As part of the DX Legal Assessment, I have worked on what should be DxDAO’s approach to the United States from a legal perspective. Below is a synthesis of my work. Feel free to make comments or raise questions or issues.
Following discussions with some contributors, we decided to focus on the following topics:
DAOs and the General Partnership
A presentation of U.S. securities framework
A general overview of future US laws and policy
THE GENERAL PARTNERSHIP ISSUE
The law does not like the void and somehow, the U.S. general partnership has been the most common legal category that many commentators think should apply to DAOs.
To give you a bit of background without being too technical, a general partnership is US law is defined as “the association of two or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership”.
The main criteria to define a general partnership are the following: (i) co-ownership, i.e. the “power of control” over a business and (ii) sharing profit and losses, i.e. people not to place their money, efforts, labor and skill and divide profit and bear the loss.
With this definition in mind, it’s easy to understand why many DAOs, in particular so-called “investment DAOs” such as The DAO (referring to the first DAO here) may be referred to as general partnership. Many US legal minds have argued so.
But this does not necessarily apply to all DAOs, especially to DxDAO.
Why is this important? Because of the consequences: if you’re deemed to be part of a general partnership, you may be exposed on several fronts and in particular:
Civil liability : for instance, if a deceived contributor, a competitor or any third-party engages in a lawsuit in the U.S against DxDAO and the DAO is sentenced by a U.S. court, you might be required, as a contributor, to pay for any associated damages caused by the DAO, if the DAO is insolvent or cannot cover the associated damages.
Tax liability : a general partnership must file an annual information return to the US tax administration, the Internal Revenue Service to report the income, deductions, gains, losses, etc. From a tax perspective, the general partnership “passes through” profits or losses to its partners. Each partner has therefore the obligation to report their share of the partnership’s income or loss on their personal tax return.
In practice, this has been exacerbated recently by a recent case, the bZx DAO case, where deceived token holders have acted against (i) a DAO managing a DeFi protocol, (ii) the initial LLC which developed the protocol and (iii) founders of the protocol and LLC (great resume here if you’re interested).
Importantly, between the time of my work and now, the CFTC (the US agency in charge of regulating commodities) have acted against the same DAO but to claim that it was an … unincorporated association. This raises other legal issues and it will be very interesting to follow the developments of these cases, both the class action and the CFTC action.
For contributors to limit potential legal risks on this front, it is helpful working through a company / legal status and not personally. As I mentioned before, it would be better if this would be a prerequisite to work at DxDAO, rather than an option.
Also, I believe not working exclusively for the DAO and having something on the side is generally a good idea. You may work at 100% from time to time but it might be useful at some point to demonstrate that your company is offering services to other clients.
It’s impossible to address legal issues surrounding crypto without of course discussing US securities law.
The SEC and the investment contract
As you may know, securities are regulated in the U.S. by the Securities and Exchange Commission (“SEC”) and are required to be registered with the SEC. The SEC a is a federal agency; to keep it simple, it’s one the many arms of the U.S government.
The SEC has jurisdiction (power) over securities. Securities includes bonds, stocks or may other forms of investment. It also includes a specific category which is the “investment contract”. The investment contract definition has been set out in the infamous Howey case.
This is an old case from 1934 which involved a hotel that sold land containing orange groves to tourists along with a contract that leased the land back to the hotel and gave the purchasers a share in the net profits of the orange harvest, which was the product entirely of the hotel operator’s effort.
The Court determined the arrangement created a security through a four-part test: (i) an investment of money, (ii) in a common enterprise, (Iii) with the expectations of profits; (iv) to be derived from the efforts of “others”.
Through this test, the SEC has ruled many times that crypto assets were securities. This test enabled the SEC to largely interfere in the development of crypto trough enforcement and policy interventions.
In practice, only the fourth prong does really matter, and it is basically a decentralization test. The question is: can you identify an active participant on which investors are relying on for the value of the token? If yes, then the token might qualify as a security. If not, the token does not pass the test, and it’s not a security.
What does it mean in a nutshell? Decentralization matters !
The SEC’s approach to crypto
In the context of my work, I have prepared the following table which summarizes some of the main defining steps in the SEC’s approach to crypto:
As you can see, the SEC has been very active, and it is even more active since Gary Gensler has been appointed chair in April 2021. Mr Gensler has publicly said many times that to him, only bitcoin was out of the reach of US securities law and that most of crypto assets were securities.
Yes, this may include Ethereum, and from a purely US regulatory standpoint, the transition to PoS was probably a mistake. But this is another debate
This severe approach has been criticized by different stakeholders in the US, but so far, nothing seems to stop Mr Gensler from enforcing US securities laws to crypto. This can change with a new chairman or an intervention from the congress with some clear laws defining what is a crypto-asset and what is a security.
Which token may qualify as securities ?
Although the SEC’s approach is very severe and not very clear, there are several criteria that we know that the SEC uses to qualify a security. In particular, in a very recent case involving insider trading allegations at Coinbase, the SEC deemed 9 crypto assets as securities.
Those assets are the following:
What are the common features ? There are at least 5 :
(1) Operating in the U.S. and offering tokens to the U.S. public : 5 out of the 9 tokens analyzed by the SEC qualifiy as a security and were issued by corporations having their principal place of business in the U.S. This is no surprise since the SEC has always been very vocal about addressing token sales to the U.S. public.
(2) Conducting an ICO and retaining an important part of the supply: almost all companies mentioned in the SEC’s complaint completed an ICO. In most cases, the founders and the team retained an important part of the token initial or future supply.
(3) Incomplete projects : in most cases, the SEC noted that the teams behind the token sale did not complete the project the token was intended to be part of, which was an indication to qualify the existence of a security.
(4) Forward looking statements / marketing the tokens as an investment opportunity : in most cases, the founders or the team behind the project publicly commented the tokens, their price action, what they intended to with it (e.g., “I will never sell the X token”) and the SEC did not hesitate to quote tweets, retweets, websites, whitepapers medium articles or blogposts. This means that token issuers must be very careful with their communications.
(5) Listings on secondary markets : the SEC pointed out on several occasions the efforts of the founding teams to see their tokens listed on Coinbase and / or the mention that the tokens will be available on other markets.
On a more specific note, please note that the DFX token, which was deemed a security, is a liquidity token acting as an incentive to use a DEX. This is very surprising and is putting at risk potentially all liquidity tokens, such as the UNI token.
More guidance is needed from the SEC and the law needs to go beyond the Howey test, otherwise most crypto will be at risk but it’s not clear yet where things will go in the US. In the end, it is also an option that all crypto except Bitcoin ends up within the realm of US securities law and that all token issuers would be subject to the SEC…
There were two major regulatory developments in the US in 2022 :
The Executive Order on Ensuring the responsible development of Digital Assets (“Executive Order” – Marc 2022) : it is a written document signed by the president of the United States that contain directives directly from the President to federal government agencies. It encouraged various agencies of the US government to coordinate to identify risks and establish policy frameworks. This document may have triggered many of the SEC and CFTC interventions this year.
The Lummis-Gillibrand Responsible Financial Innovation Act (“RFIA”): on the 6th of June 2022, two senators published a bi-partisan draft legislation which has the ambition to create a framework for digital assets and blockchain technologies in the U.S. This is a complete regulatory framework which is yet to be adopted and it’s unlikely to see it into legislation any time before 2023. The RFIA addresses a wide range of issues, such as securities and commodities laws, consumer protection or stablecoins. Importantly, the bill provides a definition of DAOs :
The term ‘decentralized autonomous organization’ means an organization—
“(i) which utilizes smart contracts (as defined in section 9801 of title 31, United States Code) to effectuate collective action for a business, commercial, charitable, or similar entity,
“(ii) governance of which is achieved primarily on a distributed basis, and
“(iii) which is properly incorporated or organized under the laws of a State or foreign jurisdiction as a decentralized autonomous organization, cooperative, foundation or any similar entity”.
Given most DAOs are not incorporated, the practical application of these rules is unclear. It does not seem that the bill implies a requirement or an obligation for DAOs to actually incorporate as an LLC, a foundation or any other kinds of legal entity which, in turn, takes us back to the question whether unincorporated DAOs may constitute… a general partnership (or an uncorporated association). You can see the all content of the draft bill here.
There are currently a lot of ongoing cases which will shape the future of crypto legal in the US. It is really hard to keep up - even between the time of my work and now, there has been so many developments!
A very good resource to keep up with all US cases is this page which references all crypto legal cases in the US. Have a look and you’ll be surprised of how many cases related to different topics are ongoing.
Cases to watch
For DxDAO in particular, I would closely watch the following:
bZx DAO class action : a US judge will have to decide whether a DAO is or is not a general partnership. Although the bZx DAO is very different from DxDAO, there will be for sure very important guidance that will help DxDAO structure its operations.
Uniswap class action: a user who lost approximately $10.000 in buying obscure ERC-20 tokens (e.g., EthereumMax) in the midst of the last bull run has initiated a class action against Uniswap Labs and some prominent venture capital firms that invested in Uniswap Labs. The complaint claims that Uniswap Labs has control over the Uniswap protocol and that Uniswap Labs has offered unregistered securities. There will be interesting legal debates as to whether Uniswap Labs has control over the uniswap protocol (they always claimed they only managed the front-end).
I hope this gave some insights, feel free to comment or ask some questions!