Securities, Regulations, and DAOs

In this, the latest installment in our series about decentralized autonomous organizations (DAOs), we’re looking at securities and regulatory concerns. Our first alert was an overall explanation of DAOs, and our second looked at the tax implications of DAOs.

To remind you, a DAO is a mechanism that empowers groups with common interests to serve a broad range of purposes through smart contracts on a blockchain. A DAO can raise a lot of money quickly and its members decide collectively what to do with that money by voting. No bank is necessary. For example, ConstitutionDAO raised money to bid at auction on a copy of the U.S. Constitution (it was outbid), and UkraineDAO quickly raised money to assist Ukraine after the Russian invasion. Many cryptocurrency projects are now forming DAOs to govern themselves. The hottest questions in the cryptoverse focus on how digital assets—and DAOs, in particular—will be regulated.

Are DAOs subject to securities laws? Maybe.

There are many types of DAOs: Protocol DAOs, which issue tokens; Collector DAOs, which acquire collectibles; Social DAOs, which allow people to meet other like-minded people; and Creator DAOs, where members create, distribute, consume, and value content. It is not yet clear in what circumstances—if any—the Securities and Exchange Commission (SEC) or a court would view the tokens that DAOs issue to be “securities,” as defined by the federal securities laws, and thus subject to the SEC’s regulatory framework and oversight. According to the Supreme Court’s Howey test—the test that is most typically applied to digital assets—an “investment contract” must satisfy the following four elements to be considered a “security”:

• an investment of money;
• in a common enterprise;
• with a reasonable expectation of profits; and
• to be derived from the efforts of others.

Courts have not yet addressed whether DAO tokens are securities. But what the SEC has said about digital assets and DAOs, when considered with case law in other contexts, offer some context for thinking about the regulatory framework for digital assets—one that ideally will seek to balance innovation with investor protection. Of course, as with most digital assets, there are credible arguments that DAO tokens do not satisfy at least one of the four “investment contract” elements. But the strongest arguments may lie under the fourth element, the efforts-of-others element, because of DAOs’ decentralized nature.

DAOs are so new, the SEC probably hasn’t published anything about them, right? Wrong.

Although today’s frenzy about DAOs and other digital-asset projects might suggest that DAOs are brand new, the SEC addressed the DAO concept almost five years ago. The SEC’s July 2017 “The DAO Report” detailed its investigation into an organization named “The DAO,” which was intended to function like a decentralized venture capital firm. In 2016, The DAO sold $150 million of “DAO Token” digital assets to the public, with the intention of investing the token holders’ aggregated funds in digital-asset projects and later distributing returns to the token holders. The token holders could either keep their tokens in hopes of reaping returns later, or convert their tokens into other digital assets on third-party platforms. Each token granted its holder a vote in DAO governance matters, including in selecting investment projects and deciding whether profits would be reinvested or distributed. The DAO’s promoters selected a group of managers called “curators,” who performed security functions and managed governance for the organization.

The SEC concluded in its report that DAO tokens were “investment contracts,” and thus subject to U.S. securities regulations. Focusing on the Howey test’s fourth element—whether the asset holders expected any profits to be generated by the “efforts of others”—the SEC concluded that The DAO’s success depended largely on the efforts of its promoters and the curators, who monitored operations, safeguarded funds, and determined which investment proposals would be submitted for a vote. Individual DAO token holders, in contrast, did not determine which proposals would make it to a vote; they were also not provided with enough information to make informed choices about their votes; and they were limited in their ability to communicate effectively and coordinate with one another. So, the thousands of token holders, who knew each other only through pseudonyms, had little choice but to rely on the curators to further the organization’s goals. This, according to the SEC, satisfied the efforts-of-others element of the Howey test.

Has the SEC published anything since the 2017 DAO Report? Yes.

The SEC again acknowledged, in its 2019 report, Framework for “Investment Contract” Analysis of Digital Assets, that determining whether a digital asset is an investment contract likely turns on the Howey test’s efforts-of-others element. According to this report, it is more likely that purchasers of a digital asset are relying on others to realize profits if that asset has one or more of the following characteristics:

• The project team is responsible for the network’s development, improvement, operation, promotion, and essential tasks;
• The project team created or supported a market for the digital asset;
• The project team plays a continuing managerial role in making decisions about the network or digital asset—such as making decisions about governance, code updates, or how third parties participate in validating transactions; and 
• Purchasers of the digital asset reasonably expect a project team to undertake efforts to promote its own interests and enhance the value of the network or asset.

The SEC noted in the “Framework”—as it had previously—that digital assets which qualified as securities when issued could later be re-classified as non-securities. For example, William Hinman, then the Director of the SEC’s Division of Corporate Finance, stated during the Yahoo! Finance All Markets Summit in June 2018 that digital assets operating on “sufficiently decentralized networks and systems” might not be securities. Hinman focused on the fourth Howey element when he said, “[W]hen the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.” In May 2019, then–SEC Chairman Jay Clayton likewise stated that a digital asset may no longer be classified as a security if “purchasers would no longer reasonably expect a person or group to carry out the essential managerial or entrepreneurial efforts.”

In short, to evaluate the efforts-of-others element, one must determine if those efforts are sufficiently significant—i.e., do the managerial efforts affect the failure or success of the enterprise? The DAO, for example, satisfied this test because a core group of DAO members had extensive responsibility for its day-to-day operations.

How about the courts: What do they say about DAOs?

DAOs looking to mitigate the risk that their membership tokens will constitute securities might want to look at how courts have analyzed the efforts-of-others element in other contexts, for example, in loan-participation agreements or in general partnerships. The efficient administration of loan-participation agreements depends on some centralization of management, but courts have concluded that loan participants’ interest income typically does not depend on the managerial efforts of others; instead, income depends on the debtor’s success.¹ To the extent that investment DAOs operate like loan-participation arrangements, courts may conclude that token holders’ income from such DAOs also does not depend on the efforts of others. One possible scenario might be to have any returns generated by an investment DAO flow directly and automatically from the investments themselves with no possibility of any manager deciding how to allocate the returns.

A DAO may mitigate the risk of being subject to securities regulations if its members actively control its operations—as members might in a general partnership or a joint venture. In that respect, a DAO may be able to invoke the widely adopted Williamson framework, developed by the Fifth Circuit in 1981, for determining whether an individual participant in a partnership or joint venture depends on the “efforts of others. ² Any such analysis would have to consider the unique characteristics of DAOs compared to general partnerships. But under the Williamson test, an ownership interest in a partnership is more likely to be considered an “investment contract” if the answer to any of these three questions is yes:

1. Is the entity’s structure and management akin to that of a limited partnership or traditional corporation by leaving little power in the hands of individual owners? 
2. Are the individual owners so inexperienced and unknowledgeable in the affairs of the business that they are incapable of intelligently exercising their powers to promote the organization’s success? 
3. Are the owners so dependent on the entrepreneurial or managerial abilities of a manager that they themselves could not replace the manager or otherwise exercise meaningful control over the organization?

Let’s examine these questions more closely:

The use of an individual owner’s funds in a partnership is more likely to resemble an “investment contract” if that owner has little practical ability to influence the organization’s decisions. But an owner is less likely to be deemed reliant on “the efforts of others” if that owner has retained some authority and control over the organization.

The Fifth Circuit identified several characteristics that courts should consider in determining whether the first Williamson factor had been satisfied: the manager’s formal powers (compared to the investors’); whether the investors exercised their formal powers; the venture’s voting structure; what information was available to investors; communication among the investors; and the number of investors.

Question 1 focuses on the DAO’s structure, including the total number of token holders participating in the DAO and the extent to which the DAO’s smart contracts reflect the owners’ oversight, managerial, and voting powers. Courts have generally concluded that organizations with more than several dozen general partners presumably have centralized management and control because it would be impractical for so many partners to each retain some authority and control over the organization. But, DAOs may successfully argue that their unique structure and decision-making enables larger numbers of individuals to maintain meaningful control over the organization’s affairs.

Question 2—Ability of Owners to Exercise Control Intelligently

Investors need not be experts to be capable of “intelligent” management, but they should have enough experience and knowledge that they can make independent decisions about their investments. How much experience and knowledge an individual DAO participant has about the DAO’s business will determine whether this factor applies.

Question 3—Owners’ Dependence on Managers’ Abilities

Owners with a realistic alternative to relying on a manager—even if that alternative is not necessarily preferable—might not be considered “dependent” on the efforts of others. Courts or regulators are likely to consider how complete a particular DAO’s network is and whether a member can effectively use the governance mechanisms to control the DAO’s future.

What do I need to know now?

Ultimately, whether the SEC or a court would view a DAO as offering and selling securities depends on that particular DAO’s facts and circumstances. When forming a DAO, members should consider:

the DAO’s purpose; 

• how many token holders will participate in the DAO; 
• what powers token holders will have; 
• when the operational network will be complete; 
• how many essential functions and operations will be performed by on-chain smart contracts; and
• how token holders will use on-chain smart contracts to effect DAO decisions.

In this rapidly evolving area of law, we will do our best to keep you informed. Stay tuned for the next client alert in our DAO series (spoiler: It’s about bankruptcy). That alert will be followed by others on liabilities and legal entities, and bankruptcy-related issues. In the meantime, you will probably have questions. Contact professionals at O’Melveny for answers.

Each client alert in this series includes some crypto-lingo at the end to help you navigate the cryptoverse. Here are some terms:

• Ape: To buy a newly issued coin or token, as in “We better ape into this NFT right now!” 
• Bags: The coins and tokens in your portfolio. If you hold onto your bags too long, you are a bagholder.
• FUD: This stands for “fear, uncertainty, doubt,” and refers to any criticism of crypto-currency. Spreading FUD about a particular token can cause its price to drop. 
• Rug Pull: A scam in which developers raise money for a crypto project, then disappear with the loot.

¹ Union Planters Nat. Bank of Memphis v. Com. Credit Bus. Loans, Inc., 651 F.2d 1174 (6th Cir. 1981).

² Williamson v. Tucker, 645 F.2d 404 (5th Cir. 1981).

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. William K. Pao, an O’Melveny partner licensed to practice law in California, Bill Martin, an O'Melveny counsel licensed to practice in New York, Michael McMillin, an O'Melveny counsel licensed to practice in Texas, and Kaitie Farrell, an O'Melveny associate licensed to practice in California, all contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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