FTX filed a petition under Chapter 11 of the U.S. Bankruptcy Code on November 17, 2022. So what now?

In the bankruptcy system, FTX and associated entities (generally referred to as “FTX” throughout) is now the “debtor” and if FTX is alleged to owe an individual or entity money, they are the “creditor” with a claim against the debtor’s bankruptcy estate. This article is a brief primer on steps FTX creditors can take to ensure their status and claim is properly documented with the bankruptcy court and considered in the event of distribution of assets by the estate. A general overview of how a Chapter 11 reorganization under Chapter 11 of the U.S. Bankruptcy Code can be found here.

A. Review Deadlines and Consult Appropriate Counsel

The Bankruptcy Code requires that notice be sent to creditors and interested parties in a case under the U.S. Bankruptcy Code. (See 11 U.S.C. § 342). The Notice of Bankruptcy Case (“Notice”) is issued by the bankruptcy court and is mailed to the parties appearing on a Creditor Matrix prepared by the debtor describing the debtor’s creditors and implicated debts.

The Notice from the FTX proceedings can be downloaded here.

As soon as an individual or company receives a Notice, they should begin by:

Assessing the value of the potential claim against the debtor (in this case, FTX) and gathering supporting documentation.

Creditors interested in filing a claim should preserve all documents related to their relationship with the debtor and be prepared to share those documents with the bankruptcy court in connection with the claims process and as described in Section C infra.

Determine whether to take an active role in the bankruptcy proceedings by joining a creditor’s committee, engaging in an adversarial action, or other efforts.

Noting any deadlines set forth in the Notice.

Coordinating with internal or external counsel and consider retaining local counsel, depending on the posture and value of the claim.

With custodial crypto exchanges like FTX, there is the additional important consideration of whether creditor assets are assets of the bankruptcy estate, or if title remains with the customer. In the Celsius bankruptcy, Judge Martin Glenn recently ruled that customers whose funds were held in a purely custodial manner would be returned to the customers because they were not assets of the estate. Bankrupt crypto lender BlockFi has also petitioned the U.S. Bankruptcy Court to allow clients to withdraw cryptocurrencies that are held in their BlockFi Wallet Accounts. According to FTX’s terms of service, title to customer crypto assets on the FTX platform remains with the customer. However, one significant distinction between the Celisus and FTX cases is that FTX’s apparent misuse and co-mingling of custodied customer assets across the FTX debtor group may simply mean there are no ascertainable customer-owned assets to return.

B. Where Can I Find Information About the Case

The most efficient way to access information regarding a pending bankruptcy proceeding is to review the case docket and obtain copies of the debtor’s bankruptcy schedules and other pleadings filed that discuss the debtor’s financial situation.

These documents can be found on PACER/ECF for the U.S. Bankruptcy Court for the District of Delaware.

If creditors/attorneys don’t have access to PACER/ECF, the docket and information about relevant dates/deadlines are hosted by a third-party here (this is required by the bankruptcy court so the public can readily access information).

The creditor or counsel should monitor the case and relevant deadlines. Counsel can file a Notice of Appearance and Request for Service of Papers. (See Fed. R. Bankr. P. 9010(b)). After filing a Notice of Appearance and Request for Service of Papers, counsel will receive electronic notice of all pleadings filed by parties in the case and be notified of any hearings and deadlines established by the Court.

With respect to the need to retain local counsel, the U.S. Bankruptcy Court for the District of Delaware permits parties (pro se or through out-of-state counsel) to file or prosecute a proof of claim or a response to their claim. The Court may, however, direct the claimant to consult with Delaware counsel if the claim litigation will involve extensive discovery or trial time.

C. The Proof of Claim

A Proof of Claim is an essential initial element in the bankruptcy process. It documents a creditor’s right to repayment from the debtor. The proof of claim describes the type of claim, priority status, and the amount of the outstanding debt. Filing a Chapter 11 bankruptcy proof of claim can affect whether, how, and when you receive repayment from the debtor.

A proof of claim will need to include redacted copies of any documents supporting the claim that are required by Bankruptcy Rule 3001(c), including:

Any writings supporting the claim (i.e. contracts, correspondences, invoicing, etc.).

An itemized statement of the interest, fees, expenses, or charges.

Documents demonstrating the existence and scope of a security interest in property of the estate.

When a claim is based on an open-end or revolving consumer credit agreement, a statement including the following information that applies to the account must be included:

• the name of the entity from whom the creditor purchased the account;

• the name of the entity to whom the debt was owed at the time of an account holder’s last transaction on the account;

• the date of an account holder’s last transaction;

• the date of the last payment on the account; and

• the date on which the account was charged to profit and loss.

Chapter 11 creditors technically do not need to file a proof of claim and should receive notices automatically by mail because the debtor is required to list its creditors in the Creditor Matrix. However, this assumes the debtor has accurately described the nature and amount of the debt owed in its schedules and has not designated the debt as disputed.

Even if a creditor is not technically required to file a proof of claim, filing the claim can be a useful exercise and will supersede the information — whether correct or not — filed by the creditor and listed in their schedule of assets and liabilities. Filing a proof of claim and supporting documentation also allows creditors to dispute any inaccuracies in the debtor’s schedules such as:

• the category of debt;

• the amount listed;

• when the creditor is not listed in debtor’s schedules;

• whether the claim is designated as disputed, unliquidated, or contingent.

Instructions and an electronic proof of claim form in the FTX case can be found and submitted here, as shown in the screenshot below. Instructions for filing a claim via mail can be found here.

FTX’s case information is provided below for convenience:

In re: FTX Trading Ltd., et al.

Case No. 22–11068 (JTD)

The last possible date that creditors are allowed to file their proof of claim against a Debtor in a bankruptcy case is known as the Bar Date. This is effectively the deadline for creditors to adhere to the bankruptcy claims timeframe through timely submissions of proof of claim to be accepted by the court. Assuming their information is correctly listed with the court, the creditor should receive a Notice of the Bar Date issued by the bankruptcy court. As noted below, in the FTX case, there is currently no deadline to file claims.

Generally, the bar date is set by the court within 90 days of the initial bankruptcy filing; however, the complexity of FTX’s insolvency may extend this timeline.

D. Types of Claims

In the administration of a bankruptcy estate, there are four types of claims. The type of claim will be relevant to the documentation accompanying the proof of claim. The character of the claim determines when and how any amounts are paid to the creditor. A brief overview of the four types of claims is provided below:

A secured claim is debt supported by collateral or a lien on a specific property of the debtor. Secured debt, like a mortgage or car loan, is backed by specific collateral that may be claimed by a lender if the debt goes unpaid. Secured claims have priority in the bankruptcy process, meaning they are paid before other creditor classes.

An unsecured claim is, by definition, one that does not meet the requirements of a secured claim. Unsecured debts, such as credit card or medical bills, do not grant lenders any specific collateral rights. Crypto firms that sought bankruptcy protection in 2022, including Voyager Digital and Celsius Network, have classified most of their customers, particularly those with interest-bearing accounts, as unsecured creditors. In the case of FTX, the interests of this class of unsecured creditors will be represented by a committee composed of account holders, investment funds, and an affiliate of U.S. crypto firm Genesis.

An unsecured priority claim is debt entitled to special treatment in the bankruptcy claims process and is paid ahead of unsecured non-priority claims. Examples include:

• Employee compensation;

• Unpaid contributions to employee benefits plans;

• Tax obligations owed to the government;

• Pending personal injury or workplace injury or death claims;

• Certain deposits are given to the creditor to secure future goods or services;

• alimony and child support;

• The costs of administering the bankruptcy case (e.g. professional accounting and legal fees);

If an unsecured claim does not fall under any of the categories above, then it may be considered a non-priority unsecured claim. Nonpriority unsecured creditors are the last to get paid when money is available.

E. What Happens After I File?

Once a proof of claim has been filed, debtors — assuming they did not file and confirm electronically — can confirm that their claim was received by the bankruptcy court by enclosing a stamped self-addressed envelope and a copy of the completed form, and the court will return a stamped confirmation in the mail.

Chapter 11 bankruptcy proceedings — including what will almost certainly include many sub-cases pendant to the FTX bankruptcy called adversarial proceedings — are generally lengthy endeavors. Administration of the FTX’s bankruptcy will likely be further complicated by fraud and other civil and criminal allegations that might result in a Ponzi determination and civil forfeiture proceedings. Ultimately, it may be many years before a Plan of Reorganization is approved and claim payouts are ultimately distributed. This is further assuming there are sufficient funds available to make any payment to creditors. However, by submitting a valid proof of claim to the court, creditors can ensure their bankruptcy claim is accurately represented in the case, and that there is some legal right of recourse against FTX.

lawpanda is a U.S. attorney with an active litigation and counseling practice assisting builders, developers, traditional companies, and decentralized communities. He is a member of  BanklessDAO’s Legal Guild, LexDAO, LeXpunK, the Blockchain Lawyers Group, and member/consultant/contributor to a variety of DAOs and protocols. When he’s not writing for Decentralized Law, he is working to reduce operational and governance friction between on-chain and legacy entities through corporate structuring and common-sense legal solutions. Read his scribblings on Mirror and connect on Twitter, LinkedIn, or at lawpanda.eth@gmail.com. *

A decentralized autonomous organization is a non-entity technological structure that facilitates social coordination and collective online decision making. DAOs are, by definition, community-led entities with no central leadership, and they sometimes govern themselves on the blockchain using smart contracts. They are particularly attractive in the digital age because the members are not limited by geographic location, enabling organization on an international level.

Unlike corporate shareholders, limited liability company members, or participants in other, more traditional legal entities, DAO members do not enjoy the type of personal liability protection granted through an entity’s fictional legal personhood. Decentralization makes conducting enforcement actions or otherwise suing a DAO more technically difficult because there is no centralized leadership, entity, or place of business. Beyond that, many DAO members are anonymous or pseudonymous, providing a further layer of insulation against legal action. Even so, a recent lawsuit against Ooki DAO has highlighted how the Commodity Futures Trading Commission (CFTC) is attempting to subject unidentified DAO members and token holders to liability — in violation of their full and fair procedural due process rights.

The CFTC's Action Against Ooki DAO

In September 2022, the CFTC issued an agreed administrative settlement order imposing a $250,000 civil penalty on bZerox (bZx) LLC and its founders, Tom Bean and Kyle Kistner. bZx and the founders did not admit wrongdoing but agreed to cease violations of federal commodities laws.

The complaint and accompanying settlement order alleged that Bean and Kistner designed the protocol as a collection of smart contracts on the Ethereum blockchain, which facilitated transactions without intermediaries and created an unregistered retail digital commodity derivatives exchange, in violation of the Commodity Exchange Act (CEA) and CFTC regulations. In the United States, these types of margin retail commodity transactions are required to take place on designated regulated contract markets, such as the Chicago Mercantile Exchange.

The CFTC concurrently commenced an enforcement action in California federal district court against bZx DAO, which had been rebranded to Ooki DAO (Ooki). The CFTC's complaint says that Bean and Kistner transferred control of the protocol from bZeroX to a DAO in August 2021 because they thought it would be “enforcement-proof.” The civil enforcement action is based on the same alleged violations by the bZx entity and its founders. According to the CFTC's complaint, Ooki is comprised of token holders who vote on the governance of the protocol, regardless of whether directly (as a token holder) or indirectly (as a delegate of a token holder), and this voting constitutes membership in an “unincorporated association” of the Ooki DAO.

The CFTC intends to prevent DAOs from using their decentralized nature and lack of legal structure to avoid liability from enforcement actions, asserting that “Ooki DAO exists for the exact same purpose as bZeroX before it — to run a business, and specifically, to operate and monetize the Ooki Protocol”, and alleging that Ooki permitted leveraged commodities transactions that can only be lawfully conducted on a designated contract market (DCM) pursuant to the CEA Act and acted as an unregistered futures commission merchant (FCM) by soliciting and accepting orders for trading on the protocol.

The CFTC also alleges that Ooki's failure to comply with Bank Secrecy Act provisions requiring FCMs to implement a customer identification program, know-your-customer (KYC) policies, and an anti-money laundering (AML) program violated CFTC rules. The CFTC has requested an injunction precluding further activity and that Ooki rescind any contracts or agreements with investors and pay restitution for funds it unlawfully obtained.

While an enforcement action against founders or their associated startup entity is not unusual, the CFTC's expansion of the action to DAO members is unprecedented and has been decried by many as arbitrary and blatant regulation by enforcement. The action is particularly unusual and novel based on the CFTC’s theory that Ooki is an unincorporated association under California law, which allows the DAO, in theory, to be sued as a whole and encompassing each alleged individual member of the association.

Putative Expansion of DAO Member and Token Holder Liability

The CFTC's decision to expand the enforcement action to DAO members is the subject of vigorous internal debate. CFTC Commissioner Summer K. Mersinger issued a dissenting statement, calling the decision to impose liability on the DAO and token holders “arbitrary” and “based on an unsupported legal theory amounting to regulation by enforcement while federal and state policy is developing”. Mersinger, a Republican who was appointed to the CFTC by President Joe Biden, said the agency should have engaged in formal rulemaking on DAO liability. “The commission's approach in these actions will have public policy implications that extend far beyond this particular settlement and lawsuit,” Mersinger said, “yet the commission has made this consequential decision with no public notice or input whatsoever. It is regulation by enforcement, plain and simple”.

One of Commissioner Mersinger's — and indeed most practitioners' who have reviewed the case — main criticisms of the CFTC's action against Ooki is that the CFTC based their theory of liability on California state law precedents from contract and tort law that hold individual members of a for-profit unincorporated association personally liable for the debts of the association. However, arguments relating to Ooki's liability are substantive arguments, meaning the CFTC is required to first comply with certain procedural requirements before it can attempt to hold Ooki DAO or its members liable.

While some of the substantive and procedural issues are intertwined, this article isn’t about whether the CFTC can hold the DAO and its members liable or enforce a judgment against them. It’s about how the CFTC has improperly served legal papers on ‘the DAO’ which has been characterized as an unincorporated association for purposes of the lawsuit to attach liability to each individual member.

In California, an unincorporated association has the ability to sue or be sued, but liability flows to the individual members jointly and severally instead of to a legal entity. Members of an unincorporated association have duties and liabilities to each other that stem from the rules of the association. The members agree — usually through a written constitution — to cooperate in furthering a common purpose, and will normally appoint a committee to manage the unincorporated association’s affairs. While clubs and charities are often constituted as unincorporated associations, the members of a management committee of a charity that is formed as an unincorporated association are likely to be trustees, which inherently limits their liability.

Unincorporated associations generally have one or more places of business or are registered with the state in some way. As noted by the CFTC, however, Ooki DAO is not registered with any state, does not have a principal place of business, and has not designated representatives to accept service on its behalf. A key characteristic of DAOs is that unrelated, and often anonymous, individuals coordinate ad hoc proposals about how to run the underlying protocol. An individual may have voted or delegated their votes on none, some, or all of these proposals.

This is in contrast with an association with a clear decision-making structure and constituency. In other words, despite the CFTC’s allegations, Ooki does not particularly look like an unincorporated association, and the CFTC’s inability to effectuate service on Ooki by standard mechanisms is just one of several factors highlighting that difference.

How Do You Serve a Chatbot?

In late September, the CFTC filed a Motion for Alternative Service asking for the court's permission to serve the DAO and its members by posting the complaint via a help chat box and posting a notice on the online forum to check the chat box. The CFTC argued that it should be able to effectuate service in this manner because the DAO has “no physical office address or any publicly identifiable persons associated with its business” and “the Help Chat Box and Online Forum are the sole mechanisms the Ooki DAO has chosen for the public to contact it directly”. In support of its request, the CFTC relies on prior 9th Circuit jurisprudence where federal district courts authorized email service on allegedly similarly situated organizations, i.e. organizations that only operated a website, had no known physical location, and provided only an email address to be contacted on the website.

In support of its Motion for Alternative Service, the CFTC supplied a detailed affidavit documenting the CFTC’s search for mechanisms to effectuate service on Ooki. The affidavit described the “extensive steps” the CFTC took to “identify an individual authorized to accept service of process on the Ooki DAO’s behalf or a physical location to which a summons and complaint could be mailed”. Efforts included searches of law enforcement databases and of business registration information in all fifty states. The CFTC also filed a supplemental motion and affidavit describing a post in Ooki’s Online Forum that refers to the litigation against Ooki. The CFTC proffered these communications about the lawsuit as demonstrative that service through the forum would provide appropriate notice to the Ooki members who were supposedly already aware of the litigation based on posts and discussions. The CFTC also argues that this method of service is appropriate and “reasonably calculated to give actual notice to the Ooki DAO because it is the method the Ooki DAO itself holds out to communicate with it”. (See Motion for Alternative Service, p.9).

The court subsequently granted the motion with minimal explanation and noted service was effective on the DAO on September 22, 2022. This means that Ooki — as a whole and with respect to each alleged member — is required to file a responsive pleading within twenty-one, sixty, or ninety days from the date of service — dependant on a variety of factors — or face default judgment against the DAO and alleged members jointly and severally.

Why Courts Are Obsessed With Procedural Due Process

In the United States court system, substance yields to procedure. What this means is that before a court can hear the merits of a legal argument, that argument must first meet certain requisite procedural requirements in its presentation to the defendant. These requirements are necessary to comply with state and federal procedural due process and ensure proper notice of the plaintiff's claims is provided in a timely manner that allows a ‘full-throated response’.

Civil actions must follow the procedures set out in the jurisdiction’s rules of civil procedure, and in the federal system, the procedures set out in the Federal Rules of Civil Procedure (FRCP). Under FRCP 4(e)(1), a plaintiff may serve a defendant according to the laws of the “state where the district court is located or where service is made”. California law, for example, allows a court to authorize “alternative service” through “a manner which is reasonably calculated to give actual notice to the party to be served …” Notwithstanding any service procedures allowed by state law, service on a defendant must also comport with constitutional notions of due process. The Due Process Clause of the Fourteenth Amendment to the United States Constitution commands,

“nor shall any State deprive any person of life, liberty, or property, without due process of law”.

The protections enumerated in the Due Process Clause require that deprivation of life, liberty, or property by adjudication be preceded by notice and opportunity for hearing appropriate to the nature of the case. These notice requirements are designed to provide a defendant the information necessary to prepare and defend against claims brought against them and prevent deprivation of the rights set forth in the Constitution.

Generally, both a summons and a complaint must be served on the defendant within a certain amount of time. Service by a process server is the most recognized mechanism, but methods such as certified mail, posting notices on property, or publication in newspapers are now widely accepted. More recently, email and social media forums have also been found to provide appropriate notice, but only in certain specific instances where the court deems the mechanism to be “reasonably calculated” to put the defendant on notice.

Due Process Must Be “Reasonably Calculated”

The Constitution does not require any particular means of service of process, only that the method selected be reasonably calculated to provide notice and an opportunity to respond. That standard was articulated in the 1950s Supreme Court's opinion in Mullane v. Central Hanover Bank & Trust Co. and has remained largely the same to present day.

In Mullane, the bank relied on a New York banking law to provide notice of a settlement to beneficiaries through newspaper publication. It is important to note, however, that while statutory notice by publication was sufficient for beneficiaries whose interests or addresses were unknown because there was “no other means of giving them practicable and effective notice,” for beneficiaries with a “known location,” the Court held statutory notice through a newspaper publication was “not reasonably calculated to reach those who could easily be informed by other means at hand”. In other words, where the identity or address of the beneficiary was known, service in-person or by mail was required.

The Supreme Court was noticeably careful not to commit itself to any formula, and balanced the individual interests sought to be protected by due process with the interests of the state. However, as time passes and as technology evolves, what mechanisms qualify under the standard of “reasonably calculated” notice has and will continue to change.

The Reasonably Calculated Standard in the Digital Age

In 2002, the United States Court of Appeals for the Ninth Circuit allowed service of process through e-mail as an alternate method in Rio Properties, Inc. v. Rio International Interlink. The court found that the defendant created a scenario where email was the only way to reach it for the purposes of service. The court opined that the defendant “acquiesced” to service via email because their business structure not only desired contact through email but also declined to list an “easily discoverable street address in the United States or in Costa Rica”. Given the circumstances, the court found that “[email] may be the only means of effecting service of process”.

The Rio court acknowledged the gravity of its decision, noting that there were no prior U.S. Court of Appeals decisions addressing the propriety and constitutionality of service of process by email. Because the Constitution only requires that the method of service selected be reasonably calculated to provide notice and an opportunity to respond, “[t]his broad constitutional principle unshackles the federal courts from anachronistic methods of service and permits them entry into the technological renaissance”.

Ten years after Rio, in Baidoo v. Blood-Dzraku, the New York Supreme Court allowed service by Facebook. “Under the circumstances presented here, service by Facebook, albeit novel and non-traditional, is the form of service that most comports with the constitutional standards of due process”. To demonstrate this method of service was proper, the plaintiff in Baidoo had to show that they could not locate the defendant — i.e. a physical address — to use the “nail and mail” or other method of alternate service.

As with the Baidoo plaintiff, the CFTC’s Motion for Alternative Service, and accompanying affidavits on Ooki included detailed affidavits (See DE 11-1 and DE 13-1) demonstrating their process, articulating why no other means of service was viable, showing the account or forum truly belonged to the defendant, and that the defendant logged in often enough to see the message. The Baidoo court made clear that “inasmuch as plaintiff is unable to find defendant, personal delivery of the summons to [the defendant] is an impossibility”. In allowing the plaintiff to effectuate service through Facebook message, the court in Baidoo emphasized that their decision would be based on the more flexible constitutional standard than the dearth of bright line precedent.

In 2018, in Democratic Nat'l Comm. v. Russian Fed'n, the Democratic National Committee (DNC) obtained leave to serve process on Wikileaks via Twitter because Wikileaks was a seemingly unincorporated “virtual” presence with no confirmable physical address. The DNC’s motion stated, “WikiLeaks is an organization of unknown structure whose primary activity is running a website, Wikileaks.org, on which it publishes confidential or classified information . . . [w]hile WikiLeaks’ physical presence is difficult to discern, it has a robust online presence, including an active presence on Twitter, using the handle @WikiLeaks”. The DNC alleged WikiLeaks was an unincorporated association and subject to service based on the same rules. WikiLeaks had also openly admitted to having read the complaint through Twitter. It is, however, somewhat distinguishable that WikiLeaks maintained P.O. box addresses in multiple locations, something Ooki clearly does not do, and service was directed to those addresses in addition to through Twitter.

While not yet attempted in a federal district court, several courts have also now allowed service via “airdrop,” including a court in the U.K. and a New York State court. These courts permitted service via transmission of a digital token to the defendant's wallet address. The service token contained a hyperlink to the relevant court filings in the case and a mechanism that allowed the data of any individual who clicked on the hyperlink to be tracked. It is not clear to what extent this mechanism of service would comport with procedural due process requirements for U.S. defendants; however, it would not be surprising to see plaintiffs attempt to utilize the mechanism in the near future in federal district court litigation.

Service of Process Outside the U.S.

One notable flaw in the CFTC's Motion for Alternative Service is its failure to address whether any Ooki defendants reside outside the U.S. This is problematic to the extent that an order allowing alternative service could be unenforceable and violate international treaties relating to service of process on non-U.S. residents outside the U.S.

Generally, a plaintiff may serve process on an individual in a foreign country under U.S. federal rules through certain specified means outlined in FRCP 4(f), including: 1) by any internationally agreed means of service that is reasonably calculated to give notice, such as those authorized by the Hague Convention; 2) if there is no internationally agreed means, or if an international agreement allows but does not specify other means, by a method that is reasonably calculated to give notice, or 3) by other means not prohibited by international agreement as may be directed by the court. As with the due process requirements discussed previously, this rule is a flexible standard that allows service through any means that comports with due process.

For example, the court in WhosHere, Inc. v. Orun allowed, along with a demonstration of proof of actual account ownership and regular use, service on a defendant located in Turkey via LinkedIn. In 2016, in St. Francis Assisi v. Kuwait Finance House, the United States District Court for the Northern District of California allowed the plaintiff to effectuate service of process on an otherwise unreachable international defendant via Twitter. However, in both of these cases the plaintiff's identity and nationality were readily identifiable.

Conversely, in Cox v. Coinmarketcap OpCo, LLC, the court denied the plaintiff’s request for alternative service via social media because “w]ithout further proof of the country of residency for the individual Defendants . . . [t]he Court can only speculate as to whether service by Twitter is prohibited by international agreement as the country of residency cannot be identified”. Similarly, with respect to Ooki, the CFTC’s allegation that alternative service on unknown defendants of unknown nationalities and residing outside of the U.S. is allowed would seem to be facially improper.

Can a Chatbot Appear in Court?

At publication of this article, no defendant has filed a responsive pleading or had counsel enter appearance in the case. However, the presiding judge, Hon. William H. Orrick, has set a remote hearing for November 30, 2022, in order to allow parties who have filed amicus curiae — friend of the court — briefs to present the arguments set forth in their briefs. See Docket Entry 28. Briefs have been filed by LexPunK, the Defi Defense Fund, and Paradigm (the Amicus Parties). Because the CFTC’s motion to effectuate alternative service was already granted, briefs filed by the Amicus Parties are being accepted and interpreted as motions for reconsideration of the court’s decision to permit alternative service on Ooki. The CFTC’s response to the Amicus Parties’ briefs is due November 7, 2022, with replies due one-week later.

The hearing will also likely address, to some extent, Ooki’s characterization as an unincorporated association under California law and its ability to sue and be sued. The substance of the Amicus Parties’ briefs is more fully addressed in our next article. The hearing can be publicly viewed via Zoom consistent with the instructions set forth on Judge Orrick’s bio page and as described at Docket Entry 28.

In Closing

Ultimately, the CFTC seeks to sanction anonymous individuals, who may reside across the world, who have not entered into a partnership or similar contract with each other, and whose only common connection seems to be their shared use of Ooki software on the blockchain. The CFTC’s main argument is that service via help chat box as well as a notice on its online forum is the appropriate mechanism for service because that is the only mechanism provided by Ooki to facilitate communication; and, based on discussion in the forum, members are aware of the lawsuit. However, this position does not take into account that while the DAO non-entity may conceivably be aware of the lawsuit and certain members of the community may be aware of the lawsuit, there are countless other token holders who are not and may be improperly determined to have been served and face default judgment.

Additionally, because of the Ooki token’s delegation feature, Ooki token holders may not have ever voted to direct the DAO, and delegation functionally renders the identity and location of the delegated voters unidentifiable. This means the token holders — at least for the purposes of service of process — are more similar to ‘doe’ defendants, requiring further investigation to properly identify and join into the lawsuit. The CFTC’s inability to identify Ooki members would also seem to further undermine the substantive argument that Ooki is a collective business enterprise directed by token holders. Ultimately, the CFTC’s novel use of California law to facilitate performative service and impose joint and several liability against countless unnamed U.S. and international token holders seems to fail to comport with notions of fair play and procedural due process.

If the CFTC is able to circumvent procedural due process requirements through alternative service mechanism that do not actually put every potential defendant on notice, the flawed substantive argument that Ooki is an “unincorporated association comprised of Ooki Token holders” cannot effectively be addressed through dispositive motion or subsequent presentation of evidence, and that is why substance must always yield to procedure.

* * *

*lawpanda is a U.S. attorney with an active litigation and counseling practice assisting builders, developers, traditional companies, and decentralized communities. He is a member of  BanklessDAO’s Legal Guild, LexDAO, LeXpunK, the Blockchain Lawyers Group, and member/consultant/contributor to a variety of DAOs and protocols. When he’s not writing for Decentralized Law, he is working to reduce operational and governance friction between on-chain and legacy entities through corporate structuring and common-sense legal solutions. Read his scribblings on Mirror and connect on Twitter, LinkedIn, or at lawpanda.eth@gmail.com. *

** **

You’re an enterprising founder with a unique project in the Web3 space. You have received angel investment and set up your startup company using Stripe Atlas, Doola, or the like. Somehow, you found enough devs to build the project, and you’ve come up with a killer marketing campaign. You know the right people, and your cap table is ready to go for those first funding rounds. As you begin meeting with investors, they start asking about SAFTs and SAFEs, token warrants, ICOs, and what kind of SPV you will utilize to launch your token and in what jurisdiction. You then realize that you have no idea how the rest of this stuff works. Should you talk to an attorney? Where do tokens even come from?

This article is meant to provide a very general — non-legal advisory — overview of some of the steps and mechanisms involved in the funding and issuance of a token. There will, of course, always be distinctions and exceptions based on considerations such as whether a project is anon or doxxed, whether it exists as a fully on-chain entity or has one or more associated development companies (‘devco’) or other operational entities, whether the project is raising VC funding, and whether the project intends to establish a DAO or remain operating in a more centralized manner. Notwithstanding this multitude of considerations, however, obtaining funding and effectuating token issuance in the manner discussed below is a common journey for many projects.

Bitcoin’s Immaculate Conception

According to Nic Carter, “Bitcoin benefited from an extremely rare set of circumstances. Because it launched in a world where digital cash had no established value, it circulated freely. That can’t be recaptured today since everyone expects coins to have value. Not only was it fair, but it was historically unique in its fairness. The immaculate conception”.

Unlike Bitcoin, most projects require investment and funding, with all of the attendant regulatory concerns and  considerations for investor/founder exit. Digital tokens are expected to return value for investors. While Satoshi never had to worry about securities laws, almost every subsequent project does.

In 2017, spurred largely by the ICO boom, the then U.S. Securities and Exchange Commission (SEC) Chair, Jay Clayton, stated that cryptocurrencies are ‘intended to provide many of the same functions as long-established currencies such as the U.S. dollar, euro, or Japanese yen but do not have the backing of a government or other body’. However, he also noted that whether a given digital asset that is labeled as a cryptocurrency is a security ‘will depend on the characteristics and use of that particular asset’. While that sounds like an appropriately nuanced position, the current SEC Chair Gary Gensler stated in a 2021 interview that investors ‘buying these tokens are anticipating profits’, which is one of the conditions that any asset must meet to be deemed a security, and this causes them to fall under the SEC’s jurisdiction.

The ability to serve as a replacement for a sovereign currency can be difficult to achieve. As Scott Kupor, managing partner at Andreessen Horowitz, has previously written, “in the pre-network stage, tokens will generally be characterized as securities in light of the “reliance on the efforts of others” prong of the Howey test. However, post-network launch — provided that the network is sufficiently decentralized — the nature of the token can change from security to non-security, owing to the fact that the holder of the token is no longer relying on the efforts of others”. In that context, the token is seemingly transformed into an alternative currency or commodity. It is not clear, though, whether the SEC would agree that a token can cease to be a security.

In the United States, Section 5 of the Securities Act requires that market participants register ‘securities’ with the SEC prior to offering them for sale unless an exemption applies. Section 2(a)(1) defines the term ‘security’ by enumerating a list of financial arrangements that Congress expressly intended to capture within the purview of the statute. A digital asset may be deemed a ‘security’ and be subject to federal securities laws if the asset is one of the enumerated examples of securities. Unsurprisingly, blockchain-based coin and token offerings are not expressly listed among the enumerated examples of securities in Section 2(a)(1). However, alongside the enumerated examples of asset classes commonly referred to as securities, Congress curiously included but did not define a catch-all term—‘investment contract’.

According to the Howey Test, an investment contract exists if there is an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others”. Because of this draconian default characterization as a security in the U.S. and other jurisdictions, most entities issuing tokens are, in function, attempting to recreate the aspects of Bitcoin’s issuance that allow it to be characterized as a currency or commodity and not as a security. Ultimately, the mechanisms to fund a project and launch a token in a manner that does not violate securities laws often require a behind-the-scenes legal shell game that results in what appears to be the immaculate conception of a token that is then bestowed upon an awaiting community for governance, investor exit, and whatever other purposes.

If you’re not doxxed or are somehow out of the reach of the more ‘oppressive’ regulators, you could certainly always drop a contract and issue a token, then conduct a sale on-chain. Unfortunately, most projects don’t have that option, if for no other reason than founders are concerned about liability or that the potential funding won’t be sufficient to achieve the project's goals.

https://twitter.com/RyanSAdams/status/1301183836462682112?s=20&t=rsqpDNc5J6XENH5gidpFdg

Initial Coin Offerings

Initial Coin Offerings (ICO) are probably the most well-known funding mechanism for projects in the crypto space. An initial coin offering, like an IPO, sells something to fund the creation or operation of a new cryptocurrency. An arguable and important distinction between an IPO and an ICO is that contributors to an IPO are investors who are acquiring shares of the company, i.e. equity. In contrast, ICO backers are acquiring what might more appropriately be characterized as a product in the form of the token, which does not generally represent equity in the token’s issuing company or network. However, despite what seems like a fairly clear distinction, in the U.S. the SEC requires projects to follow private placement and public offering rules when conducting an ICO. However, for the same reason that Special Purpose Acquisition Companies (SPAC) were incredibly popular in the 1990s and again in 2020 and 2021, most projects don’t want to deal with the hurdles and regulatory burden of registering a public or private offering. Ultimately, an ICO or SPAC merger is generally considered easier.

ICOs first became popular in 2017 because they allowed entities in the crypto space to raise capital and fund development without having to go through the regulation-intensive processes mentioned above. Numerous projects sold tokens in the period between 2017 and 2018. According to a Harvard Business review article,  the average amount of capital raised by a via ICO in 2017 was thirteen million, with the number increasing to twenty-five million through the third quarter of 2018. According to Coindesk, most of these sales netted less than $100 million, though projects remained eager to utilize the mechanism despite the looming regulatory risk. The success of these ICOs consequently attracted significant regulatory scrutiny, most notably from the SEC . As a result, ICOs have largely fallen out of favor as a funding mechanism due to the associated regulatory obligations and potential exposure to regulators. They are also just flat-out banned in certain jurisdictions like China.

SAFTs

For institutional investors, equity term sheets are a standard mechanism for investment in early-stage companies. Instruments such as a convertible or a ‘simple agreement for future equity’ (SAFE), which was initially popularized by Y-Combinator, are generally used to convey future equity to investors. However, when an investor receives a startup’s native token instead of equity, a simple agreement for future tokens (SAFT) is utilized. The SAFT was initially hailed as a novel way to carry out ICOs in a manner that complied with federal securities rules. As with the distinction between an IPO and an ICO, where a SAFE offers equity in exchange for an investor's early-stage investment, a SAFT provides for the delivery of fully functioning future tokens once issued.

In the 2017-2018 ICO boom, SAFTs were often utilized by institutional investors in conjunction with an ICO. As with ICOs in general, the two-step ICO + SAFT strategy quickly ran afoul of the SEC, which brought several high-visibility enforcement actions against offerings from the messaging app Telegram and rival messaging app Kik. In both instances, the SEC found that distributing tokens to investors in the form of a SAFT with a view toward onward distribution in the U.S. by those investors is not, in fact, a private placement but a preparatory step for a public offering via cryptocurrency exchanges, with the SAFT holders being regulated not as investors, but as statutory underwriters for onward distribution to the public. Due to the SEC’s creative assertions, this entire line of litigation is confusing, even to experts in the space.

Currently, at least in the U.S., the SAFT — instead of the yet-to-be created token offering — is characterized as a security that can be offered to accredited investors in a private placement. Outside the U.S., the necessity of restricting SAFTs or tokens to accredited investors will be determined by local legislation. In function, SAFTs are generally utilized when the project has already decided on the type of token it plans to issue, has already detailed tokenomics, and has created a token distribution plan (including prices and stages of distribution). This is because a SAFT cannot be signed without detailing the material terms of issuing and transferring tokens to investors.

SAFT terms usually include:

• Total volume of the token issuance

• Amount of investor allocation of tokens

• Price of tokens at the time of transfer to the investor

• Conversion event (the moment when SAFT is converted into tokens for the investor)

• Information about vesting, lock-ups, and other encumbrances on the investor's tokens, which are important for the successful operation of the project's tokenomics.

Therefore, a detailed paper with a description of token use cases, tokenomics, and token distribution plans is generally considered necessary to prepare a full-fledged SAFT. In exchange for this promise of future tokens, Web3 startups can use funds from the sale of SAFT to develop their projects, mint their tokens, and issue their tokens to investors, who usually have an expectation that there will be a secondary market to sell these tokens.

Token Warrants

More recently, token warrants have gained favor as an investment mechanism among Web3 venture funds. In a recent tweet, Su Zhu of the embattled Three Arrows Capital (3AC) accused 3AC's liquidators of failing to exercise StarkWare token warrants, causing 3AC to allegedly lose out on significant future returns from the putative StarkWare token. In doing so, he inadvertently dropped a whole lot of alpha regarding StarkWare’s plans for token issuance.

A token warrant is a broad instrument that secures investors' rights to tokens that will (or may) be issued in the future. Issuing warrants doesn’t mean a token will be issued — though it seems very unlikely that StarkWare is not issuing a token. While SAFE and SAFT documents are well known and widely utilized by investors, not all founders, retail, and non-institutional investors are familiar with the warrant mechanism. Token warrants can be distributed to equity holders in an associated devco or parent entity. They can also be issued from an entity specifically created to issue the warrants and tokens. Token warrants do not usually specify the amount of the issue, the allocation for the investor, the price, or any other significant conditions, but only establish the investor's right to receive these tokens proportional to the equity ownership percent times the token allocation percentage for investors (for example, in a situation where 25% of tokens are allocated to investors, a seed investor holding 10% of the company’s equity would acquire a right to 2.5% of the project’s tokens, or 10% x 25%). To further incentivize investors, protocols often include a significant discount from the market rate on the token purchase price when the warrant is exercised.

Entities like SporosDAO are now utilizing token warrants in their startup solutions to provide compliant sweat equity distribution mechanisms to contributors. The mechanisms utilized by Sporos track contributions in a manner that is meant to limit a startup's legal considerations by allowing tokens or future tokens to remain non-transferable, or illiquid, until the occurrence of a liquidity event. This arguably shields distribution of tokens or equity from securities registration for the timeframe leading up to the liquidity or token generation event.

Entity Structuring

One of the main motivations — and struggles — for DAOs to associate with or ‘wrap’ in a legal entity is due to the creation of fictional legal personhood, which provides liability protection and the ability to contract and act as a counterparty to a warrant, SAFT, or other agreements. For anonymous teams, this similarly creates a variety of issues. To the extent a project has a devco or other entity in place while it is seeking funding, that entity can contract on behalf of the startup or putative DAO. However, even if there is an entity in place, most projects ultimately utilize multiple distinct entities in a ‘stack’ to facilitate conducting a raise or token sale, issuing a token, and managing the project after the token generation event. This arguably provides optimal risk mitigation because it silos function and liability. This structure may also seem familiar as it is generally analogous to structuring in legacy financial offerings and investment funds.

In addition to the startup entity/devco or unregistered DAO, an ‘optimized’ legal stack that provides the most potential insulation often includes: 1) a special purpose vehicle (SPV) that issues or countersigns funding instruments (the SAFT/warrant/options/conducts the ICO, etc.); 2) an entity that stewards the project or community after the token generation event (often a foundation as the sole beneficiary of the SPV or other nonprofit structure); and 3) an entity that performs necessary development or service work on behalf of the project or DAO (this is often the devco). In some instances, separate SPVs are utilized to manage fundraising and token issuance.

In addition to acting as a counterparty, the SPV’s primary purpose is to establish a limited liability shield between token creation and distribution events and the potential personal liability of the project founders and investors. Once the token distribution event is completed, the SPV transfers its assets, generally consisting of the balance of the tokens initially issued and proceeds of any token sale, to a foundation beneficiary or other entity. After assets have been transferred to a foundation or other appropriate entity, the SPV is dissolved to avoid non-fraudulent regulatory issues or legal risks associated with token sales and issuance that might carry over to the entity that is now managing the token treasury.  

A common combination is a British Virgin Islands (BVI) Company as an SPV and a Cayman Islands Foundation Company, which can also be made ‘faceless’ if formed without founders and members. It is worth noting that while these solutions are often considered optimal, they are generally cost prohibitive for many projects. Arguably, this is because organizations and protocols utilizing these structures have historically been in the financial sector, where cost is not a significant barrier to entry. 

Broken down for clarity, the sequence of funding and token issuance is generally as follows:

• Creation of startup devco entity and/or DAO (the DAO may or may not be initially registered in some jurisdiction). The devco or registered DAO can enter into certain initial agreements.

• Individual contributors may consider creating their own entities (state LLCs for U.S. citizens, for example) to contract with the DAO or devco, as opposed to being directly employed by the devco.

• Creation of an SPV to act as a counterparty or issuer for warrants, SAFTs, or other investment and funding mechanisms.

• The SPV receives the aggregate funding collected and holds these proceeds.

• Funds are utilized by the SPV — often through a grant to the devco or contractors — to facilitate any further development, audits, and infrastructure for the protocol or token before a sale or issuance.

• An additional SPV may be established solely for the purposes of token issuance to provide further layers of liability protection.

• Once token issuance and any sale is completed, the SPV(s) transfer any retained funds or assets to an operational entity and dissolve.

• If the project is structured as a DAO, handover of governance can be effectuated.

• There are a variety of iterations of the project development, pre-token funding, and token issuance processes that will ultimately be specific to the project based on the jurisdictional tethers of the team, investors, and requirements of jurisdictions where associated entities are registered.

Wrap It Up

Tokens are a tool for successfully distributing a project's core value. While token distribution can incentivize participation, create (non-equity) value, and aid in the development of credible decentralization, the mechanisms that facilitate investment in the protocol, the function of token issuance, and distribution of those tokens, are often complex and compartmentalized or operating in regulatory gray areas.

Due to regulatory uncertainty, most crypto ventures strive to achieve the holy grail of decentralization. From Ethereum to decentralized finance platforms like Compound, Synthetix, and Maker, these protocols emerged under the centralized leadership of core teams who gradually relinquished control to a larger community. However, these protocols and core teams required significant initial seed capital that could not be easily raised in a decentralized manner at the time, or likely even now. Behind every decentralized protocol, there was a startup entity, foundation, SPV, etc. that could contract with investors and secure appropriate funding to achieve the project’s goals. However, externally, it often appears that the project token was immaculately co[i]nceived from the ether, à la Bitcoin.

lawpanda is a U.S. attorney with an active litigation and counseling practice. He is a member of BanklessDAO’s Legal Guild, LexDAO, the LexPunkArmy, and member/consultant/contributor to a variety of DAOs and protocols. When he’s not writing for Decentralized Law, he is working to reduce operational and governance friction between on-chain and legacy entities through corporate structuring and common-sense legal solutions. Connect on Twitter, LinkedIn, or at lawpanda.eth@gmail.com.

subscribe://

collect://

Decentralized autonomous organizations represent a new organizational structure that, in form if not always function, allows for decentralized decision making using blockchains and token-voting mechanisms. Where legacy industrial corporations are reliant on the separation of management and ownership, DAOs offer a radically different template for organizational participation where ownership and management are merged — driven by smart contracts, fluid memberships, and transparent transactional channels.

One of the most discussed aspects of DAOs is the ongoing debate surrounding their legal status and structure, and the mechanisms that allow DAOs to interact with the rest of the world. What mechanisms will allow an organization that is intrinsically global to benefit from legal personality and limited liability? Can this occur without being incorporated in a single jurisdiction? What are the ideal jurisdiction and entity structures? Ultimately, can an on-chain organization comply with jurisdictional legal obligations while retaining its sovereignty, and do they even want to?

Incorporating a DAO in any jurisdiction is generally not straightforward due to  administrative — more so than substantive — hurdles. Most jurisdictions won’t accept reference to on-chain code as an operating agreement or bylaws, and even incorporation of these fundamental aspects of a DAO by reference can be difficult. Additionally, identifying the members of a largely anonymous or pseudonymous organization can be problematic, for obvious reasons. Incorporating or associating a DAO with a pre-existing legal entity structure is generally analogous to fitting a square peg into a round hole. With enough manipulation or hammering, it may eventually work, but your peg will almost certainly no longer retain its original desired attributes.

A handful of forward-thinking jurisdictions are already making modifications to current entity structures or working to create new structures to support DAO incorporation in their regions:

• In the United States, Wyoming, Vermont, and Tennessee have implemented changes to existing limited liability company (LLC) laws, in addition to recently proposed federal legislation regarding DAO recognition.

• The Republic of the Marshall Islands (RMI) has already passed legislation implementing a non-profit DAO LLC structure and is working to implement additional for-profit structures.

• The Kazakh government is modifying existing structures with the stated ultimate goal of creating bespoke structures that will accommodate for-profit and non-profit DAOs in a special economic zone known as the AIFC.

• Additionally, in 2021, the Coalition of Legal Automated Applications (COALA) published a proposed model law that emphasizes recognition by jurisdictions, as opposed to registration, to accommodate the global and transnational nature of DAOs.

Legal uncertainty continues to impede the growth and widespread acceptance of this new form of social organization. However, many may have forgotten that the U.S. LLC only came into existence in the late 1970s. The LLC only then acquired the full taxation and liability protection benefits that have allowed it to become one of the most commonly utilized enterprise structures since the early 1990s. The legislative changes required to reach that point were only brought about due to lobbying efforts by affected businesses and associated interest groups. Similar efforts, likely on an international scale, may be required to facilitate widespread adoption and use of DAOs — in whatever format — as a viable organizational structure or business model.

The U.S. Limited Liability Company Is a Gen Xer

As mentioned, the U.S. LLC structure was developed in the late 1970s to address the radically different tax regimes imposed on incorporated and partnership structured businesses and the lack of limited liability in unincorporated U.S. entities. Partnership tax provisions impose only one level of taxation at the owner level (i.e. ‘pass-through’) and provide a number of other benefits, including the ability to allocate profits and losses more flexibly. Corporate tax provisions (with limited S corporation exceptions) require corporations to pay two levels of tax, once at the entity level and again at respective shareholder levels.

At the time of the LLC's creation in 1977, partnership classification regulations administered by the Internal Revenue Service (IRS) imposed certain requirements on all unincorporated business organizations seeking the benefits of partnership taxation — and also precluded application of limited liability for non-corporate organizations. In 1988, the IRS issued Revenue Ruling 88-76 allowing the initial Wyoming LLC to be classified as a partnership despite the presence of limited liability protection. Adoption of the LLC as a recognized entity structure ultimately represented a new solution to the limitations imposed by the two-tier corporate tax structure and the preclusion of a limitation on liability by unincorporated organizations.

The 1977 Wyoming Limited Liability Company (LLC) Act established the first unincorporated business entity in the United States to combine statutory limited liability protection with the ability to be taxed as a partnership for federal income tax purposes.

The Wyoming Act was written specifically for Hamilton Brothers Oil Company (Hamilton). Due to the high-risk and speculative nature of their investments, Hamilton needed a flow-through entity to provide one level of taxation and limited liability protection similar to the Panamanian ‘limitada’. In contrast to the U.S. entities available at the time, limitadas provided direct limited liability as well as the opportunity to secure partnership status for U.S. income tax purposes.

However, Hamilton quickly discovered that limitadas faced administrative challenges in the U.S. and, because no analogous company existed, raised doubts about the extent to which U.S. courts would recognize their limited liability feature. Because no feasible domestic entity combining limited liability and partnership taxes existed, Hamilton utilized attorneys and lobbyists to establish an unincorporated domestic entity similar to the foreign limitada in a friendly jurisdiction. The proposed entity would satisfy the literal criteria of a partnership while also offering direct limited liability protection to all participants.

The proposed LLC Act was modeled after the German GmbH Code and the Panamanian LLC Act. These entity structures had four basic characteristics:

1. The LLC’s name must contain some form of the word ‘limited’.

2. LLCs are afforded full juristic personality.

3. LLCs may use the partnership concept of ‘delectus personae’, in which the LLC is given control over the admission of new members.

4. An LLC will dissolve on the death of one of its members, unless otherwise stated in the articles of association.

The newly developed LLC structure was initially introduced to — and rejected by — the Alaska legislature. Shortly after the rejection of the LLC legislation in Alaska, Hamilton presented an identical LLC bill to the Wyoming legislature, which promptly achieved enactment on March 4, 1977.

Armed with the newly established Wyoming LLC legislation, Hamilton submitted a request for a positive partnership classification ruling from the IRS, the federal agency charged with determining whether unincorporated businesses escape association status. In 1980, following significant lobbying efforts, the IRS issued a favorable private letter ruling to Hamilton Brothers Oil Company regarding its Wyoming LLC. Unfortunately, this form of opinion is only applicable to the soliciting party. In early 1983, the IRS announced that it would review the impact of applying limited liability to organizations classified as unincorporated. During the five-year study, while LLC tax status and limitations on liability remained in limbo, further growth in LLC legislation and businesses employing the structure predictably ground to a halt. The LLC had little prospect of mass adoption as long as its taxation status was in question.

On September 2, 1988, the Internal Revenue Service issued Revenue Ruling 88-76 — a public interpretation of the law on which all taxpayers may depend — allowing the Wyoming LLC to be classified as a partnership despite its limited liability attributes. Following the IRS's landmark decision to recognize the LLC's right to be taxed under the partnership rules, states began to implement legislation adopting the LLC as a business structure. By the end of 1996, all fifty states and the District of Columbia had passed legislation allowing the formation of LLCs within their borders. This new business form rose from obscurity, to be a viable alternative to partnerships and corporations, in less than 20 years, a rate unprecedented in the development of business organizations.

Ultimately, the LLC's battle to emerge as an independent, viable alternative for doing business revolved around convincing the IRS that it met the partnership classification requirements. The LLC’s current viability as an entity structure only came about due to concerted lobbying efforts, and DAO proponents should understand that such targeted efforts will certainly be necessary to craft legislation that will allow DAOs to operate optimally and without sacrificing their inherent attributes.

Current U.S. Legislative Efforts

In 2022, Senators Cynthia Lummis, R-Wyo. and Kirsten Gillibrand, D-N.Y. co-sponsored the Responsible Financial Innovation Act. DAOs were clearly not at the forefront when drafting the bill; one half a page out of the 69 pages of legislation addressed recognition of DAOs. The bill specifies that the default classification for these community-led entities is as business entities for tax purposes. It also requires most DAOs to be properly incorporated in accordance with existing laws of an identifiable jurisdiction, such as an LLC or partnership. The bill allows putative DAOs to avoid business disclosure requirements and not be considered a business entity if they can prove they are sufficiently ‘decentralized’. Ultimately, the legislation leaves a lot to be desired. It is, however, at least a starting point.

At the state level, Wyoming, Vermont, and Tennessee have made efforts to accommodate DAOs by enacting laws that specifically acknowledge the validity of blockchain smart contracts as governing documents. Theoretically, this allows DAOs to simply point to the respective blockchain or contract to legally verify the members of the LLC while concurrently maintaining the benefits of blockchain technology — privacy and immutability.

Jordan Teague and other crypto-native attorneys have discussed some of the inherent limitations and design-choice issues associated with existing U.S. DAO LLCs.

Compared to creation of the Wyoming LLC in the 1970s, legislative efforts to accommodate DAO registration in the U.S. have primarily been related to minor administrative modifications. Where the early Wyoming LLC Act combined attributes from distinct already-existing legal structures, the U.S. LLC acts are simply making administrative concessions. Due to the unique attributes associated with DAOs, a bespoke entity structure — designed specifically to accommodate the unique needs of an on-chain entity while still allowing real-world interactions and limited liability — may ultimately be the ideal way to accommodate DAO registration and activity.

Modification and Bespoke Entity Creation in RMI

As of 2022, the Republic of the Marshall Islands (RMI) officially recognizes DAOs as legal entities, thanks to the Amended Not-for-Profit Entities Act of 2021 (Act). The act allows DAOs to register as Marshall Islands Non-Profit DAO LLCs and is based on legislation passed by the RMI government with the assistance of the founders of MIDAO Directory Services Inc. (MIDAO). In addition to its legislative efforts, MIDAO is a multinational organization that was formed to act as the registered agent for RMI DAOs and to assist DAOs in registering in the Marshall Islands under the new amendment.

As previously stated, MIDAO led efforts to facilitate pro-DAO legislative changes. Former RMI chief secretary and co-founder of MIDAO, Bobby Muller, has stated that his country recognizes that now is a “unique time to lead” the “blockchain revolution”, and that DAOs will play an important role in creating “more efficient and less hierarchical organizations”. MIDAO's strategy is to provide a competitive cost of incorporation, a supportive government with internationally recognized courts, and an environment open to technological advancement. In addition to the non-profit LLC structure, MIDAO is also currently working on legislation that will allow the registration of a for-profit DAO LLC option that may be particularly useful to investment DAOs.

Modification and Bespoke Entity Creation in the AIFC

Poko is a Y Combinator-backed startup that, in addition to on-chain DAO governance tools, is focused on making wrapping or associating DAOs with associated legal-entity frameworks as frictionless and inexpensive as possible. Poko believes that operating in a DAO should not preclude the project or members from taking advantage of the benefits afforded to a governmentally recognized legal entity, including the ability to contract, limitations on liability, tax implications, and other advantages associated with corporate personhood or jurisdictional personality. Poko is approaching its legislative efforts in iterative cycles in order to create a live-model jurisdiction that will allow DAOs to have a legal form that is compatible with on-chain governance.

Poko is working with the Kazakh government to establish a new DAO jurisdiction based in the Astana International Financial Centre (AIFC). The AIFC is a Kazakhstan-based common law special economic zone that is developing innovative and forward-thinking financial regulations. AIFC was created in 2018 to establish a modern financial and legal hub between Asia and Europe. In 2021 it received an influx of bitcoin miners, and other cryptocurrency-related entities, as the result of China’s ‘crypto ban.’ As a result of this exposure, Kazakhstan became interested in developing a dedicated crypto/Web3 industry. To facilitate the initiative, the President endorsed a national crypto strategy.

Cryptocurrency exchanges such as Binance and Bitfinex are set to open operations in the AIFC before the end of 2022. In contrast to other offshore hubs, AIFC and the government are implementing training programs to accommodate more than one hundred thousand information and technology engineers, with the goal of providing value to the crypto economy via a trained pool of workers. To distinguish itself as a well-regulated Web3 jurisdiction, the AIFC has implemented, or is considering, the following legislation:

• A national crypto strategy which allows crypto-fiat rails for exchanges.

• Introduction of a central bank digital currency.

• Implementation of laws recognizing NFTs as a distinct form of IP.

• DAO governance structure experimentation and development of public goods.

Poko has been granted exceptions in the AIFC to create an initial limited number of ‘test’ DAOs, associating them with existing legal entity frameworks (foundations and special purpose vehicles (SPVs)). To facilitate the process, certain requirements that DAOs might have difficulty fulfilling have been eliminated for the test DAOs. Poko has already established the first investment DAO SPV in the AIFC and is working with regulators to have the next 100 test DAOs approved by the end of July 2022. Accommodations for the initial SPV-structured DAO included streamlining the overall registration process — and ensuring a fully electronic process, determining the best way to conduct KYC/AML/CFT requirements, issuing tax registration numbers, and establishing crypto-fiat banking rails.

Based on the findings derived from the test DAOs, Poko will develop and introduce proposed DAO-specific legal structures to the AIFC in 2023. Considerations for this bespoke entity would include 1) zero percent corporate, income, capital gains, and dividend distribution tax rate until 2066; 2) the ability to utilize a common law legal regime based on English law for the first time in central Asia; 3) a frictionless corporate e-filing system that can be integrated with Poko’s dashboard; and 4) an independent court with leading British judges and International Arbitration Center for dispute resolution. Poko is also collaborating with the banking authority to establish a pilot crypto-fiat banking facility to accommodate crypto-native transactions.

Poko’s goal is to facilitate decentralized on-chain and off-chain decision making and to allow DAOs and their members to choose their own on-chain and off-chain governance structures. Poko will provide entities in the AIFC — and eventually other jurisdictions — with the resources they need to succeed. Poko has stated that it is working to make Astana the ‘A’ in the ‘ABCD’ (Astana, BVI, Cayman, and Delaware) of the most popular DAO legal entity options.

The COALA DAO Model Law

​The DAO Model Law (ML) was published in June 2021 by the Coalition of Legal Automated Applications (COALA). COALA is an international, multidisciplinary research and development initiative that seeks to clarify blockchain technologies, smart contracts, and decentralized applications. The initiative is made up of lawyers, academics, economists, and computer scientists, among others. The ML seeks to strike a balance between the importance of innovation and experimental freedom in technological development.

As previously referenced, DAOs face significant legal uncertainty that arguably limits their development and use. The ML aims to create uniformity and legal certainty while allowing for additional innovation. This is facilitated by not requiring formal registration with a jurisdiction, unlike other regulatory frameworks or entity structures that may accommodate wrapping or association with a DAO. The ML combines autonomy for DAO members with separate legal personality for the DAO in order to encourage pseudonymous participation and to recognize that human-to-machine or machine-to-machine interactions can carry out valid legal acts. Participants in DAOs are also granted limited liability under the ML. The ML is ultimately intended to allow DAOs to retain their underlying characteristics and attributes while providing legal personhood with all of the associated protections and benefits.

Because DAOs are inherently transnational, the ML strives to adopt a consistent set of rules that can be implemented across jurisdictions. DAOs formed in accordance with the ML's formation requirements will be recognized as legal entities separate and distinct from its members. To ensure its broad applicability, the ML provides a minimum set of rights, duties, and protections that are widely recognized in legislation governing analogous corporate entities in major jurisdictions. The ML also includes specific provisions that address the unique characteristics and challenges faced by DAOs, including procedures in the event of adversarial forks in the underlying blockchain, DAO restructuring, or failure events. Although no governmental authority could directly enforce the ML provisions onto a DAO, the baseline of legal certainty is meant to incentivize adoption.

Despite the ongoing and active discourse regarding DAO entity structures in the Web3 community, the ML garnered minimal attention when announced in 2021. It has, similarly, not generated significant discussion. However, this could simply be based on the timing of the announcement or other unknown considerations. Notwithstanding, the ML represents, at the very least, a useful starting point for discourse with regulators and should not be disregarded. It is also worth noting that this is just the first iteration of a proposed model law. The ML’s executive summary references the UNCITRAL Model Law on Electronic Commerce as a loose exemplar for the ML. Legislation based on the Model Law on Electronic Commerce has only been adopted in 85 of the 193 member states of the United Nations in the 25 years since its issuance in 1996.

Proponents of the ML will likely face significant challenges in persuading legislators that the principles of functional and regulatory equivalence on which the ML is based protect the interests of their jurisdiction. As with the development of the U.S. LLC in the 1970s, the development of a viable DAO Model Law necessitates a bottom-up, community-driven approach informed by both legal scholars and policymakers, as well as the experience of people working on the ground and interacting with DAOs on a daily basis.

Say it With Me: We Are Still So Early . . .

As more people and money flock to DAOs, it will be important to resolve lingering questions about the legal rights and responsibilities of these entities and their members. In the U.S., states are leading the way. Outside of the U.S., entities like MIDAO and Poko are working to facilitate more significant legislative changes that will allow DAOs to be considered a viable entity structure, appropriate for widespread adoption. And, while slightly more esoteric in format, COALA’s Model Law provides a useful roadmap for DAO proponents attempting to enact legislative changes.

It took nearly twenty years, from 1977 until 1996, for creation and widespread adoption — i.e. adoption by all 50 states and the District of Columbia — of the LLC entity structure in the U.S. Even this seemingly protracted period represented an unprecedented rate of adoption. Wyoming’s DAO LLC legislation was only enacted in August 2021 and does not ultimately represent a significant or groundbreaking modification of the entity structure in comparison to the LLC’s combination of pass-through taxation and limited liability protection.

In the future, there will almost certainly be iterations or combinations of existing entity structures to accommodate ‘wrapping’ or other association of legal entities with DAOs before a more ideal structure is modified or created. Needless to say, it’s still relatively early in the legal lifecycle of DAOs and their associated legal structures and it is likely that existing structures will change or new structures will be developed in ways that have not yet been considered.

lawpanda is a U.S. attorney with an active litigation and counseling practice. He is a member of BanklessDAO’s Legal Guild, LexDAO, the LexPunkArmy, and member/consultant/contributor to a variety of DAOs and protocols. When he’s not writing for Decentralized Law, he is working to reduce operational and governance friction between on-chain and legacy entities through corporate structuring and common-sense legal solutions. Connect on Twitter, LinkedIn, or at lawpanda.eth@gmail.com.

https://banklessdao.substack.com/p/decentralized-finance-decentralized?s=r

Financial services regulation is complex and growing more complex each day. Regulators do not always understand which transactions, derivatives, or other financial instruments give rise to the need for regulatory intervention to prevent systemic risk or impact. Complicated financial products precipitated the financial crisis that began in 2007. Those that grew up during or in the wake of the crisis were understandably disillusioned. Legacy financial institutions and other market participants’ avaricious, self-serving, and predatory behavior arguably led to the U.S. federal government’s 700 billion USD bailout of Wall Street intermediaries, while normal people were left with an economy for a period that is now termed the ‘Great Recession’. As a result, developers began to imagine a financial services industry without traditional intermediaries, sparking ‘FinTech,’ and eventually decentralized finance.

A core goal of DeFi is to eliminate legacy financial market intermediaries such as investment banks, depository banks, exchanges, clearinghouses, and broker-dealers, and to increase overall liquidity, transparency, velocity of money, and decrease transaction friction. DeFi allows developers to create new types of financial products and services, eliminating aspects of counterparty risk, by allowing financial assets to be exchanged in a trustless way.

DeFi[ned]

DeFi is a commonly used term to describe the ecosystem of financial services built on decentralized blockchain technology, which replace traditional financial intermediaries with freely accessible, autonomous, and transparent on-chain contracts. DeFi protocols adhere to values of permissionless-ness and transparency. DeFi allows people all over the world to lend, borrow, send, or trade assets using non-custodial wallets and without having to involve a bank, broker, or other intermediary. Users can also explore more advanced financial instruments such as leveraged trading, structured products, synthetic assets, insurance underwriting, and market making while always retaining complete control over their assets.

As of February 2022, DeFi total market cap continued to reach new all-time highs, and cumulative revenue has grown to over 4.2 billion USD since June 2020. As new DeFi services recreate and reinvent elements of Traditional/Centralized Finance (interchangeably ‘TradFi’ and ‘CeFi’) services, and billions of dollars of digital assets are pledged to DeFi capital pools, policymakers and regulators are faced with challenges in balancing the risks and opportunities presented by this more transparent and permissionless financial system. While DeFi might offer greater efficiencies and opportunities for inclusion, there are also attendant considerations such as the extent of actual decentralization, governance complexities, technical risk, and ultimately systemic risk throughout a burgeoning composable ecosystem.

Disintermediation Is a Feature, Not a Bug

DeFi was developed as a peer-to-peer method of transacting without reliance on a system of intermediaries that has historically allowed artificial manipulation of markets and opaque redistribution of risk. DeFi represents an affirmative attempt to eliminate intermediaries in financial transactions. Instances where intermediaries have failed to appropriately manage counterparty risk often result in systemic market disruption where the costs of self-interested misconduct are generally externalized to the market and taxpayers.

Notwithstanding the goals of decentralization and the dynamic attributes of distributed digital ledger platforms, many cryptocurrency broker-dealers, clearinghouses, and exchanges currently operating in mainstream markets still rely on elements of traditional financial intermediation. For example, some platforms rely on centralized order books; others centralize aspects of trade execution or settlement. True decentralization is more often than not merely aspirational.

An alternative way to look at DeFi is that it does not actually eliminate financial intermediation, but enables new ways of performing those same intermediary functions through trustless codes and contracts which are programmed to reduce transaction costs and information asymmetry. Based on continuing infrastructure developments, DeFi platforms have the capacity to adapt, reduce, and possibly eliminate institutional intermediation in trading and transactions.

The Synthetix ecosystem is one of the earliest examples of a fully decentralized protocol eliminating traditional counterparty intermediation in derivatives trading. Two more recent innovative composable protocols in the Synthetix ecosystem are Lyra and Kwenta.

• Lyra Protocol is a collection of smart contracts that allow liquidity providers to provide capital for traders to buy or sell options to/from the market via an Automated Market Maker.

• Kwenta is a decentralized derivatives trading platform offering real-world and on-chain synthetic assets. Kwenta is built on the Synthetix protocol and traders can access synthetic liquidity entirely created by SNX token stakers.

There are no direct counterparties for a trade in the Synthetix protocol, but it does use a counterparty-like model where SNX stakers assume a proportion of the Synthetix debt pool when they mint sUSD (synthetic U.S. dollars). While these protocols arguably include aspects of the traditional intermediation process in their code, this automation and decentralization does not require the involvement of a self-interested counterparty or allow transactional opacity.

Counterparty Risk Management

Despite centralized financial institutions’ demonstrated lack of transparency, consumers and markets seem to place the utmost trust in them. Proponents of the traditional TradFi/CeFi regulatory regime highlight incidents involving technical failures and attacks on DeFi services resulting in loss of capital as reasons for implementing analogous regulation. However, this seems to be a simplistic argument and purposefully ignores repeated systemic failures in TradFi that have resulted from a lack of transparency and appropriate risk management.

Counterparty risk is the possibility that the other party to a transaction, the ‘counterparty’, will default on its obligations to a financial instrument. This could include failure to repay a loan creating a credit risk, or failure to settle a transaction by delivering the specified asset creating a settlement risk. TradFi industry and regulatory ‘initiatives’ to manage counterparty risk generally involve centralized control and regulation. Due to the interconnected contractual and economic nature of the relationships among the largest market participants, one financial institution’s default on its obligations adversely affects the financial institution’s trading partners, hindering their ability to meet their obligations, and so on down the chain. Systemic risk may also occur if an exogenous shock to the financial system causes widespread, contemporaneous losses across financial markets that trigger the collapse of one or more systemically significant financial institutions or a series of financial institutions.

To mitigate the classic ‘run on the bank’ scenario, regulatory efforts have historically focused on prudential measures such as board risk oversight, safeguarding solvency by imposing mandatory capital requirements, limiting the size or types of assets held, and limiting the types of permissible transactions. While regulators have established these mandates, authorities have generally delegated most counterparty risk management oversight to the self-interested market participants themselves. Despite these efforts at regulation and oversight, centralized systems seemingly allow artificial manipulation of risk constraints to benefit the very intermediaries that have been charged with preventing excessive systemic risk. This was recently demonstrated by the Archegos implosion.

Archegos’s TradFailure

In April 2022, Coindesk contributor David Z. Morris somewhat presciently highlighted the potential systemic impact of counterparty failures in the crypto market — using Archegos as an example and Luna/Terra as an analogous potential risk case. The Archegos example also highlights ongoing issues with opacity and TradFi disclosure and reporting ‘requirements’.

In March 2021, the family office fund Archegos Capital Management imploded, causing billions in losses to the prime broker intermediaries (including Goldman Sachs, Morgan Stanley, UBS, Nomura, Deutsche Bank, and Credit Suisse). The quick summary of what occurred is that Archegos duplicatively pledged collateral to multiple brokers to continually leverage-up trades on a portfolio of approximately ten stocks including Viacom, Discovery, and Tencent. The firm utilized total return swaps, which are functionally contracts between the broker and fund providing exposure to an underlying asset. The client gains — or loses — from any changes in asset price, and the broker, not the client, shows up in filings as the registered holder of the shares. As Archegos’ assets increased in value with the bull market, the leveraged position was continually increased. In March 2021, an unexpected drop in Viacom price forced a margin call, and the positions began to unwind as the underlying stock held by the brokers was sold into the market. The market impact of unwinding the heavily leveraged positions eventually led to billions in losses for the involved intermediary banks and impacted the market as a whole — albeit only briefly.

Archegos purposefully utilized various regulatory loopholes — or just ignored reporting requirements — to obfuscate their positions. Even though total return swaps are a legitimate financial instrument, the Archegos incident has focused regulatory attention on the processes and controls used by prime brokers to extend leverage. Archegos betting on certain stocks using total return swaps made it difficult for prime brokers to understand the full extent of Archegos’ positions and leverage. In addition, because Archegos was a family office — as opposed to a traditional fund — it was exempt from registration as an investment adviser with the U.S. Securities and Exchange Commission (SEC). The SEC and other regulators have suggested they could now start to scrutinize risk management systems more thoroughly, particularly if counterparties use synthetic structures to not only increase leverage but also to avoid disclosing it.

The most concerning aspect of the Archegos implosion is that the intermediaries   involved appear to have been highly culpable in allowing Archegos to take the positions that it did. Wall Street firms invented the swap derivatives used, provided Archegos with as much as 85 percent margin debt on the derivative trades and were collecting a huge amount of fees while also profiting on the stock underlying the leveraged swaps. Archegos is a prime example of where a failure to properly evaluate counterparty risk, due largely to lack of transparency, caused significant systemic risk. Standard practices for evaluating risk failed because the firms involved were not incentivized to appropriately monitor Archegos, at least until they sustained 10 billion USD in losses.

More Terra/Luna Stuff, Really?

Contrast Archegos’ implosion with UST’s depeg on the Terra blockchain and Luna’s consequent debasement. Allegedly, on-chain data showed significant selling of UST into other stablecoins for no clear reason — though it seems like it could be because the entire market was precipitously dropping at the time and investors were de-risking. There are already a variety of semi-conspiracy theories regarding Luna/Terra’s downfall. However, the algorithmic stablecoin structure and UST’s fast growth, seemingly without scaled backing funds, are also just as likely the cause as a concerted attack by an imagined bad actor. While both Archegos’ 10 billion USD implosion and Luna/Terra’s 40 billion USD collapse caused significant pain in the markets, an important distinction is that Luna/Terra’s algorithm, contracts, inflow/outflows, funding, etc. have always been open and on-chain. Arguably, there were no self-interested intermediaries allowing unmitigated counterparty risk to exist in exchange for profit.

The fallout from the Archegos and Luna/Terra incidents will, unfortunately, be what you would expect: more regulation. More centralization will always be the solution offered by regulators. If DeFi cannot protect against counterparty risk through decentralized means, it will be forced to adhere to standards set by centralized regulators. As DeFi evolves, which, and to what extent, regulators attempt to exercise jurisdiction will become increasingly relevant. In the U.S., the DOJ, CFTC, FinCEN, FINRA, and SEC may all attempt to implement some oversight on decentralized platforms and their customers. It is likely that many DeFi tokens will be considered securities and the SEC will mandate increased disclosure requirements. DeFi platforms may also be considered ‘exchanges’ under SEC jurisdiction and be required to submit to ongoing examinations.

The relative lack of centralized governance and intermediaries in DeFi arguably prevents or limits artificial manipulation of markets to redistribute counterparty risk. Given full transparency, decentralized markets may be better suited to assess risk and respond accordingly. DeFi systems should preclude the possibility of being as artificially risk-controlled as TradFi systems, helping limit the potential for poor management and irresponsible trading practices. That said, we also watched Luna/Terra go to zero — dragging Anchor with it — as the result of manipulation or breakdown of the algorithm and despite active intervention to prevent a digital bank run. Notwithstanding, DeFi’s major value lies in its ability to address systematic counterparty risk through disintermediation and transparency.

lawpanda is a U.S. attorney with an active litigation and counseling practice. He is a member of BanklessDAO’s Legal Guild, LexDAO, the LexPunkArmy, and member/consultant/contributor to a variety of DAOs and protocols. When he’s not writing for Decentralized Law, he is working to reduce operational and governance friction between on-chain and legacy entities through corporate structuring and common-sense legal solutions. Connect on Twitter, LinkedIn, or at lawpanda.eth@gmail.com.

subscribe://

collect://

First published in BanklessDAO’s Decentralized Law, “Regulatory Certainty and the Rule of Law,” April 28, 2022.

https://banklessdao.substack.com/p/regulatory-certainty-and-the-rule?token=eyJ1c2VyX2lkIjo0MjM0ODg5LCJwb3N0X2lkIjo1Mjk3OTc3OSwiXyI6ImE3d29LIiwiaWF0IjoxNjUyMTIyOTY2LCJleHAiOjE2NTIxMjY1NjYsImlzcyI6InB1Yi0zMzY4NTEiLCJzdWIiOiJwb3N0LXJlYWN0aW9uIn0.glMkk1815sUywTn_T0-fZqVeW9qhf0l1eSqSGYEk-aE&s=r

Social media influencers have become a pipeline for branding, product promotion, and advertising campaigns to persuade the masses across a range of platforms. Advertising campaigns through social media are incessant and inescapable. This form of native advertising is designed to fit into the flow of content and can be difficult to discern. Due to limitations on where and how crypto projects can advertise compared to other industries, influencers arguably play an outsized role in advertising and promotion of crypto, DeFi, and Web3 projects. This in turn leads to what feels like an unreasonable amount of shilled promotional content where the business relationship between the brand and influencer is, at best, unclear. The lack of clarity can be particularly deleterious to new, or even experienced, crypto users and shines a negative light on the industry as a whole.

Most jurisdictions have one or more agencies mandated to ensure that advertising and promotion is truthful, not misleading, and in some instances is subject to explicit disclosures. In the United States, that agency is the Federal Trade Commission (“FTC” or “Commission”), which monitors advertising on television, radio, print media, and the internet. The Commission has asserted that most consumer protection laws implicated by advertising are not medium-specific; they apply not only to traditional advertising media, but also to native advertising and influencers on the internet. However, while the FTC Act’s prohibition on ‘unfair or deceptive acts or practices’ encompasses all forms of internet advertising, enforcement of violations of these standards seems to be sorely lacking, at least with respect to social media influencers.

Crypto Influencers: You’re Getting Paid?

What is an influencer? The name is generally self-explanatory and correlates with audience size and reach on various internet fora. FTC regulations require clear disclosure of any relationship with a promoted brand or project. The FTC’s Endorsement Guide, for example,  places the burden on influencers to make it ‘simple and clear’ when they have a relationship with a brand. For influencers, appropriate disclosures can include hashtagging ‘ad’ or ‘paid promotion’ in captions for posts endorsing goods or specific brands. However, a quick search of content by potential and actual influencers quickly reveals that appropriate disclosures are few and far between.

On-chain sleuth @zachxbt recently published a long list of known influencers crypto shills and the respective costs for their services.

Zach does caveat that not everyone on these lists does undisclosed promotions, but the ‘vast majority’ do. It is probably a good rule of thumb to take discussion or potential endorsement of new projects by large accounts with a grain or two of salt.

In the last several years, @zachxbt has been doing at least part of the FTC’s job by identifying scammers and warning of the dangers of unscrupulous influencers. For Zach a key issue is ‘not disclosing paid ads’. He says this is common in the crypto space and is increasing in the NFT space. Over time, @zachxbt’s threads have highlighted non-disclosure issues from crypto influencers like @moon_guurl and @HelloImMorgan, as well as more ‘mainstream’ influencers like Lindsay Lohan. George Floyd and Logan Paul’s involvement with the Bored Bunny NFT project is one of the more recent egregious examples of undisclosed shilling gone wrong, where the influencer promoters, whether gifted NFTs or paid in fiat as the tweet below suggests, clearly did not disclose their relationship with the project that ultimately rugged users for over 21 million USD.

Influencers posting about crypto or other financial products often try to limit their liability by including disclaimers like #DYOR (do your own research), #NFA (this is not financial advice), or similar. These ‘disclosures’ are seemingly meant to advise followers to be cautious. However, this type of disclaimer can at most only alert the audience the influencer is not a licensed financial professional who would be required to conform to specific standards when discussing financial products. Hashtagging #NFA or #DYOR like a mantra has minimal actual function, and does not in any way constitute, or eliminate, FTC disclosure obligations or related liability.

A recent article by @DazaiCrypto provides a good overview and further insight regarding some of the ongoing problems in the crypto-influencer community, such as failure to disclose affiliation with projects or pump-and-dump issues. If the FTC won’t regulate influencers, then disclosure of this type of information by individuals like @zachxb and @DazaiCrypto becomes increasingly important and necessary, particularly as crypto becomes more mainstream.

Podcast Ads

As with influencers’ social media postings, the majority of ads within podcasts come directly from the host, whether they are read live or pre-recorded. As with most native advertising, this form of communication can be particularly effective because listeners are generally more likely to believe something said by a trusted host as opposed to pre-produced ads from a company. Ads delivered in this way are likely to come across as testimonial by the host; the sense is that they believe what they are saying about whatever they are promoting. If there is a ‘material connection’ between a podcaster and the product or service — in other words, a connection that might affect consumers’ perception of the credibility of the endorsement — then that connection should be clearly and conspicuously disclosed.

Unfortunately, there are regular examples of non-compliant ads in the crypto podcasting community. Crypto podcasts, in particular, often discuss a variety of dApps, protocols, programs, brands, and projects. If the host is an investor, holds a significant position in the token or protocol, or acts as an advisor, any lack of disclosure, or even a discussion where the relationship is not apparent, likely violates FTC requirements.

FTC Requirements: Laws or Guidelines?

The FTC does not make laws. The FTC issues ‘rules’ and ‘guidance’, often called ‘policy statements’ or ‘business guidelines’. Through the FTC Act, FTC rules and guidance have the backing of existing laws, including the Fair Credit Reporting Act, the Telemarketing and Consumer Fraud and Abuse Prevention Act, the Children’s Online Privacy and Protection Act, the Do-Not-Call Registry Act, and the Dot Com Disclosures Act. Violations of FTC rules can result in prosecution under the laws mentioned above, including the associated civil — and in some cases criminal — penalties. FTC rules can be enforced at the federal or state level by the Department of Justice or state Attorneys General. The applicability of FTC law to Internet advertising is addressed in “Dot Com Disclosures: Information about Online Advertising”, one of many guidelines provided to the public.

The FTC uses enforcement actions to identify non-compliant individuals and entities, as a model for other advertisers or influencers to follow, and to illustrate which actions to avoid in future advertising. The FTC has traditionally been aggressive when deploying its delegated authority and has used Section 5(a) of the FTC Act, in tandem with its interpretive definition of ‘deception’, as a sword. Successful FTC enforcement actions for deceptive advertising, endorsements, and claim substantiation have been brought against a range of industries and entities including Google and Facebook.

Everyone Asks ‘Wen Disclosure’, But No One Asks ‘What Disclosure’?

The FTC requires influencers to place disclosures in such a way that someone viewing or hearing the content will not miss the information. This is meant to ensure that the average consumer can easily tell the difference between sponsored content and non-sponsored content.

Endorsement messages should make it obvious that there is a material connection with the brand. A material connection to the brand includes a personal, family, or employment relationship, equity ownership, or a financial incentive. Testimonials and endorsements must reflect the typical experiences of consumers, unless the ad clearly and conspicuously states otherwise. A statement that not all consumers will get the same results or ‘DYOR’ is not enough to qualify a claim. Testimonials and endorsements by influencers can't be used to make a claim that the advertiser itself cannot substantiate.

Will the FTC Hold Those Who Breach the Rules Accountable?

Brands and influencers should understand that FTC rules generally allow an enforcement action against the brand, the influencer, and anyone in between or associated with the improper promotion. There isn’t really a safe harbor or ‘mea culpa’ option. That said, in the face of the widespread successes of influencer marketing, the FTC has struggled to regulate influencer commercial speech and improve compliance with FTC rules. At the close of 2020, the FTC had issued only one ruling against individual influencers, supplementing its previous issuance of 90 educational letters, and 21 follow-up letters.

The FTC has generally focused its enforcement efforts on larger entities, i.e. on brands rather than individual influencers. This is likely because targeting a company is far less difficult and resource intensive than the multitude of online influencers who don’t have readily apparent addresses and can’t be easily served with a subpoena or cease and desist letter. Whatever the reason, the FTC appears reluctant to engage in the type of enforcement tactics it regularly deploys in other areas, which in turn seems to have contributed to rampant non-compliance by influencers.

With an immeasurable volume of native advertising content appearing on an ever-increasing number of platforms, the FTC does not have the bandwidth to review every instance where disclosure would be needed, or even respond to specific complaints. However, more recent and egregious activities by high-profile influencers may elicit sufficient consumer outrage to draw the FTC’s attention or spur changes in the enforcement posture. There is also the potential that certain NFT and DeFi projects that allegedly constitute securities will give rise to increased promoter liability through SEC enforcement actions, as with Bitconnect. However, until something changes, such as the FTC allowing a private right of action under Section 5 of the FTC Act, DYOR, this is NFA, and don’t expect the FTC to enforce influencer disclosure requirements.

lawpanda is a U.S. attorney with an active litigation and counseling practice. He is a member of BanklessDAO’s Legal Guild, LexDAO, the LexPunkArmy, and member/consultant/contributor to a variety of DAOs and protocols. When he’s not writing for Decentralized Law, he is working to reduce operational and governance friction between on-chain and legacy entities through corporate structuring and common-sense legal solutions. Connect on Twitter, LinkedIn, or at lawpanda.eth@gmail.com.

https://banklessdao.substack.com/p/legal-entity-solutions-for-daos-decentralized?s=r

Over the past few years, there have been increasing calls for digital asset entities to go on the offensive to elicit guidance and clarity from U.S. regulatory bodies such as the Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), and Internal Revenue Service (IRS). Litigation can often be a valuable tool for obtaining clarity, or resisting perceived regulatory overreach by the government. This type of action is usually referred to as a  ‘pre-enforcement challenge’ or ‘preemptive action.’ Generally, a party seeking to pursue a pre-enforcement challenge must demonstrate a ‘credible threat’ of enforcement. In other words, someone seeking pre-enforcement relief must show that: (i) they engage or plan to engage in conduct that arguably falls within the scope of a given law; and (ii) it is likely that the government will enforce that law against them. Once these prerequisites are established, the party can seek declaratory — or other — relief clarifying the law or regulation. However, in many cases, statutes and regulations procedurally limit potential challenges in a manner that can ultimately reduce precedential efficacy. For instance, challenges to certain SEC orders and rules need to follow specific procedures, and challenges to U.S. tax laws in certain venues do not allow for the issuance of declaratory relief.

Issues relating to Coinbase’s ‘Lend’ product and Terra’s suit against the SEC in response to subpoenas are two examples of calls for, or the actual filing of, affirmative pre-enforcement actions. A current and ongoing example of preemptive litigation designed to elicit regulatory clarity is the suit brought by Josh and Jessica Jarrett against the IRS. The suit — seemingly backed by the Proof of Stake Alliance — attempts to establish precedent regarding interpretation of the Internal Revenue Code as it relates to taxation of proof-of-stake (PoS) rewards. The Jarretts’ suit highlights some of the issues presented when attempting to utilize preemptive litigation as a mechanism to clarify regulatory uncertainty.

In 2019, the Jarrets requested a refund of amounts paid to the IRS on Tezos staking rewards issued in the native token. There is currently no direct guidance from the IRS on how PoS rewards are taxed. Existing guidance has addressed instances where a taxpayer receives tokens as part of a hard fork and from proof-of-work mining. In those instances, the IRS has determined that because cryptocurrency is ‘property’ for tax purposes, the tokens received are ordinary income at the time the taxpayer can dispose of them, i.e. at the time they are created and issued as block rewards. By contrast, the Jarretts have asserted that this type of PoS staking reward is not taxable until it is sold, exchanged, or otherwise disposed of by the taxpayer. In May 2021, when the IRS did not respond to their request in a timely manner, the Jarretts filed suit in the U.S. District Court for the Middle District of Tennessee. On February 3, 2022, the U.S. Department of Justice (DOJ) Tax Division informed the Jarretts and the court that a full refund had been approved and that it had directed the IRS to issue the refund. However, the Jarretts rejected the IRS’s offer because the IRS would not provide assurance that staking rewards constitute taxable income at the time of disposition. Instead, the Jarretts continue pursuing the suit in an effort to receive a definitive ruling they believe will be binding on the IRS.

The IRS’s offer to the Jarretts prompted widespread — and presumptively premature — claims that the IRS has capitulated on its position regarding staking rewards. Unfortunately, the fact that the IRS issued a refund to the Jarretts does not provide any inference of guidance that taxpayers can or should rely upon. Notwithstanding the Jarretts’ rejection of the IRS’ offer, the tax refund was purportedly delivered on February 14, 2022. On February 28, the DOJ filed a motion to dismiss the Jarretts’ attempt to obtain an official ruling from the court.

http://proofofstakealliance.org/wp-content/uploads/2022/03/Brief-in-Opposition-to-Governments-Motion-to-Dismiss-Jarrett-v-US.pdf

An important procedural issue raised by the the DOJ, and overlooked by the myriad of internet posts claiming victory for the Jarretts, is whether directing a refund renders the Jarretts’ case moot as there is no longer a live controversy for the court to settle. The DOJ also stressed the second, arguably determinative, point that prospective or declaratory relief is unavailable in a refund lawsuit in the district court. The lack of resolution of the Jarretts’ claims regarding the treatment of staking rewards is not likely to be a strong argument against mootness. The Jarretts have filed a timely opposition to the DOJ’s motion. It is also worth noting that Coin Center filed an amicus brief echoing the Jarretts’ arguments and reiterating the importance of and need for clarification. However, it is unlikely that the court will ultimately issue a ruling on the motion that is favorable to the Jarretts.

Notwithstanding any ultimate outcome, the best-case precedential value of the Jarretts’ lawsuit is likely to be nominal. For anyone not familiar with the inner workings of the IRS’s tax administration regime, there are multiple levels of formal and informal guidance affecting taxpayers as individuals or as a whole. Beyond that guidance, lawsuits to clarify ambiguities in the law can be heard in three primary trial court forums, the U.S. Tax Court, U.S. District Courts, or the U.S. Claims Court. The taxpayer has the right to choose the forum, subject to venue considerations. However, these three courts have different jurisdictional scope, procedural guidelines, and issue rulings with varying levels of precedential value. Ultimately, even if the court issues the type of order the Jarretts are seeking, the decision is not binding beyond that district. As noted on the table below, the Jarretts’ case would have to be appealed through multiple levels of appellate courts before it would have widespread precedential value.

Currently, PoS blockchains represent over half of the 1.68 trillion USD cryptocurrency market capitalization, and five of the top ten PoS blockchains have a stake rate greater than 50%. This is not including the valuation of Ethereum’s future transition to PoS. How the United States government treats PoS rewards is incredibly relevant to U.S. citizens and domiciled digital asset entities and requires clarity. While the offer of a refund to the Jarretts was lauded as an important and exciting moment for the crypto community, most commentators incorrectly attributed the IRS’s response as setting precedent. Unfortunately, because the IRS may have rendered the lawsuit moot by issuing a refund and because the venue precludes declaratory relief, even in the best case scenario for the Jarretts it is unlikely their lawsuit will generate regulatory clarity or have an impact on future IRS policy and guidance.

Individuals and digital asset entities subject to U.S. laws are subject to regulatory uncertainty that often limits involvement and innovation in the cryptocurrency space. Preemptive actions are an important and often necessary mechanism to resolve that uncertainty. However, parties considering litigation as a mechanism to elicit clarity should understand that litigating effectively against the U.S. government involves a variety of legal issues and procedural hurdles that are not generally present in litigation between private parties, and should plan accordingly if they intend to establish meaningful precedent.

lawpanda is a U.S. attorney with an active litigation and counseling practice. He is a member of BanklessDAO’s Legal Guild, LexDAO, the LexPunkArmy, and member/consultant/contributor to a variety of DAOs and protocols. When he’s not writing for Decentralized Law, he is working to reduce operational and governance friction between on-chain and legacy entities through corporate structuring and common-sense legal solutions. Connect on Twitter, LinkedIn, or at lawpanda.eth@gmail.com.

subscribe://

collect://

https://banklessdao.substack.com/p/market-crashes-and-crypto-regulation?s=r

Attorneys practicing in the United States are required to follow certain accounting and ethical standards when receiving and retaining client funds as payment for future costs and services. Each state adopts its own set of standards, though they are similar enough to discuss as monolithic requirements for U.S. attorneys. Funds received for future work are generally called a “retainer” and the transaction is ideally—though not always—documented by a written “retainer agreement.” When an attorney or a law firm holds fiat funds as a retainer, or in escrow or anticipation of disbursing a settlement, a trust account must be used to segregate these funds and avoid commingling between operating and other accounts. Attorney trust accounts are subject to stringent requirements, including approval of the banking entity by the state’s bar association. As written and implemented, these requirements create a significant, if not total, impediment to the retention of cryptocurrencies in attorney trust accounts. Based on current guidance the general rule seems to be that an attorney may accept and retain crypto as advance payment for future work provided that the fee is reasonable, the agreement is affirmed in writing demonstrating the client’s understanding and informed consent, and that the fee arrangement otherwise complies with the jurisdiction’s rules of professional conduct.

The IRS Treats Crypto as a Commodity

Legal ethical rules in most U.S. jurisdictions treat cryptocurrencies as a commodity and recognize it as a property asset with its value tied to market demand, as opposed to a form of traditional fiat currency. This characterization is based upon the U.S. Internal Revenue Service’s definition of “virtual currencies.” These same ethical rules allow attorneys to accept a variety of property assets in addition to cryptocurrencies, including gold, artwork, and ownership interest in the form of corporate stock as advance payment for future work. Payment in non-fiat assets must be documented in a written “alternative fee agreement” to comply with ethical requirements. Alternative fee agreements are subject to the same general requirements as other attorney-client fee agreements—however volatility and the property-like nature of non-fiat assets create additional ethical considerations and require additional disclosures and confirmation of client understanding which are not required when utilizing fiat funds.

Additional Ethical Concerns for Attorneys Retaining Client Funds in Crypto

As with client retainers paid in fiat funds, attorneys engaging in alternative fee agreements and entrusted with the property of clients must hold that property with the care required of a professional fiduciary. This means the attorney or firm must be competent in the underlying technology in order to ensure the safety and protection of client funds and must appropriately segregate the assets from those of the attorney and other clients. These requirements are meant to eliminate the risk of commingling or other potential impropriety. The quickest and most likely way for a U.S. attorney to be disciplined or disbarred is to allow the comingling of a client retainer and firm or personal funds before the fees are earned. In addition to concerns regarding segregation of retainers from other funds, payment in crypto implicates two additional potential issues. First, there is a prohibition against agreements for “unreasonable fees.” The shifting value of non-fiat assets and desire to protect the client from over or underpayment is stated as the primary reason for this concern. The second concern is that an alternative fee agreement contains the qualities of a business transaction with the client. Engaging in business transactions with a client will generally require providing the client an opportunity to obtain separate counsel to negotiate the fee agreement, due to the potential conflict of interest between client and putative counsel. To alleviate these issues, a comprehensive alternative fee agreement can address the potential ethical concerns and ensure compliance with relevant ethical rules.

Current Advisory Opinions Are Only Somewhat Helpful

In the context of attorneys who are operating in the crypto space, current ethics opinions regarding acceptance and retention of crypto payments seem only somewhat helpful. Because each U.S. jurisdiction sets and implements its own rules of professional conduct, there are often technical differences in the requirements for each jurisdiction and the current opinions provide an incomplete framework of guidance. Additionally, ethics opinions often only address very specific, often esoteric, ethical issues and regularly reach similarly narrow conclusions. For example, the New York City Bar’s opinion is premised on the proposition that an attorney is requiring clients to pay in crypto. It seems less likely that a firm would demand payment in crypto from an unsuspecting and unsophisticated client, as opposed to the client expecting the firm to accept crypto. Nebraska’s opinion requires an attorney receiving crypto as a retainer to immediately convert it into U.S. dollars to allow the funds to be deposited into a trust account. Requiring a law firm to exchange crypto into dollars upon receipt seems problematic for a variety of reasons that should be readily apparent. A further problem is that legal ethics opinions are usually written for a generalized audience, meaning explanations of crypto are framed in simplistic language that often misses or misstates technical nuances between types of assets and mechanisms of payment. Current U.S. legal ethics opinions don’t seem to consider that attorney-client agreements and payments in the crypto space are generally taking place between sophisticated individuals and entities who are familiar with how cryptocurrencies operate and their inherent volatility.

Because current ethics opinions are targeted for the widest potential audience, alternative or more technical mechanisms that might be used by sophisticated practitioners and their clients to retain and disburse crypto client retainers are not usually contemplated or addressed. One example of a technical, decentralized, and blockchain-centric mechanism to hold and disburse client funds in a manner that arguably complies with ethical requirements for holding client assets may be LexDAO’s LexLocker. LexLocker is an on-chain “multi-track, arbitrable escrow for Ethereum business transactions summoned by LexDAO legal engineers.” Using LexLocker, users can lock funds in the contract pursuant to their legal agreements and settle the payments encoded therein as work is completed. This mechanism arguably mirrors disbursements of fiat funds from a trust account once work has been performed. This is just one potential mechanism that would facilitate safeguarding client retainers. However, the U.S. legal field tends to demand skeuomorphic solutions to issues presented by changes in the technological landscape. Escrowing funds in a smart contract may ultimately prove too novel a concept for recommendation by a legal ethics committee or widespread adoption among current practitioners.

TL;DR: This is Not Legal Advice and DYOR

Attorneys practicing in U.S. jurisdictions with crypto-centric clients should be able to receive payment in crypto for flat-rate and invoiced work without issue. However, when receiving and holding client retainers for future work, attorneys must ensure they comply with the jurisdiction’s rules of professional conduct. It is important to note that the potential risks faced by an attorney accepting cryptoassets as a retainer are entirely based on the strict construction and application of the relevant ethical rules, which could eventually be modified so payment of a retainer in cryptocurrency is treated the same as payment in fiat funds. Additionally, and potentially most important, attorneys who accept retainers in cryptocurrencies must be competent in utilizing the technology and able to protect the client’s assets. In this case, competence requires that attorneys understand and safeguard against the many ways cryptocurrency can be stolen or lost. In the same way an attorney might be disciplined for depositing a fiat client retainer into their personal account or the firm’s operating account, an attorney accepting a crypto retainer could be disciplined for falling prey to a phishing attack, for losing access to the wallet containing the funds, or for simply sending funds to be disbursed back to the client to the wrong wallet address.

lawpanda is a U.S. attorney with an active litigation and counseling practice. He is a member of BanklessDAO’s Legal Guild, LexDAO, the LexPunkArmy, and member/consultant/contributor to a variety of DAOs and protocols. When he’s not writing for Decentralized Law, he is working to reduce operational and governance friction between on-chain and legacy entities through corporate structuring and common-sense legal solutions. Connect on Twitter, LinkedIn, or at lawpanda.eth@gmail.com.

subscribe://

collect://