CryptoLaw Newsletter #8 - 29 June 2021

Scroll down for our Spotlight on a Model Law for DAOs (decentralized autonomous organizations). By Ann Sofie Cloots

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Another week full of legal developments. From US Fed speeches to regulatory warnings on Binance – below are some of the legal crypto highlights of the week.

Digital assets

  • FATF – The Financial Action Task Force postponed its decision on the revised Guidelines on Virtual Assets and Virtual Asset Service Providers to October. The decision was taken during FATF’s plenary session of 20-25 June, at which it finalised its second 12-month review of its existing standards on virtual assets and VASPs. So far, 58 out of 128 reporting jurisdictions says they have implemented the current FATF Standards: 52 regulate VASPs and 6 prohibit them. However, ‘the majority of jurisdictions have not yet implemented the FATFs requirements’, including the ‘travel rule’, FATF said. The second review report identifies potential future FATF actions to prevent crypto crime, including crypto-related ransomware. The report will be published on 5 July.  

  • UK – Self-proclaimed Bitcoin inventor Craig Wright won a case in the UK High Court on Monday, claiming that Bitcoin.org infringed his intellectual property rights by publishing the Bitcoin Whitepaper on its website. The case was won by default: Bitcoin.org’s pseudonymous operator Cøbra did not mount a defense. There is much scepticism about Wright’s claim to be Satoshi Nakamoto, Bitcoin’s inventor. (Decrypt)

  • Privacy coins – Monero: The rising popularity of privacy coins for ransomware attacks is making life harder for law enforcement agencies. Monero developer Justin Ehrenhofer estimates that at present ‘about 10 to 20 per cent of ransoms are paid in monero, and that the figure will probably rise to 50 per cent by the end of the year.’ The US IRS issued a bug bounty to help track monero and several companies are actively working on improving its traceability, but so far this has not dented monero’s increasing popularity. However, its appeal as a ransomware payment tool may be limited as ransomware victims may be more reluctant to pay in monero: the relatively limited supply of monero makes it harder for victims to buy the coin to pay ransomware and its privacy features increase the risk that monero-payments somehow involve sanctioned entities, putting the transaction at risk of violating sanctions rules.  (FT)

  • Iran – Authorities seized 7,000 mining devices in Teheran, according to state-controlled media. In May, Iran banned crypto-mining for four months, citing energy consumption concerns as the country faced electricity blackouts.  (Decrypt)

  • UK – Binance’s CZ tweeted a note of appreciations received from UK South East Regional Organised Crime Unit for Binance’s cooperation in an investigation on dark web drug trafficking. This was a small particle of light for Binance in a week otherwise clouded by legal woes in different jurisdictions.

  • Ontario (Canada), UK and Japan  – Binance will cease operations in the Canadian province of Ontario by the end of the year. The Ontario Securities Commission recently started proceedings against KuCoin entities and Bybit for alleged securities law violations. (Cointelegraph) Binance was fending off regulatory attacks in other parts of the world too, in the past few days. The Financial Services Agency of Japan on Friday issued a warning that Binance is operating without the necessary registration. A Binance spokesperson said the exchange “does not currently hold exchange operations in Japan, nor do we actively solicit Japanese users”. (Cointelegraph) A day later, the UK’s Financial Conduct Authority followed suit and said Binance is not allowed to offer its services in the UK without the necessary prior approvals. Binance had already come under scrutiny in Germany and elsewhere for its offer of tokenized securities. If authorities wish to start proceedings against Binance, they may need to find out first which entity to sue – Binance says it has no headquarters. (Decrypt)

  • US – Litigation around the Mt Gox hack continues. A US federal judge at the US District Court for the Northern District of Illinoi rejected class certification, stating it was unreasonable to assume all 30,000 putative class members understood or even read Mt Gox’s terms and conditions, as lead plaintiff Gregory Greene allegedly did (Law 360). This is the second time Judge Feinerman rejected such an application by former Mt Gox users. (Cointelegraph)

  • US – The president of the Federal Reserve Bank of Boston, Eric Rosengren, sees stablecoin Tether as a ‘challenge’ to financial stability. “I do worry that the stablecoin market that is currently, pretty much unregulated as it grows and becomes a more important sector of our economy, that we need to take seriously what happens when people run from these type of instruments very quickly.” (Yahoo Finance) However, other Fed officials disagree (see below, Randal Quarles on CBDCs).

  • US – Cathie Wood’s ARK files for bitcoin ETF. (CNBC) Yet another ETF application to add to the pile on the SEC’s desk.

  • Tanzania’s Central Bank may reconsider its crypto ban after comments made by the country’s President. (Reuters)

  • Korea – A number of smaller crypto-exchanges in South Korea are reportedly considering suing the government for passing responsibility of vetting crypto-exchanges to banks. New rules adopted by the Financial Services Commission require crypto-exchanges to prove they hold a real-name account with banks. Banks have been reluctant to offer such real-name account services to crypto exchanges other than the top-4 exchanges. (Cointelegraph)

  • Germany – BaFin granted Coinbase a license for crypto ustody services and proprietary trading, the first licence it has issued for such business in Germany. (Reuters)

  • Mexico’s Minister of Finance, Arturo Herrera, confirmed in a FATF presentation that crypto is banned from Mexico’s financial system. On Twitter, he reiterated: ‘Los activos virtuales no constituyen una moneda de curso legal en México ni tampoco son divisas bajo el marco legal vigente.’


DeFi

  • IOSCO organised a video meeting at which DeFi projects such as dYdX and Uniswap presented, and which representatives from the US CFTC and SEC (among others) attended. (FT) Few details are available about this meeting, but the fact that it takes place is a good sign.

  • I interviewed US SEC Commissioner Hester Pierce on DeFi regulation. Video to follow soon – stay tuned!


CBDC

  • Israel – More details are emerging about Bank of Israel’s plans for a digital shekel: the central bank is trying out Ethereum for its recently launched internal digital shekel, according to a spokesperson. (Bloomberg)

  • Switzerland – The Swiss National Bank has no plans to issue a digital franc. (Coindesk)

  • US – The Fed’s Randal Quarles said foreign CBDCs and stablecoins should not be seen as a threat to the US dollar. In a speech, he said: ‘we do not need to fear stablecoins’, although ‘[w]e do have a legitimate and strong regulatory interest in how stablecoins are constructed and managed, particularly with respect to financial stability concerns.’ He disagreed with those who see a digital dollar as the answer to a ‘threat’ of stablecoins and said that a US-linked stablecoin ‘might support the role of the dollar in the global economy’. On bitcoin, he was less positive: ‘bitcoin’s principal additional attractions are its novelty and its anonymity. The anonymity will make it appropriately the target for increasingly comprehensive scrutiny from law enforcement and the novelty is a rapidly wasting asset.’

  • US – New York Fed’s John Williams also commented on CBDCs in a panel discussion organized by the Bank for International Settlements. ‘Major questions need to be addressed’ as central banks and other entities consider digital currencies, Williams said.  (Reuters)


Smart contracts

  • DAO – COALA (Coalition of Automated Legal Applications) published a model law for Decentralized Autonomous Organizations (DAOs). The DAO Model Law drafters ‘believe that it would be desirable to adopt a uniform, model set of rules that could be implemented internationally to provide legal certainty for DAOs and their members and participants.’ (See below, under Spotlight)

  • DAO – Uniswap’s governance token holders adopted a proposal to create a US 501(c)(4) nonprofit entity ‘to provide grants for political, educational, and legal engagement’. Initially called the ‘DeFi Political Defense Fund’, the DeFi Education Fund will have access to 1 million UNI to achieve its aims. Its goals are: ‘1) pushing back against misguided regulatory, legal, or political threats to decentralized finance; 2) achieving regulatory clarity for decentralized finance and related activity; 3) advancing laws that support decentralized finance and decentralized governance; and 4) spurring other DeFi protocols’ governance bodies to contribute to the effort (through this entity or their own).’ The entity’s board of directors will have seven members, including the general counsel of Aave Companies, Compound Labs and dYdX Trading, as well as WEF’s Sheila Warren. The funds will be held in a separate address, with a 4/7 multisig (4 of the 7 board members will need to sign). Tyler Whirty tweeted that ‘the Yes quorum was met with votes from 5 addresses’ for this ‘[l]argest ever DAO treasury distribution (excluding liquidity incentive programs’, although there were 157 votes in total. The proposal caused some intense debate among UNI holders.


Revolving door

  • Crypto investment fund a16z hired former SEC’s William Hinman as an advisor on regulatory issues for its new crypto fund. A16z’s crypto hiring spree also added Brent McIntosh to its ranks –  a former Under Secretary at the US Treasury. (Decrypt)


Spotlight: What type of legal beast is a DAO?

Decentralized Autonomous Organizations (DAOs) are no longer a fiction. They already exist and operate on-chain. How the law deals with DAOs and DAO users or contributors, however, is far from clear.

To reduce legal uncertainty, a DAO Model Law was drafted by a working group of COALA (Coalition of Automated Legal Applications).

The Model Law for Decentralized Organizations (DAO Model Law) offers a template for lawmakers around the world to turn DAOs into entities with legal personality, mimicking several aspects of traditional corporate law, but tweaked to accommodate a DAO’s unique features.

Why do we need new laws for DAOs, you may wonder?

Very few DAOs are incorporated as a company. Having company status gives several benefits to an association, including separate legal personality (which means it can enter into contracts, for example, or start a lawsuit in its own name) and, by default, limited liability for its shareholders. To benefit from these features, however, a business formally has to incorporate as a business, following the necessary legal procedures, such as (typically) registration with a company registry, submission of formal documents such as a list of initial shareholders, legal name, type of company (private or public, for example), number of shares, etc.

Any business or other association that does not follow these formalities will not be recognized by law as a company. Since most DAOs do not go through the formal incorporation process, they will typically not be a ‘company’ in any jurisdiction.

This does not mean they are necessarily unregulated or outside of the scope of law, however.

Many jurisdictions will apply a default legal category to an organization that undertakes commercial activities of some sort, without having the legal status of a company. This means DAOs not incorporated as a company may be, by default, categorized as another type of legally recognized association.

In some jurisdictions, the default legal category may be that of partnership. Carla Reyes, for example, analysed how DAOs could be classified as partnerships under US law. A partnership classification raises serious concerns for DAO members, as partners in a partnership face unlimited liability for the partnership’s debts, typically. If we classify DAOs as partnerships, by legal default, DAO members and contributors could unwittingly face unlimited liability claims for the DAO ‘partnership’ debt.

Reyes suggested that the old US concept of a business trust could be dusted off for DAOs. That may be suitable in the US, but many jurisdictions are unfamiliar with the concept of a trust or business trust.

The US State of Wyoming took a different approach. It amended its company law rules to allow for a new type of limited liability company (LLC), the DAO LLC. The ‘Wyoming Decentralized Autonomous Organization Supplement’ amends the Wyoming Limited Liability Company Act. A DAO can incorporate as a special type of LLC. Doing so gives the DAO the advantage of separate legal personality for itself and limited liability for its members. Such DAO LLC will have to make clear in its name that it is a DAO or LAO (limited liability autonomous organization). Traditional fiduciary duties in such DAO LLC may be reduced or eliminated. The DAO may also restrict transfer of ownership interest, withdrawal or resignation.

Wyoming’s DAO LLC has been criticised as too flexible or not flexible enough. It remains an odd merger between a traditional corporate form and the particular features of a DAO.

COALA’s DAO Model Law aims to overcome such odd hybrids, by allowing a DAO to become a new type of legal person, with legal provisions adapted to its needs.

The DAO Model Law very much leans on traditional corporate law scholarship. The commentary mentions familiar discussions on agency costs, for example. Where possible, it replaces off-chain obligations from traditional company law with on-chain technological equivalents:

‘The deployment of a smart contract on a blockchain with relevant data about a DAO is not functionally equivalent to registration into a corporate registry, but the policy objectives of publicity and certainty are fully achieved.’

The DAO must provide a unique Public Address through which anyone can review the DAO’s activities and monitor its operations. Software must be available to allow a layperson to ‘read’ the key variables of the DAO’s on-chain smart contracts. The Model Law also requires a ‘publicly specified mechanism’ that allows any layperson to contact the DAO. A DAO must also have a dispute resolution mechanism binding on the DAO members and participants, and one to solve conflicts with third parties.

Notwithstanding these publicity and transparency requirements, the Model Law leans on the overall principle of ‘participant beware’ – an approach not all regulators may favour.

The Model Law also offers limited liability to DAO members (those with governance rights in the DAO), much like shareholders in a traditional company. The veil can be pierced in cases of fraud ‘and failure to comply with binding arbitral awards or court orders’, however, mirroring exemptions to shareholder limited liability in many jurisdictions. DAO members who vote against DAO compliance with a binding arbitral award or court order would face (proportionate) unlimited liability under the draft rules.

The Model Law mirrors many aspects of traditional company law and has provisions on meetings, (off-chain) representation, voting rights, proxies and minority protection. It gives much flexibility to the DAO to decide on its governance and rights given to members (for example, minority protection is not mandatory). Developers, members, participants or legal representatives of a DAO shall not have any fiduciary duties, unless so provided by the DAO by-laws (or if they explicitly hold themselves out as fiduciaries).

It also adds DAO-specific provisions, for example on contentious forks, DAO restructuring and failure events (modelled on directors’ liability provisions: liability may attach for gross negligence and bad faith). On  taxation, it proposes to make a DAO a ‘see-through’ entity for tax purposes.  

Some aspects of this DAO Model Law, including the ‘participant beware’ approach, may not be appealing to lawmakers in all jurisdictions. However, it is an important step in getting the discussion going on how the law deals with decentralized autonomous organizations.

Contributors to the DAO Model Law are Constance Choi, Primavera De Filippi, Rick Dudley, Silke Noa Elrifai, Fatemeh Fannizadeh, Florence Guillaume, Andrea Leiter, Morshed Mannan, Greg McMullen, Sven Riva and Ori Shimony.

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