In the past year, Decentralized Autonomous Organizations, or DAOs, have gained prominence among blockchain and cryptocurrency enthusiasts as an alternative to traditional corporate governance structures. DAOs, in their simplest form, are a collection of often anonymous individuals who have banded together using blockchain technology to pursue a stated goal with decentralized and democratic decision-making. Financing for DAOs is frequently accomplished through crowdfunding in exchange for the issuance of digital assets known as “tokens” that provide the owner with voting rights in the governance of the DAO, or other privileges.
As DAO’s have proliferated to include groups dedicated to buying a copy of the Constitution, fostering a community of creators, and sharing ownership of parcels of land, so too have questions about how a DAO’s legal structure and operations can comply with securities laws, protect members from liability, and abide by tax regulations.
One of the central questions being asked by DAO members is whether the tokens being offered are “securities” subject to regulation by the U.S. Securities and Exchange Commission (SEC).[1] While the answer to this question with respect to any particular DAO involves a fact-intensive inquiry, the SEC has provided some guidance on this topic in a Report released in 2017. The SEC’s guidance followed the analysis in the seminal case SEC v. Howey Co., 328 U.S. 293 (1946). The SEC makes clear that it views DAO-issued tokens as “securities” when (i) the tokens were issued in exchange for money, (ii) purchasers of the token expected the tokens to increase in value, and (iii) the value of the enterprise was linked to the managerial efforts of the founders running the DAO.
As DAO founders design their organizations and token structures, unless they qualify for a registration exemption they are well advised to consider how tokens may ultimately be viewed by regulators. This means considering questions such as:
- Does the token have a use case other than fundraising and speculation?
- Is there a general expectation that the core team will further develop the product/project?
- Will the DAO be facilitating liquidity pools, market making, or listings on exchanges?
These considerations may take on more urgency as the SEC’s posture towards regulating DAOs becomes clearer. Already there are signs that the SEC intends to increase scrutiny of crypto projects. In November 2021 SEC Chair Gary Gensler identified a number of upcoming enforcement priorities with an emphasis on looking behind decentralized finance to determine the economic reality of a transaction. This was shortly before the SEC halted registration of one of the first blockchain-based LLC’s to apply for token registration due to concerns of misleading information in the application.
The next few years are poised to be eventful as the DAO ecosystem continues to mature. Until there is greater clarity from regulators, DAO founders should consider the existing guidance as they look to design decentralized organizations.
About the author: Todd Williams is a partner with the firm. His diverse litigation, trial, and counseling experience includes representing individuals and entities in blockchain-related businesses.
[1] Securities offerings are also regulated by state laws, which frequently have broad interpretations.
February 11, 2022
