Dawn of the DAO
Australian securities law and the second wave of blockchain innovation
A revolutionary asset class cumulatively worth billions of dollars has emerged from the deep web and Australian regulators aren’t ready
[Please note: this was published back in 2016 before the “Bitcoin Bubble” which prompted regulators to provide clarity on the operation of the law in this area. It has not been updated and as such is unlikely to present an accurate depiction of the current regulatory landscape]
Commenting on the laws inability to keep pace with advances in medical science, Justice Windeyer of the High Court of Australia remarked that the law is “marching with medicine, but in the rear and limping a little”.[1] As the world embraces the second wave of blockchain innovation, I would argue that the law is crawling behind on all fours and losing ground.
Self-executing smart-contracts operating within an increasingly advanced online economic eco-system powered by blockchain technology are creating exciting opportunities and unique legal challenges. The Decentralised Autonomous Organisation (“DAO”) epitomises both. Whilst considerable column inches are devoted to blockchain and the efficiency gains to be realised by established incumbents, far less attention has been given to the rise of the DAO and whether the Australian legal system is adequately equipped to accommodate it.
Building blocks
Before we continue, those new to blockchain may wish to familiarise themselves with some foundational concepts/terms.
The Decentralised Autonomous Organisation
When you strip everything back, a company is essentially a complex interconnected web of contracts, (employment contracts, licensing agreements, debt and equity arrangements etc). With increasing precision, contracts and processes can be encoded to self-execute on the occurrence of predefined triggers. When layered across the blockchain — which provides certainty and security — these so-called smart-contracts can create self-sustaining online entities without a recognised legal personality and unbound by jurisdictional limitations; popularly referred to as DAOs.
The term DAO was coined by Ethereum founder, Vitalik Buterin, back in 2014.[3] Whilst he distinguished Decentralised Organisations (humans interacting with each other in accordance with an encoded protocol enforced on the blockchain) and Decentralised Autonomous Organisations (entities making decisions independent of human input), the term DAO is often used as a catchall to refer to any blockchain-based entity where ‘corporate governance’ and participation is dictated by precoded rules.[4]
The term DAO may indeed be a misnomer, as Coinbase Founder Fred Ehrsam explains that they are really “decentralised software protocols” that allow a group of people on the internet to collaborate on a specific problem or project.[5] The applications of the model are largely confined to organisations that rely on network participation, with distributed ownership and control incentivising people to contribute to or adopt a network technology. An accessible analogy would be a Facebook or Twitter operated on a distributed network that allows its users to vote on new features by expending crypto-tokens (“tokens”) they have acquired from past network participation.[6] Ehrsam theorises that businesses based on network effects “will start to be built decentralized first”.[7]
Through the issuance of crypto-tokens, DAOs are able to create their own self-contained economic systems. These blockchain based assets can serve a variety of functions: providing access to a network, operating as a form of internal currency or providing token holders with profit-share or voting entitlements. Crypto-tokens are freely transferrable and their price may fluctuate over time, in a manner not dissimilar to company shares. Many DAOs have raised significant amounts of capital to fund further development by creating and selling these tokens.[8]
What follows is a consideration of the status of these tokens under Australian securities law as well as broader questions of liability. Please note that neither crypto-tokens nor the entities that issue them are homogenous and the application of Australian legal principles will be complex and fact-specific. None of the information below should be construed as legal advice.
Crypto-tokens
Crypto-tokens defy simple categorisation, with their function limited only by the imagination of their creator and the technical constraints of the blockchain on which they operate. However, they can be broadly categorised as either User Tokens or Equity Tokens.
User Tokens
User tokens are effectively digital currency used to access network services, with Albert Wenger likening them to ride-tokens at a fair ground.[9] DAOs are designed to require these tokens as a metaphorical ‘fuel’. Some examples include:
Ethereum — a distributed network with a built-in flexible programming language allowing smart-contracts to be encoded into its blockchain. Individuals can acquire Ether tokens by contributing computing power to process transactions.[10] Conversely, those running smart-contracts on the network are required to pay for the privilege. Ethereum originally raised USD $18m in Bitcoin when it first released its tokens to the public.[11]
Steemit — a media democratisation platform, similar to Reddit, that aims to build a decentralised media network by incentivising contribution and participation.[12] Members receive Steem tokens for ‘upvoting’ good comments/content and contributors who are ‘upvoted’ are similarly rewarded.
Equity Tokens
Equity tokens provide a level of ownership or control over a DAO but are not required to access services provided by the network. Equity tokens are often sold to finance network development. In exchange for their contributions, token holders are entitled to “dividends” in the form of profit sharing or transaction fees and often have conditional rights to submit and vote on proposals. Some examples include:
“The DAO” — effectively a managed fund that took contributions from investors (in the form of Ether) in exchange for transferrable DAO Tokens which provided voting rights and represented units in the fund. Token holders could put forward proposals to invest contributions in various blockchain-based companies or projects; these were then voted on by other participants.[13] “The DAO” attracted considerable attention after it raised the equivalent of USD$168 million.[14] Its spectacular rise was eclipsed only by its fall. On 17 June 2016, a weakness in “The DAO’s” code was maliciously exploited by a hacker who was able to drain a considerable amount of “The DAO’s” funds.
DigixDAO — a system for the tokenisation and documentation of physical assets. The system utilises two types of tokens, Digix Gold Tokens (DGX) that are tied to underlying physical gold and DigixDAO Tokens (DGD) that entitle holders to voting rights and a share in DGX transaction fees.[15] Singapore based company Digix Global is currently paid by the DAO to develop the Digix network.[16] In March 2016, the DGD crowdsale raised $5.5 million worth of Ether in just 14 hours.[17]
Australian Securities Law
Australian securities law largely mirrors the approach in the United States. However, where the US Securities Act of 1933 progresses on a broad definition of ‘security’, the Australian Corporations Act 2001 breaks things up into ‘financial products’ and ‘securities’ (shares and debentures).
User or Equity tokens issued by a DAO may amount to an offer of securities, a financial product or an interest in a Managed Investment Scheme (a type of financial product). The regulatory consequences that follow will depend on their categorisation.
I note that in a submission to the ‘Senate inquiry into digital currency’ in December 2014, ASIC stated that it did not consider Bitcoin or ‘digital currencies’ to be financial products and that licenses are not needed to trade or hold them.[18] However, in the past two years we’ve seen the rise of Ethereum and the Decentralised Organisation as part of the second wave of blockchain innovation. New regulatory guidance is required to accommodate these new and varied crypto-assets, for which ‘digital currency’ is far too narrow a description.
1. Securities (shares and debentures)
Under section 92 of the Corporations Act, a security includes shares in, or debentures of, a body. A body is broadly defined as “a body corporate or an unincorporated body and includes, for example, a society or association”.[19] An offer of securities is prohibited in Australia without a product disclosure statement (“PDS”).[20]
User Tokens
Equity Tokens
2. Financial Products
The term financial product refers to a facility through which a person makes a financial investment.[27] The necessary characteristics of a financial investment can be summarised: (1) an investor gives money or money’s worth to another person; (2) the contributions are used to generate or with the intention of generating a financial benefit/return; (3) the investor has no day-to-day control over the use of their contribution.[28]
Anyone who carries on a financial services business in Australia, including dealing in or advising on financial products, is required to hold an Australian financial services licence, unless and exemption applies in s911A(2) of the Corporations Act. An offer of a financial product must generally be accompanied by a PDS, containing such information as might reasonably be expected to have a material influence on a decision to acquire the product.[29] The Corporations Act establishes strict liability for false or misleading statements made in a PDS.[30]
As we will see, crypto-tokens cannot easily be pressed into the definition of a financial product and DAOs may fall outside the scope of Australian financial regulation.
User Tokens
Equity Tokens
3. Managed Investment Schemes
An interest in a Managed Investment Scheme (a type of financial product) requires an additional characteristic, namely that contributions are pooled or used in common enterprise.[39] Such schemes are subject to further compliance requirements under Chapter 5C of the Corporations Act.
User Tokens
Equity Tokens
Who’s liable?
In the event that a crypto-token falls within definition of a security or financial product, Australian financial services regulations may apply. The ASIC regulatory guide on Offers of Securities on the Internet makes it clear that in the absence of clear disclaimers and barriers to access, an online offer with the potential to impact Australian investors would be regulated by ASIC.[41] However, as we are dealing with an entity that operates wholly on the blockchain, without a recognsied legal personality, attributing liability requires a level of creativity.
The original coders of the DAO or associated entities (such as the non-profit Ethereum foundation or Singapore based company Digix Global) could be considered issuers of financial products or ‘promoters’ (advertisers of financial products or providers of advice services) under the existing law, giving rise to various statutory liabilities. These include the requirement to obtain an Australian Financial Services License[42] and an obligation to provide a PDS.[43] They would also be subject to a general prohibition against misleading or deceptive conduct[44] or unconscionable conduct.[45]
It is worth noting that entities such as brokers, agents or online exchanges that deal in, make available or otherwise circulate, distribute or disseminate these crypto-tokens would be subject to the same statutory liabilities.[46]
If tokens are not considered securities or financial products, Australian consumer laws may apply;[47] with broad application to all persons carrying on business within a State or Territory (regardless of whether the conduct occurs inside or outside Australia).[48] Original coders, associated entities or those dealing in crypto-tokens would be subject to similar duties not to engage in misleading or deceptive conduct,[49] unconscionable conduct[50] or unfair contracts.[51] Misconduct may also expose them to liability in equity (fiduciary duties, equitable fraud etc) or tort (negligence, misrepresentation etc).
Creators and promoters of DAOs often rely on ineffective disclaimers in an attempt to waive their liability. For example, “The DAO” website claimed:
“The terms of The DAO Creation are set forth in the smart contract code existing on the Ethereum blockchain at 0xbb9bc244d798123fde783fcc1c72d3bb8c189413. Nothing in this explanation of terms or in any other document or communication may modify or add any additional obligations or guarantees beyond those set forth in The DAO’s code…”[52]
Such disclaimers are impotent as you cannot waive your obligations under Australian securities or consumer law.
Looking ahead
An assessment of the DAOs place within the current Australian legal framework certainly raises more questions than answers. However, this brief excursion to the frontier of blockchain technology has demonstrated that existing financial regulations cannot easily be moulded around the varied and mutable forms of the Decentralised Organisation. Even if a legitimate cause of action could be established against the original coders, associated entities or promoters of a DAO, enforcing a judgment remains a complex and costly process. The implicated parties are possibly anonymous, probably in a foreign jurisdiction and almost certainly unaware of their obligations under Australian law.
We are witnessing the dawn of the DAO; the rise of an online economic eco-system where code is law. Maintaining any semblance of centralised control across the decentralised network will require an international and collaborative response.
References:
[1] Mount Isa Mines v Pusey (1970) 125 CLR 383, 395 (Windeyer J).
[2] Peter Van Valkenburgh et al, ‘Distributed Collaborative Organisations’ (Investigative Report, Coin Center) 8.
[3] Vitalik Buterin, ‘DAOs, DACs, DAs and More: An Incomplete Terminology Guide’ on Ethereum Blog (6 May 2014)
[4][7][10][11] Fred Ehrsam, ‘App Coins and the dawn of the Decentralized Business Model’ on Coinbase, Stories From Coinbase (2 August 2016)
[5] Ibid.
[6] Peter Van Valkenburgh et al, ‘Distributed Collaborative Organisations’ (Investigative Report, Coin Center) 5.
[8] Ibid.
[9] Albert Wenger, ‘Cryptotokens and the Coming of Age of Protocol Innovation’ on Continuations (28 July 2016)
[12] Steemit Inc.(2016)
[13] David Harrison, ‘Decentralized Autonomous Organizations’ (Report, Allen & Overy LLP, 16 May 2016) 4.
[14] Ibid 2.
[15][17] Lawnmower (2016)
[16] Demian Brener, ‘On Tokens and Crowdsales’ on Zeppelin (13 August 2016)
[18] Australian Securities and Investment Commission, Submission No 44 to Senate Economic References Committee, Senate inquiry into digital currency, December 2014, 12.
[19] Corporations Act 2001 (Cth) s 9.
[20] Ibid s 706.
[21] Paul Redmond, Corporations and Financial Markets Law (Thomson Reuters (Professional) Australia, 6th ed, 2012) 126.
[22] Ibid.
[23] Ibid.
[24] Corporations Act 2001 (Cth) s 9.
[25] Ibid s 57A.
[26] Paul Redmond, Corporations and Financial Markets Law (Thomson Reuters (Professional) Australia, 6th ed, 2012) 126.
[27] Corporations Act 2001 (Cth) s 63A.
[28] Ibid s 763B.
[29] Ibid ss 1013E, 1012A
[30] Ibid ss1041E, 1041H, 1041I.
[31] s 763A of the Corporations Act 2001 provides that “a facility does not cease to be a financial product merely because the facility has been acquired by a person other than the person to whom it was originally issued.”
[32] Corporations Act 2001 (Cth) s 763B.
[33] Ibid s 763B.
[34] Ibid s 763A.
[35] s 763E of the Corporations Act 2001 provides that a product may not be a financial product if financial benefit/return is incidental.
[36] Demian Brener, ‘On Tokens and Crowdsales’ on Zeppelin (13 August 2016).
[37] s 763A of the Corporations Act 2001 provides that “a facility does not cease to be a financial product merely because the facility has been acquired by a person other than the person to whom it was originally issued.”
[38] Corporations Act 2001 (Cth) s 763B.
[39] Ibid s 9.
[40] Ethereum Foundation, Ethereum Foundation (2016) Ethereum Homestead Documentation
[41]REG 141.5 Australian Investment and Securities Commission, Offers of securities on the internet, RG 141, 2 March 2000, RG 141.5.
[42] Chapter 7 of the Corporations Act 2001 requires an entity to hold an AFSL if the entity carries on a business involving the provision of a financial service. Financial services are defined in the Act under s766A and include providing financial product advice.
[43] Corporations Act 2001 (Cth) ss 1012A, s1012C.
[44] Australian Securities and Investments Commission Act 2001 (Cth) s 12DA(1); Corporations Act 2001 (Cth) ss 1041I (False or misleading statements), 1041H (misleading or deceptive conduct), 1041I (civil cause of action).
[45] Australian Securities and Investments Commission Act 2001 (Cth) s 12CB; Corporations Act 2001 (Cth) s 991A.
[46] Corporations Act 2001 (Cth) s 766A.
[47] Apart from certain provisions relating to linked credit providers (ACL, ss 278 to 287), the ACL does not apply to the supply or possible supply of financial services or financial products: Competition and Consumer Act 2010 (Cth) s 131A.
[48] Fair Trading Act 1992 (ACT) s 11; Fair Trading Act 1987 (NSW) s 32; Consumer Affairs and Fair Trading Act (NT) s 31; Fair Trading Act 1989 (Qld) s 20; Fair Trading Act 1987 (SA) s 18; Australian Consumer Law (Tasmania) Act 2010 (Tas) s 10; Fair Trading Act 1999 (Vic) s 13; Fair Trading Act 2010 (WA), s 24.
[49] Competition and Consumer Act 2010 (Cth) sch 2 pt 2–1.
[50] Ibid pt 2–1.
[51] Ibid pt 2–3.
[52] Dao.link Sarl (2016)
