Hi Andy and FL community,
I am a seasoned lawyer from the US back to school in the Netherlands getting an Advanced Masters in Digital Technology law. My thesis is on DAO governance/regulation. I am copying below the section of my thesis that is pertinent to this project. It is still a draft but has good information for you to consider now as I understand you want to publish this white paper soon. I am happy to address any questions on this as best I can. I am no expert in DAO governance (yet) but am willing to do the research to help us all figure this out! Currently my paper only covers US, but soon will be updated to cover EU/UK and Asia as well.
A copy of this with proper footnotes/references can be found at the following link, and you may comment on this google doc as well:
Without further ado, here is the relevant portion of my thesis so far:
Regulation of DAOs
DAOs are formed by individuals who seek to escape from the jurisdiction of any centralized government, and thus by their very nature are elusive to regulation. However, this section will explore ways in which traditional centralized government structures may regulate DAOs, and conversely, what steps a DAO may take in order to proactively avoid such centralized government regulation.
DAOs often dispense or exchange tokens similar to cryptocurrency in various different forms and methods as a way to track reputation, incentivize users, encourage action, and/or distribute ownership amongst the community. Generally, cryptocurrencies that are intended as investments are viewed as “securities” and thus heavily regulated throughout the world. Therefore, DAOs seeking to avoid regulation would also need to be cognizant of various centralized governments’ legal approaches in defining what exactly is a “security” or an “exchange” in order to avoid being deemed as either and thus open to much more regulation, scrutiny, and potential shareholder litigation.
As a full jurisdictional analysis is outside the scope of this paper, and due to the decentralized nature of DAOs, I will focus on the major global financial hubs making the assumption for the purposes of this paper that a DAO would be conducting transactions with citizens from one of these centralized governments such that some principle of jurisdiction would be applicable.
If a DAO token is considered a “security” within the meaning of the U.S. Securities Act, then it would be vulnerable to shareholder litigation and government regulation in that country. Under Section 2(a)(1) of the Securities Act, a security includes “an investment contract.” An investment contract is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.
When determining whether a particular instrument, such as a DAO token, may be classified as an “investment contract” the U.S. Securities and Exchange Commission (SEC) and federal courts apply the Howey test established by the U.S. Supreme Court in 1946. Under the Howey standard, a DAO token is an investment contract security where there is 1) an investment of money 2) in a common enterprise 3) with the expectation of profits 4) to be derived from the entrepreneurial or managerial efforts of others. Each element of this test must be met in order for a DAO token to be deemed an “investment contract,” i.e., a “security”.
“Investment of money”
The first and best way for a token to avoid being deemed a security would be for it to ensure that there is absolutely no financial investment by users. The investment of “money” needn’t take the form of cash and therefore DAO token exchanges for other cryptocurrency would meet the threshold of the Howey test. Thus, in order to avoid potential litigation and regulation, DAOs mustn’t sell anything, mustn’t hold an initial coin offering (ICO) where payments are made in exchange for tokens, and must ensure that a user gives no financial compensation for their participation in the DAO or for their DAO tokens.
However, most DAOs like “The DAO” are crowdfunded or venture capital undertakings, and thus do collect money from the users. For these types of DAOs, further structural considerations by those establishing the decentralized enterprise must be made in order to avoid being deemed a “security” which would open it up to liability, regulation and likely heavy fines, as once deemed a security the SEC will rule that the token is unregistered and then fine the DAO for this violation.
In July 2017, the SEC published a report on ICOs in regards to “The DAO” which applied the Howey test in concluding that that their tokens sold on the Ethereum blockchain were securities and therefore were in violation of U.S. securities laws because they were unregistered. More recently, in a March 30, 2019 opinion, the federal court for the Southern District of New York (SDNY) affirmed the SEC’s decision that an ICO is a security and gave more insight into what particular characteristics of an ICO could deem it a “security” under the law. We will go through these two cases element by element to determine how DAOs can avoid being seemed a “security” in the future.
According to US federal courts, “common enterprise” can be established by “horizontal commonality.” In an enterprise of horizontal commonality, “the fortunes of each investor in a pool of investors” are tied to one another and to the “success of the overall venture…a finding of horizontal commonality requires a sharing or pooling of funds.”
If the primary goal of an ICO is to raise capital to launch an enterprise and the funds raised through an ICO were pooled together to facilitate this launch, and if the success of which would increase the value of a token, then the value of the token can be said to be dictated by the success of the enterprise as a whole, thereby establishing horizontal commonality. This means pooling assets to achieve a particular goal, and if that goal is achieved the token is worth more, then the element of “common enterprise“ is met.
The very nature of DAOs are that they are common enterprises, thus, this particular element cannot be circumvented by DAOs and thus the avoidance of being deemed a security must ride on the other elements of Howey in order to succeed.
“With a reasonable expectation of profit”
The SEC ruled that this prong of Howey was met for The Dao due to the fact that there was a potential for a return on investment through earnings from the DAO’s projects which created a “reasonable expectation of profit” in the token holders which, according to the SEC, is a hallmark of a security.
For this prong of Howey, U.S. courts consider whether under all the circumstances, the scheme was being promoted primarily as an investment. Therefore, DAOs must be careful to not advertise the potential for profit or revenue or even intimate that there may be an increase in value of the token.
SEC Director Hinman in the form of a non-exhaustive list of questions intended to aid organizations in assessing whether a third party – be it a person, entity or coordinated group of actors – has an expectation of a return. A DAO attempting to avoid such a determination would be advised to refer to these questions as a check on their operations and structure.
“Derived from the managerial efforts of others”
The central question here is “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” According to the SEC, The DAO’s investors relied on the managerial and entrepreneurial efforts of its co-founders, and The DAO’s curators as gatekeepers, to manage The DAO and put forth project proposals that could generate profits for The DAO’s investors.
On this point, the SEC noted that The DAO token holders had the right to propose projects and vote on which projects would receive funding, but that the voting rights afforded to token holders did not provide them with “meaningful control” over the enterprise because token holders’ ability to vote for contracts was a largely perfunctory one. Token holders could only vote on proposals that had been cleared by the curators and that clearance process did not include any mechanism to provide token holders with sufficient information to permit them to make informed voting decisions. In fact, based on some draft proposals from The DAO token holders’ online forums, the SEC found that the contract proposals did not have enough information for token holders to make an informed voting decision, affording them less meaningful control and so more reliant on the managerial efforts of others.
Also, according to the SEC, The DAO token holders’ pseudonymity and global dispersion diluted their control. Because the token holders were widely dispersed, anonymous to one another, and limited in their ability to communicate with each other, the SEC determined that their pseudonymity and dispersion made it difficult for them to join together to effect change or exercise meaningful control. Thus a DAO wanting to avoid being deemed a security should facilitate a robust communication system amongst the community at large, one that is linked with some sort of immutable identification or reputation system such that actors are not completely anonymous or untraceable, and are able to join together and effect change or exercise meaningful control of the DAO.
Another factor in deeming The DAO tokens to be a security was that they were being traded in the secondary market, something that wouldn’t occur if tokens were considered shares in a partnership, which would be an alternative legal framework to consider applying to DAOs in a centralized authorities’ pursuit of governing them. Thus, a DAO avoiding SEC regulation would want to limit the selling of its tokens on a secondary market. This criteria was further affirmed by SDNY in the ATB Coin case.
How a DAO can avoid being a “security”
In summary, the SEC and SDNY rulings do leave some leeway for DAOs to structure themselves in such a way that they can avoid regulations as a security, even if they collect an investment and are a common enterprise, thereby alleviating it from potential litigation and regulation: 1) there mustn’t be any gatekeeper or curator - all community members must have an equal voice and weight; 2) all decisions affecting the DAO must truly be left to the token holders such that any profits made are derived solely from the efforts of the community itself; 3) the platform architecture must encourage robust communication within the community and individuals must be linked to some immutable identifier to encourage growth of relationships and of respect for reputation; 4) absolutely no indication that the token value would rise or that holders stand to profit must be made; and 5) tokens mustn’t be exchangeable on a secondary market.
In an April 3, 2019 no-action letter, the SEC provided further guidance on how tokens can avoid being deemed a security. A DAO must not use any funds derived from the token sale to develop its platform, network, or app, and must be fully developed and operational at the time any tokens are sold.
When sold, tokens must be “immediately usable for their intended functionality” and the DAO must restrict transfers to DAO-specific wallets only, meaning no external wallets are allowed.
A further limitation is one placed on the valuation of the token, which must be fixed and tied to a fiat currency. In this particular no-action letter, tokens were priced at 1 USD per token “through the life of the program,” with each token acting as a prepaid coupon for the company’s services. And if the company wants to buy back a token, it must do so at a discount.
Finally, the token must be “marketed in a manner that emphasizes the functionality of the Token, and not the potential for the increase in the market value of the Token.” This criteria stems from the Howey’s requirement to not market this as an investment with any “reasonable expectation of profit.”