On June 15, 2023, the Polsinelli Blockchain+ team put out our first Bi-Weekly rundown of some of the key stories in the Web3, blockchain, and crypto ecosystems curated by Polsinelli attorneys navigating the intersections of code, smart contracts, and U.S. law. That makes this June 27, 2024, post the first official post after passing the 1-year mark! You can catch up on all the past updates on the Polsinelli BitBlog and subscribe to get future updates in your email here. In the past few weeks, the Web3 legal space has seen multiple disputes and investigations seemingly come to an end, while others are just getting started. Terraform Labs is seeking to settle its dispute with the SEC and move on to focus exclusively on its ongoing bankruptcy proceedings, and the SEC has closed the door on its investigation into “Ethereum 2.0” (for now). While Ripple was able to defeat most of the private actions against it, some issues remain for trial, and the Kraken litigation against the SEC is on track for a busy year of discovery. These developments and a few other brief notes are discussed below. Terraform Labs and Founder Settle With SEC: June 12, 2024 Background: Terraform Labs has agreed to forgo its appeal and damages hearings after a jury found the company and its founder, Do Kwon, liable for securities fraud in April of this year. Instead, the company and founder have asked the Court to approve a settlement of ~$5 billion in fines, interest, and civil penalties. Do Kwon is personally on the hook for $204 million of the penalties, so I guess his size is not size anymore either.   Analysis: The SEC is getting basically everything it asked for in its damages briefing so this is about as white flag and waving a white flag gets. Terraform Labs already filed for bankruptcy in January of this year with estimated assets being under $500 million and the same amount of outstanding liabilities. The funds owed to the SEC under this settlement will be an unsecured claim in the bankruptcy matter, and the SEC will be left to seek its portion of whatever is left after Terraform Labs’ assets are used to pay secured creditors, administration expenses, and post-petition legal fees. So Terraform likely figured out that the difference between their proposed $3.5 million and the SEC’s suggested $5.3 billion was close to zero since the company would not be able to pay a significant portion of either of those fine options. Apparently, Terraform Labs has handed off control to the “community.” Following the settlement announcement, Ripple and the SEC exchanged jabs on whether this should change the analysis for damages in their case. SEC Calls off Investigation into Ethereum 2.0: June 18, 2024 Background: The SEC sent a letter to Consensys Software stating that the Commission staff does not intend to recommend enforcement action against Consensys relating to the SEC’s investigation into what the SEC is calling “Ethereum 2.0.” The investigation seems to be related to the switch by the Ethereum Network from validating transactions that occur on the network from “proof-of-work” to now using “proof-of-stake” for those validation functions. This switch in validation methodology inspired SEC to revisit the agency’s then director of enforcement statement in 2018 that proof-of-work Ether was not a security. The June 7 letter referred by the SEC is available here. Analysis: Is it a coincidence this decision comes within a week of the head of the SEC’s Crypto Asset and Cyber Unit in the Division of Enforcement announcing his departure? It is currently unclear if this decision is really the SEC deciding not to investigate Ethereum 2.0 or if this is just a temporary tactical strategy possibly to moot the Consensys lawsuit pending in Texas. Such a strategy would be similar to the SEC attempting to moot the Coinbase rulemaking request by stating it was “under consideration” despite ample evidence to the contrary. It will also be interesting to see if Consensys and separate Lejilex Administrative Procedures Act challenges to the SEC have the same success as a recent decision in that same federal district challenging a separate administrative agency action. Ripple Labs Mostly Defeats Securities Class Action but Issues Remain: June 20, 2024 Background: Ripple Labs mostly won on its Motion for Summary Judgement in a securities class action which was filed by various individuals shortly after the SEC brought a lawsuit against the developer of $XRP. The Court found that the plaintiffs’ federal securities claims were barred by the applicable statute of repose and that the state law claims also could not continue because the named plaintiffs lacked the necessary privity of contract with Ripple. The Court did, however, allow the individual claims for misleading statements to continue to trial. Analysis: While this is an important win for Ripple, the Order itself has some sub-optimal language on the Howey issue for surviving claims and it does not save Ripple from going to trial on the remaining claim. The Court found that plaintiffs sufficiently stated a claim that the $XRP tokens themselves are potentially securities which could give rise to a claim for misleading statements in connection with a security, even though plaintiffs bought the tokens on secondary marketplaces.   Kraken’s Motion to Dismiss SEC Case Likely to be Denied Following Hearing: June 20, 2024 Background: On June 20, 2024, the Court overseeing the SEC’s lawsuit against Payward Inc. (d/b/a, Kraken) telegraphed its intent to deny Kraken’s Motion to Dismiss during oral arguments on the motion. The Court was especially unphased with the Major Question Doctrine issue, denying the parties’ offers to present oral arguments at all on that issue. While Judge Orrick heard arguments on many of the remaining issues, he stated at the onset of the hearing that he was inclined to deny the Motion to Dismiss and follow the Order of Judge Failla in the agency’s lawsuit against Coinbase which the Polsinelli team provided a breakdown of in our April 15, 2024 Bi-Weekly update. Analysis: Attorneys for Kraken tried to distinguish the binding case law that Judge Failla was bound by in the Second Circuit as compared to the Kraken case in the Ninth Circuit, but that did not appear to sway Judge Orrick during the hearing as they focused on scheduling issues after oral arguments concluded (giving at least some indication that the Court expects the case to continue into discovery). Briefly Noted: PleasrDAO Sues Martin Shkreli: PleasrDAO is suing Martin Shkreli (AKA, “Pharma Bro”) regarding the never publicly released Wu Tang album purchased by the DAO during the latter’s DOJ-forced asset forfeiture and sell-off. This comes after the DAO hosted the first ever listening party for the album. Martin Shkreli has also claimed to be behind the $DJT “meme-coin,” with the alleged backing of Barron Trump. Article on Blockchain Patent Published: Polsinelli’s own Tom Isaacson recently published an article on overcoming common blockchain patent challenges which is worth reading for any individual considering seeking a patent over a blockchain-enabled innovation. Crypto Campaign Funding Continues to Grow: Fairshake, the pro-crypto super PAC, now has a total funding number of $169 million, with over $100 million still in its war chest, after Jump Crypto adds another $10 million to the pot. Another Major Departure in SEC Crypto-Enforcement Unit: David Hirsh, the head of the SEC’s Crypto Asset and Cyber Unit in the Division of Enforcement is leaving the agency. This follows the departure of Laden Stuart, who was involved with many of the agency’s heist profile digital asset cases. Ether ETFs Expected Approval This Summer: Gary Gensler said he expects the Ether ETF S-1 forms for issuers should be approved by this summer. Despite that, there is still seemingly lagging activity in those various S-1 applications. District Court Enforces Subpoena Against “Meme-Coin” Creator: A judge in the U.S. District Court for the Southern District of Florida has agreed to enforce a subpoena issued against the issuer of “Let’s Go Brandon” Coin (“LGBCoin”). The creator has asked for a stay in enforcement of the Order. Conclusion: As we celebrate the one-year anniversary of our Bi-Weekly updates, the past few weeks in the Web3 legal landscape have been notably dynamic. With major settlements, ongoing litigations, and regulatory shifts, we've observed significant movements that will undoubtedly shape the future of blockchain and cryptocurrency compliance and enforcement. From Terraform Labs' hefty settlement with the SEC to the evolving regulatory status of Ether, these developments highlight the evolving interaction between emerging technologies and established legal frameworks. We thank our readers for their continued engagement and invite you to subscribe for more insights and analyses that help navigate these complex intersections. Stay tuned to the Polsinelli BitBlog for further updates and expert commentary tailored to the blockchain and cryptocurrency community. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance. Also, please subscribe to the BitBlog for alerts when new stories or updates are posted by our attorneys.

It was a busy week for digital assets with the Securities and Exchange Commission, as the agency was sued by a digital asset exchange hopeful and faces responses in its pending litigation against existing digital asset exchange Payward, Inc. d/b/a Kraken. Elsewhere in Web3 law, as the Department of Energy retracted its plan to survey Bitcoin mining operations, and Wyoming passed a law which creates a corporate structure for decentralized autonomous organizations (“DAOs”) modeled off the state’s existing structure for unincorporated non-profit associations (“UNAs”). All of this took place with Bitcoin and Ether reaching all-time highs in trading values, bringing back positive news and additional funding to the ecosystem.  These developments and a few other brief notes are discussed below. Exchange Hopeful and Texas Advocacy Group Sue SEC: February 21, 2024 Background: The Crypto Freedom Alliance of Texas and hopeful exchange platform LEJILEX have sued the SEC in a declaratory judgment action, seeking a ruling that LEJILEX’s planned actions to act as a centralized platform (named Legit.Exchange) for peer-to-peer and blind bid/ask trading of certain digital assets does not require registration with the SEC as a securities exchange, broker, or clearing agency. Summary: Former Solicitor General of the United States, Paul Clement, is a listed attorney against the SEC, as are various other highly accomplished appellate litigators. Combined with a favorable 5th Circuit forum and District Court Judge draw and this is certainly a case to pay attention to. It raises very similar issues to the defenses raised by exchanges currently litigating against the agency (as explained below) but lacks any potential bad factual baggage which those exchanges may have. The SEC can be expected to seek an early dismissal on standing or other jurisdictional grounds. Kraken Responds to SEC Lawsuit; Alleging the Lawsuit is an Attempt to Stifle Free Speech: February 22, 2024 Background: The digital asset exchange Payward, Inc. (aka, “Kraken”) has moved to dismiss the lawsuit filed against it by the SEC related to the facilitation of sales of certain digital assets.  Namely, ADA, ALGO, ATOM, FIL, FLOW, ICP, MANA, MATIC, NEAR, OMG, and SOL. In a separate blog post explaining the Motion to Dismiss, Kraken claims that the day after Kraken testified to the House Financial Services Committee regarding the need to limit the SEC’s authority over regulation of digital assets, an SEC official called Kraken stating the agency’s intent to sue. Summary: This Motion to Dismiss largely follows the framework of the Coinbase Motion for Judgment on the Pleadings and the Binance Motion to Dismiss. All raise similar arguments regarding the token sales at issue not being “investment contracts” and the SEC’s alleged regulatory overreach which is argued by the defendants to be contrary to previous agency positions and violates certain separation of powers principles. What is interesting about the Kraken suit is the blog post and motion outright stating that the SEC’s lawsuit is retaliation for Kraken’s Congressional testimony. “Crypto innovators in the United States should not have to fear retaliation for their political speech. They should be free to earnestly advocate for better law and more efficient markets. They should be free from intimidation by a politically compromised agency.” Multiple Amici Come Out in Support of Kraken and Opposition to SEC: February 27, 2024 Various amicus briefs were filed in the SEC vs. Kraken lawsuit, including briefs filed by the Chamber of Digital Commerce, the Blockchain Association/DeFi Education Fund, Paradigm, and a group of State Attorney Generals. All of the amicus briefs call into question the seemingly shifting stance of the SEC on what is a “digital asset security” or an associated “ecosystem” which the SEC has argued turns a particular blockchain’s token into something which satisfies the commonality element under Howey. Tl;dr: With this being an election year, any real change in law or administrative policies is likely going to come from the courts, if at all. The amount of amicus support at the district court level for all the exchange cases has been an impressive showing from industry advocacy organizations, businesses, and political actors. The State Attorney General briefing is especially interesting, claiming the SEC is overstepping into the realm of general consumer protection and money transmission which are typically issues reserved for the states. SEC Commissioner Uyeda Warns About Unbound Administrative Authority SEC Commissioner Mark Uyeda gave a speech to the Council of Institutional Investors titled Dangers of the Unbounded Administrative State which included a section regarding the current regulation of digital assets by the SEC. In it, he warned the Commission’s “broad reading of Howey would appear to scope in many common transactions in the non-digital world, including pre-purchase commitments, collectibles, art, and land.” Tl;dr: This is the strongest statement by an SEC Commissioner without the last name Peirce to come out in opposition to regulation by enforcement by the current SEC.  “When a regulator can, without practical limitation, promulgate, interpret, and enforce rules and guidance, including retroactively, the temptation to be arbitrary in the exercise of administrative power and enforcement can be great.” Combined with his dissent to the ShapeShift settlement, and it appears politicians are getting more emboldened to publicly object to regulatory enforcements against digital asset industry participants. Briefly Noted: SEC Settles With ShapeShift: The SEC settled with Erik Voorhees’ long-inactive exchange entity ShapeShift for a $275,000 fine and an agreement that the company would no longer violate the Securities Exchange Act. Shapeshift handed off operations to a DAO in 2021, which continues to operate unaffected. As stated by SEC Commissioners Peirce and Uyeda “[t]he Commission’s enforcement action against ShapeShift is the latest installment in the serial drama of the Commission’s poorly conceived crypto policy.” SEC Seeks to Use Default Judgment in Coinbase Case: Predictably, the SEC is trying to use a default judgment in the Wahi case against Coinbase and predictably Coinbase pushed back. “The Wahi order was procured against an empty chair and its reasoning reflects as much. Coinbase respectfully submits that the default judgment against Mr. Ramani should be afforded no weight.” Wyoming Creates New Corporate Structure for DAOs: Wyoming passed a law creating a new corporate structure: the “Decentralized Unincorporated Nonprofit Association” or “DUNA” (terrible name; unless it involves sandworms). This was a structure advocated by various industry participants as a DAO corporate wrapper, and is seemingly designed primarily to avoid triggering Corporate Transparency Act reporting requirements. Advocacy Groups Block Department of Energy Survey of Bitcoin Miners: The Texas Blockchain Council filed a lawsuit challenging the Department of Energy’s recent “emergency” survey requiring bitcoin miners to provide ongoing reporting to the agency. House Majority Whip Tom Emmer has also sent a letter to the agency challenging its actions. These efforts apparently worked, as the Department of Energy retracted it survey. Blockchain Association Advocates Against Sen. Warren Proposal: The Blockchain Association wrote a letter, signed by many members who are former or current law enforcement or military, advocating against Senator Elizabeth Warren’s proposed anti-money laundering law. Digital assets aren’t going away, so laws which are impossible to comply with based on technological limitations won’t kill it. It will just drive it overseas away from the reach of U.S. regulators. Polsinelli Blockchain+ News and Speaking: Bitblog Blockchain+ Bi-Weekly key author Jonathan Schmalfeld will be speaking on May 15th at the D.C. Blockchain Summit together with key members of Congress and senior regulators and Commissioners. He will also be speaking at NFT/NYC on April 3rd. Conclusion: The landscape of digital assets and Web3 law is currently marked by a series of legal and regulatory challenges, as well as legislative attention and increased values that underscore the ongoing tension between innovation and regulation. The lawsuit by the Crypto Freedom Alliance and LEJILEX against the SEC, alongside Kraken's defense against the SEC's lawsuit, highlights the digital asset industry's resistance to what it perceives as regulatory overreach as well as its maturation in being able to assertively self-advocate. Moreover, Wyoming's pioneering legal framework for DAOs and the backlash against regulatory actions by various advocacy groups and political figures, including SEC Commissioner Uyeda's critique, reflect a broader debate on the balance between fostering innovation in the digital asset space and ensuring regulatory compliance. These developments suggest that the resolution of these tensions will significantly shape the future of digital assets and their regulation. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance. Also, please subscribe to the BitBlog for alerts when new stories or updates are posted by our attorneys.

The application of the Corporate Transparency Act to decentralized autonomous organizations raises novel legal issues. DAOs are a relatively new type of business association that lack statutory governance and liability protections for participants because they have not been formed as traditional legal entities. As a result of legislative enactments seeking to fit DAOs into traditional entity structures to promote protections for them, DAOs operated through business entities will need to comply with the CTA's disclosure obligations. What the CTA Requires: Beginning Jan. 1, 2024, reporting companies operating in the U.S. must file Beneficial Ownership Secure System, or BOSS, reports with the U.S. Department of the Treasury's Financial Crimes Enforcement Network, including owners' names, birthdates, addresses and copies of government-issued photo identification. A reporting company is an entity like a corporation, limited liability company, limited partnership or business trust that is created or registered to do business in the U.S. through a secretary of state filing. Heavily regulated businesses — such as public companies and their regulated advisors, financial institutions, insurance providers and Section 501(c)(3) nonprofits — are exempt. Also exempt are large operating companies — i.e., those with a U.S. physical street address, 21 or more full-time employees, and more than $5 million in annual gross receipts or sales as reported in a prior-year tax filing. Wholly owned subsidiaries of an otherwise exempt entity are also excluded. Companies formed by Dec. 31 must initially file BOSS reports by Dec. 31, 2024, with companies formed starting Jan. 1, 2024, having 30 days to file — with changes due within 30 days. BOSS reports may be accessed by federal, state, local and tribal law enforcement, and by financial institutions with customer consent — but will not be publicly accessible, including by Freedom of Information Act request. Beneficial owners include persons with substantial control over — and those who directly or indirectly own 25% or more of — the company's equity. Every reporting company must report at least one person, and an owner's refusal to disclose may signal their noncompliance to the Financial Crimes Enforcement Network. Fines and penalties for nonreporting or false reporting can be steep. DAO Framework: A DAO is an association of persons represented in part by rules encoded as a transparent computer program, usually controlled by the association and not influenced by a central governance body, and blockchain technology managing the DAO by decentralized autonomous means — often including a proprietary digital asset. A DAO is set up by programing the organizational structure onto blockchain technology by smart contract, with preprogrammed code setting forth the decision-making structure and governance — and a smart contract often serving as de facto governing document. DAOs typically fundraise by issuing tokens allowing for voting rights to make rule changes and take action. DAO members may view transactions on the blockchain — including a timeline of contributions and use of funds — with tokens usually purchased on decentralized platforms or directly through peer-to-peer transactions. As of June, there were reportedly approximately 2.5 million active voting DAO members and almost 7 million DAO governance token holders worldwide. As of spring 2023, only Tennessee, Utah, Vermont and Wyoming recognized DAOs, with various other states considering legislation. Many DAOs form as Delaware LLCs, and state cooperative law statutes, e.g., in Colorado or New York, or alternative DAO structures, such as benefit LLCs, also may provide a framework. As of 2022, the Republic of the Marshall Islands approved legislation recognizing DAOs as LLCs. Other popular countries for DAOs include the Bahamas, British Virgin Islands, Cayman Islands, Gibraltar, Liechtenstein, Panama, Singapore and Switzerland. DAOs' challenges, constraints and risks include those relating to: Governance; Intellectual property ownership; Contract enforceability; Infrastructure and scaling; Proper taxation and procuring insurance; Application of bankruptcy, insolvency and securities rules and antitrust; Fraud and error; Cryptocurrency risks; and Dealing with know-your-customer and anti-money laundering rules. How the CTA May Apply To and Affect DAOs: The CTA assumes that a reporting company is a legal entity with a system of beneficial ownership and governance that a DAO may not possess. Traditional partnership-based DAOs will not fall within CTA purview, but those DAOs subject to traditional state formations are considered legal entities in DAO legislation states and will need to consider CTA compliance. CTA reporting requirements will be particularly burdensome for DAOs given their structure and framework — i.e., DAOs lack managers, directors or officers — so each member, and not the DAO as an organization, may need to determine whether they have substantial control or own 25% of the DAO. A DAO that is a state-law, member-managed LLC would require each member to file a BOSS report. The CTA prohibits blank stock and anonymous reporting company ownership, in direct opposition to DAOs' compelling feature of anonymity. The Financial Crimes Enforcement Network has provided nontraditional entities with advice that substantial control includes control exercised in novel and less conventional ways, advising that control could apply to varying and flexible governance structures such as DAOs — for which different control indicators may be more relevant. While the Financial Crimes Enforcement Network is unsure of how the CTA applies, the CTA applies to state-formed DAOs nonetheless. The CTA does not address certain DAO-specific matters such as whether membership by token ownership is beneficial ownership for CTA purposes. Realistically, without directors and officers, DAOs will have trouble naming compliance personnel. Wrapping DAOs into traditional structures has exposed DAOs to reporting requirements and compliance protocols, now expanding to include CTA compliance. Using traditional DAO parameters to regulate nontraditional businesses may be incompatible with DAOs' innovative and changing nature and autonomy. DAOs required to be CTA compliant will need to monitor CTA guidance as the rollout continues. A state-registered DAO may have easier CTA compliance or may lack personnel to track CTA requirements, but be expected to track them nonetheless. Wrapped-entity DAOs should set up CTA compliance protocols — including point persons — and track ongoing compliance. Since DAOs operate through the blockchain and smart contracts, structuring a DAO to adopt CTA-disclosure procedures may be unrealistic. Traditional DAOs operated as common law partnerships do not face CTA exposure, whereas DAOs operated as or through entities established through state law filings must be CTA-compliant. The inherent characteristics of DAOs and blockchain technology will make CTA compliance challenging. Takeaways: As the CTA rollout ramps up in late 2023 and in 2024, many questions likely will arise as to how DAOs that are wrapped or state-registered should properly comply with the CTA. We would expect the Financial Crimes Enforcement Network to issue more guidance as to the application of the CTA to DAOs as the CTA rollout continues. In the meantime, the CTA rollout could lead states to slow their efforts to pass DAO-related legislation pending a better understanding of the interplay between the CTA and state-registered DAOs. Because DAOs are traditionally self-governed and self-regulated by their participants, burdensome CTA compliance requirements and rigid state regulation may further incentivize self-regulation in the DAO industry. DAOs also may be driven away from registering — or staying registered — in U.S. states if their status imposes reporting obligations with which they cannot legally comply. The CTA's compliance requirements may further the perception of the U.S. as an unfavorable environment for blockchain and DAOs, pushing DAOs toward registering or focusing operations in countries with laws that are perceived as more welcoming. In upcoming months, in anticipation of the CTA's effectiveness, proper DAO formation will require sophisticated formation and operational advice that is mindful of CTA compliance and potential pitfalls. *This article first appeared on Law360.

Listen to Counsel Robert Lamb discuss the current and new laws for cryptocurrencies and how to decipher them.

In the generally opaque emerging world of “DAOs”, a rare public dispute recently played out between the Web3 investment group Yield Guild Games (“YGG”) and Merit Circle DAO, a decentralized autonomous organization, or “DAO”, from which YGG had purchased certain “tokens” relating to the governance and purpose of the DAO. The parties to the dispute released a joint statement (available here) which seems to resolve the issue amicably, but the alleged facts underlying the dispute bring up important considerations for purchasers of tokens and related instruments issued by DAOs. Background on DAOs A decentralized autonomous organization, or a “DAO,” is an “organization” encoded as a transparent computer program, controlled by the organization members, and not by a central corporate entity. Certain legal considerations regarding the structuring of DAOs are discussed in a prior BitBlog post available here. In many cases DAOs, or supporting organizations active in the formation of DAOs, are funded through simple agreements for future tokens (or “SAFTs”). In a SAFT, an investor agrees to invest capital (often to fund initial costs for start-up of a DAO or the development of a project to which the DAO relates), and in return the investor is promised an allocation of the relevant “tokens” that govern the DAO or are to be used in its related platform. As the term implies, a SAFT is an agreement for future tokens. In any SAFT, the tokens would not be released to the investor until such time as the tokens are minted or there is otherwise a time that the tokens are formed and publicly released, often called a token generation event. Additionally, SAFT tokens are typically subject to a lock-up period where no tokens are issued until sometime after the token generation event. Even after the full lock-up expires, the tokens are usually gradually released, to the SAFT buyers, over the course of a vesting schedule. These lockups and vesting schedules frequently are in place both for legal compliance purposes and to prevent the market from being flooded with DAO tokens that could make DAO governance prone to manipulation, misalign the incentives of DAO participants, or adversely affect the price of DAO tokens. Sometimes, SAFT investors are intended to receive their tokens before complete governance of a project, or its associated tokens, are shifted to a DAO. In others, such as this instance, governance migrated to DAO members before the initial investors received their tokens and, accordingly, before they were able to vote those tokens, even though their initial investments helped seed the DAO community. YGG and Merit Circle Dispute In October 2021, YGG announced it was investing or had invested $175,000 in Merit Circle, a decentralized autonomous organization (DAO) focused on Web3 gaming. This reportedly entitled YGG to 5,468,750 Merit Circle DAO tokens, which were to unlock and begin linear vesting in May or June of 2022. At some point after that investment, the governance of Merit Circle DAO was turned over to the holders of Merit Circle DAO tokens. That DAO’s particular governance mechanisms are described in further detail here. On May 20, 2022, a community member submitted a proposal (“Proposal 13”) which it summarized as “[t]his proposal aims to demonstrate the lack of value YGG has provided the DAO since becoming a seed investor. It also aims to cancel YGG’s SAFT, refund their initial investment, and remove their MC seed tokens.” This led to a public community debate (available for review in the above proposal link) on the merits of the proposal. In the end, the community voted to approve the proposal with a clause allowing for time “for Merit Circle ltd and YGG to propose a solution that would be more beneficial for the DAO and all parties involved in case of a YES vote.” Proposal 13 set the price at $175,000 to “have their seed investment refunded, and their MC seed tokens returned to the DAO.” At the time of Proposal 13, Merit Circle’s token ($MC) was trading at around $1.00. After Proposal 13 passed, an additional proposal (“Proposal 14”) was submitted and passed, which proposed “Merit Circle DAO buys out the YGG and Nifty Fund allocation, a total of 5,468,750 $MC tokens at $0.32. For a total of $1,750,000 USDC.” This was also voted on and passed. While this amount was significantly greater than the $0.032 per token for which YGG purchased the tokens under the SAFT, it was also less than the amount for which the tokens were trading on the open market at the time, though discounts due to illiquidity of the tokens could be reasonably expected. In their joint statement, YGG and Merit Circle Ltd. (the entity which formed the DAO but allegedly was no longer in control after hand-off to community governance) stated: We both recognized the arbitrary nature of the MIP-13 proposal and the danger a precedent like this could set for the Merit Circle DAO and the industry as a whole if agreements are not upheld and investors are not respected. The chosen tool was too crude and did not do justice to prior agreements. The divergence between the prior agreement and the DAOs proposal would have likely led to legal action against Merit Circle Ltd. While the legal question is one that could probably be argued at length, both parties agreed it was better to settle. This would spare both parties from a costly, time-consuming legal process with uncertain outcomes. None of the parties had to settle, but both parties chose the constructive path to help Merit Circle move forward. While this joint statement and associated agreement likely settles the dispute between the parties, it brings up a valuable lesson for future investors into DAOs. Lessons from YGG and Merit Circle Dispute It is fairly common for early investors to DAOs or other similarly decentralized organizations to have their allocated tokens vest only after organizational governance has been handed over to the community. A purchaser of a SAFT may not even know, at the time the SAFT is sold, what entity or organization ultimately will issue the tokens, or what functionality the tokens will eventually have. While this is not always inherently problematic, it requires significant trust and can lead to situations like this where by the time the tokens are in the hands of the SAFT buyer, there is a divergence between the interests of the early investor and the community running the DAO. The SAFT is in many ways inspired by the simple agreement for future equity, or the “SAFE” commonly used by early-stage venture capital investment in more traditional businesses. While, similar to a SAFT, the traditional form of SAFE is designed to provide no guarantees that equity eventually will be issued to investors, SAFE issuers rarely choose to breach the agreement and not issue the equity provided that the conditions to the grant of the equity are met. If the issuer were to blatantly breach the agreement, it is likely that the issuer would suffer severe financial and other repercussions. An investment in a DAO has some inherent differences regarding enforcement and governance from traditional investing. Because of a DAO’s decentralized nature and the difficulty of getting DAO members informed, there is a risk that members of a DAO could choose to breach a contract or even break the law without fully knowing the consequences. In more traditional early-stage investments a jilted investor is less likely to settle for pennies on the dollar because the investor can sue the issuer for breach of contract. However, when a DAO is involved, locating the correct entity or individuals to sue can be difficult, as seen in the Sarcuni v. bZx DAO, 22-cv-00618 (S.D. Cal. 2022) litigation. This is especially true when many otherwise anonymous DAO members could be unlocatable or even possibly insolvent if a lawsuit was brought, and thus have limited financial incentive not to breach. To prevent this type of abuse, investors or DAO sponsors may wish to place a limit in the DAO’s governance smart contract which prevents certain types of actions from being voted on or approved. If that happened, the community would not have complete control over the organization, limiting their ability to take full advantage of “efficient breach” where it makes financial sense to breach contracts in certain situations. It also could be seen as curtailing a core ethos of a DAO, which is that that members have full control over its destiny. However, such a limitation could give initial investors the peace of mind that they cannot be later cut out of the fruits of their investments right before they become ripe. This dispute is a reminder to investors to perform their due diligence into the risks they face when investing in DAOs, where enforcement and governance is a work in progress, and in particular to be cautious in situations where token control is intended to be handed over to the community prior to the investor receiving its agreed-upon tokens. While DAOs are an exciting new form of corporate governance with many potential upsides regarding transparency and ownership by participants, disputes like this can be expected as DAO investors and contributors navigate the Web3 intersect between code-is-law and various jurisdictional and contractual laws.

Thoughts on Recent SEC statements and Action on Enforcement Related to Decentralized Autonomous Organizations (DAO) On November 10, 2021  the US Securities and Exchange Commission (the SEC) announced that it had halted the first ever attempt to register digital tokens issued by a decentralized autonomous organization (DAO) under the US federal securities laws. American CryptoFed – also the first DAO to take advantage of Wyoming’s new “DAO Law” that attempts to give DAOs legal status – filed Form 10 and subsequently filed a Form S-1 in an effort to register its digitals assets in the form of two coins designed to operate in tandem issued under the names Locke and Ducat. A DAO is an organization encoded as a transparent computer program, controlled by the organization members and not by a central corporate entity, often through a governance token utilized on a blockchain. In the SEC’s announcement, they alleged that the registration statement filed by American CryptoFed contained a number of deficiencies, including purportedly misleading statements such as claims that the tokens were not intended to be securities and may be distributed on the form of registration statement used for registration of securities under an employee benefit plan.  Perhaps just as importantly, the registration statement failed to provide substantive information about the issuer as is required to be disclosed in the form, such as information regarding its business, management, and financial condition. One telling example of the deficient information concerns the issuer’s ownership structure, which a pure DAO would be unable to produce by its very nature of being a DAO. This highlights several issues with being able to register DAO-issued tokens under the current regulatory framework.  The SEC disclosure forms rightly require financial statements and business information regarding the issuer.  That said, a DAO is not really an entity.  There often is a supporting entity in place alongside a DAO, and in some instances an organization that isn’t really decentralized may be mislabeled as a DAO, but the DAO itself in almost all circumstances would not be able to produce financial statements prepared in accordance with generally accepted accounting principles.  If the DAO does not have a definable business and truly is decentralized, then there may not be a management structure for which information can be provided.  Further, depending on the circumstances, the financial condition of a DAO may be of limited relevance to holders of the tokens, particularly if there truly is a level of decentralization that would allow the project to move forward even if the ‘entity’ sponsoring the token were to collapse (or the financial statements of the issuer could be looking at the wrong thing if the treasury of the DAO is not housed in that entity).   Simply put, this action implies that it will be difficult if not impossible for true a DAO to register its tokens under the current regulatory framework, even if it sets itself up in a way to attempt robust compliance. Avoiding the Line and Counsel? Any spurt of innovation, particularly the one we are experiencing now with decentralized finance and DAOs, will test the boundaries of existing regulation and hopefully lead to regulatory flexibility and updated regulations. For this reason, a recent statement by SEC Chair Gensler could use additional clarification.  On November 4, 2021, a few days before the American CryptoFed halt, at the first SEC Enforcement Forum since he became Chair, Gensler laid out a number of enforcement directives of the SEC, putting an emphasis on a the economic reality of a transaction regardless of what form it is in. In particular, he emphasized that terms such as “decentralized finance” (DeFi), “currency,” or “peer-to-peer lending” should not be taken at face value without looking at what the transaction is really doing. While it is important to understand the spirit of the law and never act fraudulently regardless of the law, the role of legal counsel is to help clients work within the law, even if it is near the boundary of the law. Gensler’s statement - “if you’re asking a lawyer, accountant, or adviser if something is over the line, maybe it’s time to step back from the line” – has the potential to deter entrepreneurs from seeking counsel and encourage haphazard action. While a measure of caution is not undue, it does have the potential to stifle innovation. This is after all a new frontier of finance where advances are made in the margins often by those who get there first. Consulting with responsible counsel is something that any innovator should be encouraged to do. Seemingly discouraging innovators from seeking counsel, and asking those who are trying to be responsible and comply with the law to not even attempt to do so, would only increase the prevalence of bad actors, exposing all parties - including investors - to the very risks that regulators are trying to avoid. Rulemaking Under Any Other Name… A few days after Chair Gensler’s statement, Gurbir Gruwal, the new Director of the Division of Enforcement gave prepared remarks discussing the role of that Division.  The remarks were largely a defense against the assertion that, with respect to the crypto industry, the SEC has been “regulating by enforcement” rather than creating new regulation.  Mr. Gruwal gave three examples to show how the Division’s Cyber Unit’s enforcement of digital assets actions are enforcing existing laws and not creating new law.  The first example he gave was the Kik ICO, followed by a recent Ponzi scheme that claimed to use DeFi but did not actually support a DeFi network and, last, the BitConnect project that also was long thought to be a Ponzi scheme.  While there was not complete consensus within the digital asset legal community about how Kik’s KIN token would be treated for federal securities law purposes, the latter two were blatant frauds of what would have obviously been securities, had they existed at all. Selecting those straightforward examples out of hundreds does not mean that there haven’t been other enforcement actions in areas where the law was quite unsettled. While the Division of Enforcement is doing a lot of great work, the speech shows that there is a fundamental misunderstanding of the industry’s frustration over “rulemaking by enforcement.” Rather than coming out with new regulations that provide somewhat bright lines, one must wade through a gallimaufry of enforcement actions, press releases, risk alerts, and speeches to determine the current state of the law. Even then, there is a wide gulf between what the SEC has endorsed and publicly warned against with any level of specificity.  In the nearly 10 months since the current administration took office, there have only been a small handful of new proposed rules and only in the last week have any new substantive regulations been approved.  “Rulemaking by enforcement” is really shorthand for the lack of clear, concise guidance needed for those who want to comply with the law to actually comply with the law.  This particularly rings true for aspects of many blockchain technologies that are fundamentally incompatible with existing regulations, even if they are compatible with the spirit of the law.  The SEC Staff has announced that it will try to tackle this problem with respect to the Advisers Act “Custody Rule” by modernizing it, but it does not appear that any other meaningful regulation relating to digital assets or decentralized finance is on the horizon. Maybe the SEC should also consider a framework under which a DAO or a supporting organization of a DAO can register securities, particularly as the discussion regarding regulation of stablecoins and DeFi starts to heat up. The prepared remarks close out as follows: “This is not “regulation by enforcement.” This is not “regulation by enforcement.” This is not “regulation by enforcement.” There. I have said it thrice and what I tell you three times is true.” This is (not) regulation by speechmaking at its finest.