts to a completely new decentralized model, unlike anything regulated currently.

According to the SEC guidance issued in 2017, they determined that “The DAO”, an entity raising money in an ICO, Initial Coin Offering, that it was indeed a security.  The difference here is that many of the DAOs created now are under the auspices of “investment clubs” or are simply voting mechanisms, whereby the SEC generally does not regulate, unless met by the “Securities Act of 1933” regulating the offer and sale of those membership interests, or under the Investment Company Act of 1940 (1940 Act), or if a person who is paid for providing advice regarding the investments of the club or its members may be an investment adviser under the Investment Advisers Act of 1940 (Advisers Act) or state law. (SEC, https://www.sec.gov/reportspubs/investor-publications/investorpubsinvclubhtm.html)

The SEC is reportedly looking into true DAOs like Uniswap in the decentralized finance (DeFi) space, as a decentralized exchange (DEX), which is a code-based organization that matches buyers and sellers of cryptocurrency.  One area of focus is lending pools, where users will provide their assets for other users to trade, which provide healthy yields, just as banks provide interest on your assets.  This may fall into the Howey Test investment contract realm. 

DAOs are in their embryonic stage with legislatures and regulators.  There is little question that this space if bursting with potential and therefore creating a framework with regulation is certainly on the horizon. 

Harvard Business School Panel: How Should ICOs and Cryptocurrencies Be Governed?

Originally published in the Legal Executive Institute

by Joseph Raczynski

BOSTON — Recently I moderated a session at Harvard Business School surrounding its first annual Business, Regulation and Technology of Blockchain Conference. It was held in conjunction with the MIT China Innovation & Entrepreneurship Fund and the Harvard Law Entrepreneurship Project’s Blockchain Initiative.

Before a crowd of 175 attendees — comprised mostly of members of the legal and financial cryptocurrency communities, and MBA and law students — the panel focused on the governance of cryptocurrencies in 2018. The panel experts consisted of Kendrick Nguyen, CEO of crowdfunding platform RepublicCaitlin Long, self-described blockchain enthusiast and former Chair and President of Symbiont; and Anil Advani, Managing Partner of Inventus Law.

The Difference between a Utility Token and a Security

In pushing to help people understand the Initial Coin Offering (ICO) market, I posed the most hotly debated question in the crypto community: What is the difference between a Utility Token and a Security?

Advani jumped into the conversation by discussing how Jay Clayton, the Chairman of the Securities and Exchange Commission (SEC), defines the distinction, “If you are running a laundromat it is a utility, but if you are raising capital that is a security.” Advani went on to explain, if the token is designed to serve as a prepaid service, or it allows you to access a company’s service, e.g. a loyalty points system, it is a token. However, if you are simply trying to use an ICO to raise capital, that is a security and hence subject to SEC regulation.

HBS-Raczynski

Nguyen agreed, speculating that he “expect to see this space to be litigated in court” and added that he hopes “that a lot more tokens will be determined to be utility tokens rather than securities.”

Long emphasized that it may take some time for regulators to sort this out, but companies need to be cautious in the meantime. “Most of the cryptocurrency platforms are not functional yet,” she noted. “So the token currently is not exchangeable for a good or service until that platform is built.” Therefore, these tokens need to be locked up until the companies are operational and not sold until they are ready, she explained, adding that if a company sold its tokens sold ahead of being functional, those tokens could well could be considered a security.

A Token Can Change its Stripes

As this topic is of paramount interest to a $500 billion cryptocurrency industry, the panelists continued the conversation, noting several recent developments. Long described a recent interaction she had with SEC Chairman Clayton. “A token can change it stripes,” Long mentioned, outlining the two stages of a company’s build. In the first phase, because there is no product the tokens are likely considered Security tokens; however, once the platform is running, and the tokens can be exchanged for goods or services, they could be converted to a Utility Token. The key, Long said, is not to “market it as an investment.”

Finally, one of the points noted by Advani was that “Chairman Clayton’s off-remarks during events are similar to Trumps tweets.” It is creating a lack of clarity in this market, thus leading to confusion and consternation, he said.

Privacy Tokens & Taxes

Some of the cryptocurrencies listed among the 1,600 currently available are completely anonymous. I posed the question about its impact on anti-money laundering (AML) rules and the market. Advani is concerned about the ability to track these sorts of assets and said it raises a deep level of concern about how any government would be able to account for this.

Another question that I presented to the panel was on taxes, prompting Long to respond: “This is clear as mud.” There is very little guidance on how to tax hard forks of a cryptocurrency and mining operations, for example, and Long went on to say that this will require legislation to help understand the various facets of the new tokenized society and tax.

While the panel covered a wide spectrum of the impact of regulation on cryptocurrencies, the primary theme that emerged is that though there are glimmers of definition from various agencies in the United States, considerable guidance is still necessary for people to better understand how to invest, create new companies, and work with cryptocurrency.