Not Legal Advice, 9/16/19: Crypto taxes, systemic risk in DeFi, and Section 230

Welcome back to the second installment of Not Legal Advice, my new newsletter-thing I publish every week where I discuss three (3) items of interest from the prior week in crypto or crypto-adjacent technology law.

Because it’s happened twice, now, it’s a tradition. Traditions are warm and fuzzy and wholesome. So gather ’round the fireside, little marmot friends, and let’s have a conversation about what happened last week, and why it’s relevant going forward:

  1. France won’t tax shitcoin trades (also they are going to ban Libra from Europe)
  2. A company called “Staked” creates the “Robo Advisor for Yield,” or as I like to call it, the “Risk Mega Enhancer”
  3. The Second Circuit Court of Appeals finds that Section 230 of the Communications Decency Act is, indeed, as broad as its detractors claim

1) France won’t tax shitcoin trades (also they’re going to ban Libra)

According to official pronouncements from the French economic ministry:

  • Cryptocurrency transactions aren’t going to be subject to VAT.
  • Cryptocurrency trading activity won’t give rise to a tax charge until the crypto is traded out into fiat.

Three things limit what I can say about the French rules.

First, my French is not very good.

Second, I’m not a French avocat, which in French means both “male lawyer” and “avocado.”

Third, even in the two countries (America and England) where I am an avocado, I am not a tax avocado.

It suffices to say that France’s treatment of cryptocurrency trading income and gains differs from the tax treatment in England and the U.S. The English guidance makes it clear that trading gains are either income or capital gains, depending on whether the so-called badges of trade are present. In practice, HMRC guidance tells us that it is likely that capital gains tax would apply:

Only in exceptional circumstances would HMRC expect individuals to buy and sell cryptoassets with such frequency, level of organisation and sophistication that the activity amounts to a financial trade in itself. If it is considered to be trading then Income Tax will take priority over Capital Gains Tax and will apply to profits (or losses) as it would be considered as a business.

and what constitutes a chargeable asset for Capital Gains Tax purposes?

Cryptoassets are digital and therefore intangible, but count as a ‘chargeable asset’ for Capital Gains Tax if they’re both… capable of being owned… [and] have a value that can be realised.

And what events give rise to the charge?

Individuals need to calculate their gain or loss when they dispose of their cryptoassets to find out whether they need to pay Capital Gains Tax. A ‘disposal’ is a broad concept and includes… selling cryptoassets for money[;] exchanging cryptoassets for a different type of cryptoasset[;] using cryptoassets to pay for goods or services [; and] giving away cryptoassets to another person[.]”

What about in the U.S.?

The sale or other exchange of virtual currencies, or the use of virtual currencies to pay for goods or services, or holding virtual currencies as an investment, generally has tax consequences that could result in tax liability…

…For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.

It’s obviously more complicated than that, but you get the general gist. Speak to a tax avocado if you have further questions.

Oh, and Americans, one of the great things about being American is that the warm, loving embrace of the United States is always with you wherever you may be on this or any other world – as all the dual-nationals I know joke, “we keep the U.S. passport as it means we have a seat on the last helicopter out.” Yes, that’s how much Americans with EU passports trust European voters.

The price you pay for that privilege is that America always taxes you on your worldwide income wheresoever you may be. So don’t think that you can move to France, offload all that premined Ether you’ve been sitting on for years into BTC and avoid the tax hit. Speak to a skeptical and conservative American tax avocado first.

Also, good on France for saying it won’t permit Libra to operate in Europe, as currently proposed.

2) Robo Adviser For Risk

The only thing I like less than DeFi is a DeFi bro.

Lately a number of offerings have sprung up offering staggering, double-digit rates of interest for cryptocurrency holders who are willing to commit their savings to crypto-first lending institutions who then claim they have profitable lending businesses on the other end of the transaction. In a low- to negative-interest-rate environment, everyone everywhere is trying to figure out where they can find yield and, accordingly, where they can make money.

The hope, the dream, is that crypto has magically solved this, has found its killer app, in the form of high yield interest-bearing accounts. From Balaji:

No offense, but I don’t buy it.

First, a number of these businesses – and there are more than one – will turn out to be Ponzi schemes. We don’t know which ones, but they’re out there.

Second, there is no such thing as a free lunch:

Third, there are those who argue that risk is not the driver of high rates and that some other black magic is at work. Let us examine this argument from the perspective of a borrower, who for present purposes we shall call Bob.

The ballad of Bob the Borrower

Sally Saver deposits 100 ETH with Lily Lender, who promises Sally Saver a 5% rate of interest on her deposit. Lily Lender now needs to get that 5%, plus enough to cover her expenses, from somewhere.

Ordinarily, that means that Lily Lender needs to make a loan to Borrower Bob at a rate of interest greater than 5%. You can’t run a lending business at a loss forever to gain marketshare and adoption unless you’re burning through venture funds to do so, as some of these businesses appear to be doing. BlockFi, e.g., has made it abundantly clear that it is taking a tech-company approach to developing a lending business:

We are OK with losing money for a while. If it was purely formulaic we probably wouldn’t have enough control to make sure it’s attractive enough to a large amount of people to hit our customer acquisition targets.

I don’t have an issue with that strategy, as long as the ledger balances out and BlockFi has enough spare VC firepower to satisfy its obligations. But we should not mistake this development, which is likely being mirrored by BlockFi’s competitors, for a fundamental change in the nature of risk. The risk hasn’t disappeared, it has simply been transferred onto the companies themselves, and they are paying for it in the form of a subsidy.

Subsidies, of course, have this pesky little problem that they eventually run out. When this happens, the risk that has been buried by them rears its head and begins to manifest itself in pricing. The likely result will be that the rates offered to savers will go down, and cost of funds will go up, and there will be a liquidity crunch among those who relied on them.

Speaking of which, who does rely on these liquidity facilities? Nobody really knows; it is this writer’s observation that crypto lending companies are extremely opaque about their lending operations, no doubt to gain an edge.

With interest rates at historic lows, however, we can probably guess that the people who are willing to pay north of 10% to borrow DAI are doing so either (a) because they have an interest in seeing Dai or related financial products succeed and are willing to absorb enormous losses to create the appearance of a thriving market, (b)  cannot obtain financing from literally any other source, or (c) in the case of over-collateralized loan protocol products like Dai, are seeking to obscure the source of their cryptocurrency wealth and are willing to absorb enormous losses to do so (by defaulting on the loan).

However, the fact remains: for every crypto loan product in existence, Bob the Borrower’s payments must be equal to or greater than Sally Saver’s returns in order for the product to be viable in the long term. 

Back to our regularly scheduled programming…

“Staked Automates the Best DeFi Returns With Launch of Robo Advisor,” trumpets CoinDesk. Staked has built a product…

Staked’s new Robo Advisor for Yield (RAY) service, which launches today, automates the process of finding high-yielding opportunities. Normally, investors have had to watch constantly and reallocate quickly to catch an enhanced DeFi return. Now they can set a smart contract to do the monitoring and allocating for them.

“This product is targeted to people who hold eth or dai and want to earn yield on it,” CEO Tim Ogilvie told CoinDesk in an interview. “If you hold ETH, you can earn more ETH. If you hold DAI, you can earn more DAI.”…

With RAY, investors can put their assets (ETH, USDC or DAI) into an asset-specific pool and the smart contract will automatically invest all or part of that pool into contracts with the best yield at any given time. For now, it will invest only on the money market Compound and with the derivatives protocols DYDX and BZX. But Staked is vetting additional smart contracts for safety and reliability.

“We’re not necessarily saying we are going to beat the market. We’re just saying you’ll get the best of what a savvy watcher would get in the market,” Ogilvie said.

“The vision we are building toward is the same level of sophistication the fixed income markets have in traditional finance,” he added.

I’m not going to lie, this is pretty cool, and offerings like it remind me of, e.g., crowdsourced or robo-offerings from companies like Betterment or eToro that have done very well.

But the reason I don’t like DeFi bros claiming they reinvented structured finance, as alluded to in my tweet above, is because I am a child of the Global Financial Crisis… and indeed I spent the first half of my career, in the throes of that crisis, working in structured finance. The great lesson of the crisis was that you cannot engineer risk out of transactions, you can only obscure it: this is the first law of conservation of risk, or as my friend Palley put it years ago, “The First Law of Lawmodynamics.”

The first law of thermodynamics says energy “cannot be created or destroyed. It can, however, be transferred from one location to another and converted to and from other forms of energy.” Maybe the same is so of liability and damages. You can’t destroy or avoid either by building a better mousetrap. You can only move it, or (arguably) move the consequences of that liability elsewhere.

There’s risk somewhere in crypto, waiting to get out. A combination of regulatory intervention and Ethereum going the way of MySpace are possible avenues. As the subprime crisis showed, even the most professional, Ivy League-educated, well-dressed “Savvy Watchers” won’t see it until it’s too late and everyone is running for the exits.

Don’t make the mistake of thinking that Staked – or any other DeFi company – is providing you with guaranteed risk-adjusted returns. They’re not, and anyone who thinks they are, had better steel themselves for a very unpleasant surprise.

rodent-3703660_1280.jpg
A marmot picture: to break up the monotony of a wall of text and get a marmot thumbnail on shared links. Distributed under the Pixabay Licence.

3) The Second Circuit Court of Appeals finds that Section 230 of the Communications Decency Act is, indeed, as broad as its detractors claim

This is more of a law nerd thing, so if you’re just here for the crypto, switch off.

Politicians hate Section 230 of the Communications Decency Act, 47 U.S. Code § 230, particularly Missouri Senator Josh Hawley. Who writes:

“With Section 230, tech companies get a sweetheart deal that no other industry enjoys: complete exemption from traditional publisher liability in exchange for providing a forum free of political censorship,” said Senator Hawley. “Unfortunately, and unsurprisingly, big tech has failed to hold up its end of the bargain.

That statement is half right. Section 230 grants a broad immunity from publisher liability for online platforms that engage in traditional publisher-like activities with regard to user-generated content. They do not have any obligation to provide that forum free from censorship; indeed, Section 230 expressly permits tech companies to engage in censorship more or less free from consequences.

Section 230 gives us two rules that are largely responsible for America’s success in building a thriving Internet economy. I explore Section 230 in detail here, but for present purposes it suffices to note that it essentially promulgates two legal rules: 

  • Platforms and users are not liable for content on their platforms that has been created by someone else (Section 230(c)(1)).
  • If a web app moderates any content off of their platform, i.e. it deletes it, and anyone sues them for doing so, the person suing the web app is going to lose (the Section 230(c)(2)).

The case is Force v. Facebook. Force brought

an action for damages against Facebook pursuant to the Antiterrorism Act (“ATA”) and related claims for having knowingly provided material support and resources to HAMAS, a notorious terrorist organization that has engaged in and continues to commit terror attacks, including the terrorist attacks that killed 29-year-old Taylor Force, 16-year-old Yaakov Naftali Fraenkel, three-month-old Chaya Zissel Braun, and 76-year-old Richard Lakin, and injured Menachem Mendel Rivkin, and the families of these terror victims.

The plaintiffs alleged:

HAMAS has recognized the tremendous utility and value of Facebook as a tool to facilitate this terrorist group’s ability to communicate, recruit members, plan and carry out attacks, and strike fear in its enemies. For years, HAMAS, its leaders, spokesmen, and members have openly maintained and used official Facebook accounts with little or no interference. Despite receiving numerous complaints and widespread media and other attention for providing its online social media platform and communications services to HAMAS, Facebook has continued to provide these resources and services to HAMAS and its affiliates.

Facebook has knowingly provided material support and resources to HAMAS in the form of Facebook’s online social network platform and communication services.

The plaintiffs provided numerous examples of anti-semitic Hamas propaganda on Facebook over a period of years in their extensive, 61-page complaint, which I will not republish here. Each plaintiff sought not less than $1 billion in damages plus attorneys’ fees.

The problem the plaintiffs faced in bringing this action is that Section 230 of the Communications Decency Act was standing in their way. Recalling the literal text of Section 230:

No provider or user of an interactive computer service shall be treated as the publisher or speaker of any information provided by another information content provider.

the burden was on the plaintiffs to demonstrate why Facebook should be treated as the publisher or speaker of Hamas’ content. The parties stipulated to the fact that Facebook was a “provider… of an interactive computer service.” The plaintiffs thus disputed:

  1. whether Facebook were “acting as the protected publisher of information” under Section 230(c)(1), i.e., it was providing some other infrastructure function that was not intended to be captured by Section 230(c)(1); and/or
  2. “whether the challenged information is provided by Hamas, or by Facebook itself,” because if Facebook is an information content provider, even in some small part (see Section 230(f)(3)), the Section 230 immunity falls away.

Facebook as protected publisher of information

At minimum, the Section 230(1) immunity is thought to apply to standard categories of speech torts such as harassment or defamation. It provides American Internet companies with a near-total defense from those claims. This is in contradistinction to the European jurisdictions such as, e.g., England, and Section 5(3) of that country’s Defamation Act 2013.

How does this work in practice? Well, let’s go back to our friend Bob Borrower from Item 2 and introduce a new character, Dan Defamer, Speech Villain Extraordinaire. Let’s also assume, arguendo, that everything that comes out of the mouth of Dan Defamer, Speech Villain Extraordinaire, isn’t protected speech according to the First Amendment.

If Dan Defamer says of Bob the Borrower, in a newspaper article, “Bob Borrower is a no-good scalliwag who does not pay his debts,” Bob the Borrower may sue Dan Defamer and the newspaper for publishing the lie (whether he will win is another matter). If, however, Dan Defamer logs on to Twitter and repeats the lie there, in the plain and ordinary meaning of the term “publisher” Twitter is a publisher as much as the newspaper is. However, it is generally understood that Twitter is not, under U.S. law, treated as the publisher of the statement and therefore is not liable for its content. Twitter is not even under a legal obligation to remove it. Dan Defamer is the speaker and it is he who is liable for the consequences of the speech.

The question presented in Force is a slightly different one, though. Rather than challenging Section 230 for speech which is itself tortious, it attempts to attack Section 230 collaterally by alleging that Facebook’s provision of an online platform, which Hamas the terrorist group then accessed, meant that Facebook itself played a role in facilitating terrorism and, accordingly, was liable to pay damages to the plaintiffs under a specific federal law which provides that victims of terrorism can seek compensation from companies that commit, or aid, abet or conspire to commit, international terrorism:

By providing its online social network platform and communications services to HAMAS, Facebook violated federal prohibitions on providing material support or resources for acts of international terrorism (18 U.S.C. § 2339A), providing material support or resources for designated foreign terrorist organizations (18 U.S.C. § 2339B), and financing acts of international terrorism (18 U.S.C. § 2339C), and committed acts of international terrorism as defined by 18 U.S.C. § 2331. Accordingly, Facebook is liable pursuant to 18 U.S.C. § 2333 and other claims to the Plaintiffs, who were injured by reason of an act of international terrorism. (Emphasis mine.)

…By participating in the commission of violations of 18 U.S.C. § 2339A that have caused the Plaintiffs to be injured in his or her person, business or property, Facebook is liable pursuant to 18 U.S.C. § 2333 for any and all damages that Plaintiffs have sustained as a result of such injuries

The relevant statute, 18 U.S.C. § 2333, reads:

Any national of the United States injured in his or her person property, or business by reason of an act of international terrorism, or his or her estate, survivors, or heirs, may sue therefor in any appropriate district court of the United States and shall recover threefold the damages he or she sustains and the cost of the suit, including attorney’s fees.

In an action under subsection (a)… for an injury arising from an act of international terrorism committed, planned, or authorized by a [designated foreign terrorist organization, i.e. Hamas]… liability may be asserted as to any person who aids and abets, by knowingly providing substantial assistance, or who conspires with the person who committed such an act of international terrorism.

But the Court rejected the plaintiffs’ reasoning, stating that:

…it is well established that Section 230(c)(1) applies not only to defamation claims, where publication is an explicit element, but also to claims where “the duty that the plaintiff alleges the defendant violated derives from the defendant’s status or conduct as a publisher or speaker.”  LeadClick, 838 F.3d at 175 (quoting Barnes v. Yahoo!, Inc., 570 F.3d 1096, 1102 (9th Cir. 2009))

Put another way, even though there is a statute which prohibits providing material support to terrorism, Facebook’s status as a publisher of user-generated content means that it benefits from Section 230’s immunity from being treated as the publisher or speaker of content provided by another information content provider. Facebook wasn’t helping Hamas produce content. Accordingly Facebook could not be found liable for hosting it.

Facebook as information content provider

If Section 230’s immunity applies to liability purportedly arising under 18 U.S.C. § 2333, the next logical step for the plaintiffs – and the argument they raised – was to try to disapply the immunity by arguing that Facebook actually helped to produce Hamas’ content.

This is sort of like a situation we’ve often seen in the Star Trek movies (in particular Star Trek II: The Wrath of Khan and Star Trek: Generations). You don’t have to blast your way through the shields if you can trick the enemy into dropping them.

In Section 230 terms, “dropping the shields” means Facebook would be doing the talking or making other affirmative and material acts that “develop” the content in issue. The plaintiffs contended:

Facebook provided “to HAMAS use of Facebook’s data centers, computer servers, storage and communication equipment, as well as a highly-developed and sophisticated algorithm that facilitates HAMAS’s ability to reach and engage an audience it could not otherwise reach as effectively,”

Which the court understood to mean:

Plaintiffs contend that Facebook’s algorithms “develop” Hamas’s content by directing such content to users who are most interested in Hamas and its terrorist activities… we have recognized that a defendant will not be considered to have developed third‐party content unless the defendant directly and “materially” contributed to what made the content itself “unlawful.”

But the court was not convinced that this was the case.

Pointing to the Ninth Circuit’s decision in Kimzey v Yelp! Inc., the court points out that the “‘material contribution test… ‘draws the line at the crucial distinction between, on the one hand, taking actions… to… display… actionable content and, on the other hand, responsibility for what makes the displayed content [itself] illegal or actionable.”

Accordingly, the court held that Facebook, in this instance, was not materially contributing to Hamas’ content; “arranging and distributing third‐party information,” the majority opined, “inherently forms ‘connections’ and ‘matches’ among speakers, content, and viewers of content, whether in interactive internet forums or in more traditional media.  That is an essential result of publishing.” i.e., Facebook was staying in its lane as an interactive computer service provider.

The court concluded:

Accepting plaintiffs’ argument would eviscerate Section 230(c)(1); a defendant interactive computer service would be ineligible for Section 230(c)(1) immunity by virtue of simply organizing and displaying content exclusively provided by third parties,”

and further that

Plaintiffs’ “matchmaking” argument would also deny immunity for the editorial decisions regarding third‐party content that interactive computer services have made since the early days of the Internet [under Section 230(c)(2)].

tl;dr?

Litigants have made many attempts, through many different means, to try to hold interactive computer service providers engaged in the publishing of third-party content but not creating that content liable as if they were a publisher.

Section 230 means what it says. The court points out that courts have properly “invoked the prophylaxis of section 230(c)(1) in connection with a wide variety of causes of action, including housing discrimination, negligence, and securities fraud and cyberstalking.” And now, the Second Circuit has affirmed that this includes liability under terrorism statutes as well.

Moment of zen

Glad to know ConsenSys reads this blog. Will have to feature them more often! 

The LAO, demystified

Today a new form of organisational governance is announced by OpenLaw, a subsidiary of the Brooklyn-based Ethereum fan club and sometimes software development company known as ConsenSys.

OpenLaw calls this allegedly new and improved beastie a “Limited Liability Autonomous Organization,” or “LAO.” 

They tell us:

One of the first substantive experiments with the use of smart contracts to manage and coordinate economic activity was The Decentralized Autonomous Organization (known as The DAO).

In early May 2016, The DAO was launched on Ethereum, animating the thoughts and imagination of developers and technologists around the globe. The DAO aimed to operate as a venture capital fund for the crypto and decentralized space. The lack of a centralized authority reduced costs and in theory provided more control and access to the investors…

…There is a strong argument that if The DAO didn’t collapse for technical or legal reasons the boom of the ICO market would have been tempered if not entirely unnecessary.

That’s not quite right.

The first time this was done was in 2014, where Casey, Tyler and I proposed linking a DAO – properly, just some software that automated organizational governance using a permissioned Ethereum template – to a private organization, specifically a 501(c)(6) non-profit trade association. ConsenSys now re-packages this as if it were their idea.

The 2016 DAO was not, as ConsenSys claims, some noble decentralized experiment on Ethereum that had the potential to save the world and forestall the ICO boom. The absence of any punishment for anyone involved in the DAO fiasco likely encouraged the ICO boom.

For those of you who are new around here, the 2016 DAO was a commercially illiterate trash fire that collapsed and took hundreds of millions of dollars with it. Anyone with half a brain figured out it was doomed before it even launched. I have absolutely nothing good to say about it and neither should anyone else. It seems to me that the only folks who were surprised it collapsed were the Ethereum “luminaries” on its own advisory board.

Moving on.

1. Structure of the LAO

After a lot of rambling about Coase’s Nature of the Firm and how reduction of transaction costs is next to godliness, OpenLaw tells us the following:

Using the tooling provided by OpenLaw, the LAO will be set up as a limited liability entity, organized in Delaware, using curated Smart Contracts to handle mechanics related to voting, funding, and allocation of collected funds. This entity will presumably limit the liability of LAO members and help clarify their relationship to avoid knotty questions related as to whether partnership law applies.

tl;dr – OpenLaw has discovered a Delaware corporation’s back office can be run with software. Carta does this today.

We will leave to one side, for the moment, what this structure’s effect will be on liability.

They continue:

This structure will also provide members of the LAO with tax flow-through treatment by the Internal Revenue Service, such that tax is not paid by both the entity and a person holding a beneficial interest in the LAO.

Hold the phone, they’ve discovered an LLC.

The proposal goes on:

Members will be able to purchase interests in the LAO and the proceeds from the purchase will be pooled and allocated by members to startups and other projects in need of financing, using a voting mechanism and tools similar to Moloch DAO… In order to comply with United States law, membership interests of the LAO will be limited and only available to parties that meet the definition of an accredited investor — although there are arguments that LAO membership interests may not be securities.

Those arguments are, of course, wrong. Although I suspect ConsenSys folks should prefer if the situation were otherwise. In a late-2018 interview in now-shuttered ConsenSys-owned online magazine BreakerMag, ConsenSys founder Joe Lubin spoke of his affinity for token launches:

The token launches, if they’re for our own companies, end up bringing capital into those companies, and if they’re consumer utility tokens, you could consider that revenue. There are a bunch of those that have brought in many tens of millions of dollars. And we also help third parties do token launches.

The U.S. Securities & Exchange Commission has since taken a very dim view of the idea of the “utility token,” as we have seen from a number of enforcement actions that first were made public in 2018 and continue to be made public at a fairly brisk pace.

So where we are, or at least where any reasonable person should be, is that the “LAO” will be selling membership interests, that these membership interests will be regulated, at least in the United States, as securities, and accordingly that the registration requirements under the Securities Act of 1933 will apply to their sale unless an exemption applies. Unsurprisingly the LAO proposal elects to adopt this approach.

The proposal continues:

 OpenLaw will help on an ongoing basis with any ongoing legal requirements and improve any tooling that may be necessary to maintain or enhance the LAO. However, OpenLaw will exercise no control over the LAO unless directed by the members.

This is a weird proposal. What OpenLaw is basically saying is that everyone in the transaction is going to be passive and OpenLaw will act as a corporate services provider.

This is similar to what one might see in a securitization, for example. In a securitization, a special-purpose entity/vehicle or SPV – usually a corporation rather than an LLC – is incorporated to be the legal owner of whatever the subject matter assets of the transaction might be. Two entities assume primary responsibility for the SPV’s continued existence: the corporate services provider, who shuffles paper and signs documents on its behalf, e.g., and the trustee, who is effectively God in that it decides how to enforce the terms of the transaction in relation to which the SPV has been created (but equally, and also like God, is extremely reluctant to interfere in corporeal affairs, except in the most serious of circumstances, and only then with express authorization from the beneficiaries whose interests the trustee represents).

LLCs are a slightly different ball game, so I am not sure that “exercising no control” over the LAO will actually work. LLCs are operated by managers – and if that manager is a co-owner, we refer to the manager as a “managing member” – who has authority to act on behalf of the LLC and also is liable for discharging certain duties, both to the LLC members and third parties with which it deals on their behalf. Manager-members owe all manner of fiduciary duties of fair dealing and disclosure to other members of the LLC.

Accordingly, this proposal can really only work if there is one LLC manager – OpenLaw or a delegate – or if all the LLC members are managing members, because I can’t see an LLC member who wants to be passive and keep their liability minimal stepping forward to assume these responsibilities on behalf of the rest of the crew. The buck has to stop with someone, at the end of the day, who assumes primary responsibility for the organization’s affairs (signing corporate filings, acting as the signatory on bank accounts, instructing counsel, replying to writs and subpoenas).

And then there’s this.

We also will be exploring on-chain verification of accredited status for the LAO using third-party oracle services (such as ChainLink) to streamline the onboarding process.

No. This is not how accredited investor verification works.

2. Ethernomics

Much like the original Moloch design, members of the LAO will be able to ragequit and immediately retrieve back their fair share of unallocated funds based on their economic contribution (regardless of voting weight). With this safety mechanism in place, LAO members will always have the option to opt-out of the LAO should they disagree with aspects of the LAO membership, investment portfolio or need to rapidly receive back their assets.

What does this mean, exactly? From Simon de la Rouviere:

Moloch DAO always leaves a door open. Every time there is a vote, one can decide to exit (“ragequit”), turning non-transferable voting shares into transferable “loot tokens”. If you destroy your loot tokens, you can exit with your proportional amount of the organization’s resources (“treasury”).

I’m not sure this makes sense in a corporate setting. Let us suppose the LAO has ten members, Alice, Bob, Carol, Darren, Errol, Frankie, Gerard, Harry, Iphraim and Jimmy that each invest 10 ETH into a LAO.

The LAO takes its first vote and unanimously agrees to invest 90 ETH into a hot new Ethereum startup, CryptoMarmots. On its second vote, the LAO wants to invest 10 Eth into another hot Ethereum Startup, ScamTrainCoin, but Jimmy decides this is a bad investment and quits.

Under this proposal, Jimmy would take 9 ETH worth of CryptoMarmots’ rewards/equity/whatever and 1 Eth, meaning the LAO would only control 81 ETH worth of CryptoMarmot rewards/equity/whatever and have 9 ETH in cleared funds to invest in ScamTrainCoin.

So: the LAO now has 81 CryptoMarmot and 9 Eth and 9 members, Alice, Bob, Carol, Darren, Errol, Frankie, Gerard, Harry, and Iphraim. A new member, Kendrick, joins with 10 Eth. What happens when the LAO decides to invest the 19 ETH it now has available to spend? Does Kendrick’s new contribution entitle him to 10% of the existing pool of assets and 10% of the voting power? If so, this strikes me a raw deal; why wouldn’t he just start his own LAO where he has 100% of the voting power? Equally, why should he be entitled to dilute the CryptoMarmot “reward token” holdings earned by the other members and held in the common treasury when he quits?

How is this more than layering an unnecessary corporate intermediary between a project that is selling tokens and the (presumably accredited) investors who wish to buy them, with potentially adverse tax consequences when compared to simply buying them outright? Seeing as the management magic of Tim Draper/Marc Andreessen/Naval Ravikant isn’t here, what’s the point of tying it up in a corporate that has no management talent whatsoever?

And most importantly, even without the investment talent, how is this not regulated as if the talent were there and this constituted an investment company requiring registration under the Investment Company Act of 1940?

Many questions.

Extending emerging Moloch designs further, LAO members can also continuously claim their fair share of profits provided by tokens received from projects that receive investment from the LAO, further incentivizing collective LAO diligence, voting participation, and membership stability.

Again, this also doesn’t make sense. Seeing as the LAO has chosen to operate itself as an LLC rather than a fund, it is likely that LAO members would insist on “continuously claiming their fair share of profits,” as the pass-through nature of an LLC means that each member’s proportion of profits will be taxed and reportable on the members’ own personal or corporate returns each and every year and possibly even quarterly. Seeing as tokens can fluctuate wildly in value, how are profits to the LLC to be calculated?

To accept funding, projects will submit an application and be required to create a Delaware legal entity and OpenLaw will provide a set of standardized documents to streamline the process. If the project is later stage, OpenLaw will work with the project to ensure that the LAO can provide funding, given the project or entity’s then-current legal structure.

Is OpenLaw planning on becoming a law firm as well?

Through this approach, a project can conceivably submit a request for funding and receive funding from the LAO in days. Below is a quick preview of how fast funding can be received.

Although it’s easy to make fun of investors, the fact is that the better ones are extremely skeptical and perform a ton of due diligence before deciding to pull the trigger on an investment. The slowness of funding from a VC firm is not a function of paper-based legacy systems causing delays. It is a human problem where people simply don’t want to give their money away unless you’ve generated sufficient FOMO/investor tingles.

Moving on:

The LAO and similar structures could lead to increased development of secondary trading for LAO interests either through private markets or potentially even on public exchanges, potentially leading to a future of publicly traded venture capital funds.

Maybe. But I’ll bet it won’t. There’s a reason VCs stay private, e.g. they don’t like or want the scrutiny that being public involves.

LAO in a nutshell: boiling down OpenLaw’s 3,000-word manifesto down to one sentence

We’re not looking at anything more complex than a Delaware LLC, with some weird corporate governance arrangements that probably don’t work, and funky tax consequences, that requires OpenLaw’s constant involvement/SaaS offering in order to function.

The marketing strikes me as typical Ethereum complexity theatre, lots of bespoke jargon and an absence of straight talk. I can discern no way that the LAO would be necessary for, let alone desirable for, the facilitation of venture investments from the perspective of an investor. Without active, third-party management, the LAO simply adds another layer of complexity (and risk!) where a normal equity crowdfunding platform would just let the investor buy the product directly, hold it directly, exercise his rights directly, and pay taxes on his own investment returns only rather than dealing with the calculation of a proportional share of the profits and losses of an LLC in which he has a minority stake.

It does have a set of pre-written investment documents written for it. It appears to be unapologetically marketed at the Ethereum community so it’ll probably attract some investment. It is unlikely to have any impact beyond that limited audience.

Cargo Cult Finance

On an entirely unrelated point, I am often asked what my opinion is about DeFi. I include all types of DAOs in this umbrella. Including, for example, MakerDAO’s DAI stablecoin.

My initial response is always the same, and it’s always exactly five words long:

DeFi is cargo cult finance.

What does this mean?

As put by Richard Feynman:

In the South Seas there is a cargo cult of people. During the war they saw airplanes land with lots of good materials, and they want the same thing to happen now. So they’ve arranged to imitate things like runways, to put fires along the sides of the runways, to make a wooden hut for a man to sit in, with two wooden pieces on his head like headphones and bars of bamboo sticking out like antennas—he’s the controller—and they wait for the airplanes to land.

They’re doing everything right. The form is perfect. It looks exactly the way it looked before. But it doesn’t work. No airplanes land. So I call these things cargo cult science, because they follow all the apparent precepts and forms of scientific investigation, but they’re missing something essential, because the planes don’t land.

And this is how that looks:

cargo_1053.jpg

With that, dear reader, I bid you good evening.

What do you legally “own” with Bitcoin? A short introduction to krypto-property

Knut Karnapp posed this very interesting question over on Twitter. His answer:

To me you own a part of the Bitcoin UTXO set uniquely assigned to you, and only you — by virtue of the corresponding private key. With this comes great responsibility. If you lose your private key, you lose your bitcoins. If your private key gets stolen civil law may dictate that the key itself and the UTXOs accessed by it are still “yours”. As far as the Bitcoin network is concerned though the private key grants power of disposition to whomever is in possession of said key.

That’s a solid answer from a de facto point of view, where continuing knowledge of the private key basically == what most people commonly refer to as control, or ownership. From a workaday transactional standpoint I basically agree with it wholeheartedly. De jure, on the other hand…

It Depends

“Ownership” is more than mere control; it is a legal concept and law is a local phenomenon. Accordingly, when you ask yourself whether and how something is owned, it’s generally a safe assumption to begin, in the first instance, by looking at the governing law of the asset and asking what that governing law says.

With certain things, like securities, the governing law of the issuing jurisdiction/entity and the governing law of the instrument (if different) are likely to be dispositive. International bearer securities, e.g.,  utilize well-worn issuance frameworks like the New Global Note structure, which divides up legal and beneficial title in the underlying security by contract in a manner that is highly certain and leaves little room for ambiguity. With real property (an apartment, a house, some land) you usually look to the law of the situs as the starting point for that inquiry. Generally speaking it’s the same story for chattels, save where ownership of those chattels is represented by a certificate of title or the like.

The problem with Bitcoin, of course, is twofold.

First, Bitcoin does not avail itself of existing categories of property, like chattels or instruments; indeed, it defies them in many respects. As a consequence, any contractual or systemic understanding of the thing – to the extent one exists at all – is going to be implied, and seeing as courts haven’t really grappled with foundational questions about what Bitcoin is, we don’t know what that implication will look like. The best we can do for now is guess what the boundaries of that implication, once set down in writing, will be.  We will call this the Classification Problem.

Second, a bitcoin does not really have a physical location, and is a fundamentally global good – it exists on every computer which runs a full node, and is arguably issued everywhere and nowhere at the same time.  But the Classification Problem will be determined by reference to local, not global, rules. We will call this the Forum Problem.

Bitcoin-as-math-problem

The “Forum Problem” is a simple one; Bitcoin has no identifiable origins, no clear home, so each different country/jurisdiction in which litigation over Bitcoin is brought (in the case of the U.S., the states and the various federal jurisdictions) will feel entitled to apply its own rules to the asset. For the majority of commercial arrangements, harmonization can probably be achieved by choice-of-law clauses among the counterparties to the transaction.

The “Classification Problem” is where things get more interesting. Here we ask what rules each jurisdiction would apply if some litigation arose which involved fundamental questions about the nature of ownership as it pertains to Bitcoin the asset. Usually, those fundamental questions are not in dispute in the kind of workaday litigation that comes before the courts. Courts take judicial notice of who owns what bitcoins based on the facts of the case; Alice sold some bitcoins to Bob, there are no competing claims to the bitcoins and the question is whether one of the parties reneged on the high-level commercial terms of the deal.

What hasn’t happened yet, and what invariably will happen as more and more cases  hit the courts, is that someone will ask the question, “what property classification do we apply to Bitcoin – WTF is it that Bob actually owns?” This is because, at its core, a bitcoin is really, in its purest essence, only a solution to a randomly-generated math problem. Because the problem is very hard, the combination of a UTXO plus the ability for a recipient to spend it, armed with the knowledge of the relevant private key, is treated by most of us today as property. That “property” creates a write permission on a massively distributed cryptographic ledger which nobody controls, although control of that write permission can be transferred to other users of that database by spending the associated coins to those other users.

Because the secret embodied by a private key one does not know is very difficult to obtain – and impossible to obtain on a commercial timescale with existing technology – people call Bitcoin a “digital bearer asset.” Bitcoin is most assuredly not a bearer asset or chattel, though. Nor is it a documentary intangible, as it is not a contract and is silent, apart perhaps from the provisions of the MIT Licence, as to what a court should do when presented with one (more on that below). Unlike physical goods which can only exist in one place at one time, it is conceivable that with a powerful enough computer, the solution could be found entirely honestly by a third party simply doing some math and stumbling upon the answer at random, or by asking the right questions and exploiting some as-yet-undiscovered weakness in the implementation.

Screen Shot 2018-11-25 at 10.41.12 AM
For example. Courtesy of Hacker News

Bitcoin might, therefore, be better described as a digital I-know-something-you-don’t-yet-know asset. “Yet,” because the information is not secret (in the same way as a trade secret, e.g.) or impossible to ascertain; it’s out there waiting to be ascertained by someone clever enough, or a computer powerful enough, to figure it out. The term “cryptoasset” that is cavalierly thrown around by your  garden-variety ICO bro inadvertently turns out to be an accurate description for this new class of ownership. Lawyers wishing to confer dignity on the phrase might call it “crypto-property” instead.

If we really wanted to make it our own and de-emphasize the “there’s a lot of cryptography in this thing” aspect of Bitcoin, which is not legally relevant, in favor of an laser-focused emphasis on exclusive knowledge of the secret key as being dispositive for control and highly relevant for ownership, I might suggest the radical step of changing the spelling of the prefix to “krypto,”  per the original Greek κρυπτῷ, so we’re left with krypto-property.”

Contrasting approaches between England and the U.S.

Who owns the solution to that really hard to solve, but solvable nonetheless, math problem? I ask this question, which seems like an obvious or even pedantic one, only because I am fairly certain that the world’s two largest common-law jurisdictions – England and Wales, and the United States – would reach different conclusions.

Now, of course Bitcoin is treated as various things by various agencies of the state – most significantly, as “property,” by both the IRS (American taxman) and HMRC (English taxman). But that doesn’t answer the question of what kind of property the stuff actually is.

In England, for example, longstanding precedent has held that “the right to confidential information is not intangible property;” see Oxford v. Moss, (1979) 68 Cr App Rep 183 (a student cheating on a test by reading the answer sheet in advance could not be convicted of theft, as the answer to the test – as pure information – was not intangible property and therefore incapable of being stolen). This principle nukes the notion that a private key is worth more than the paper that you [really should not] have written it on.

At the same time, English law may have an equity, which looks a lot like a property interest in confidential information that has been misappropriated, that gives a party wronged  (i.e., for our purposes, the person from whom knowledge of a private key was wrongfully obtained) a right to restitution. Anyone looking for the detailed treatment should read the section “Information as Property” at page 1 in Palmer & McKendrick’s Interests in Goods (1998).

I wrote a fairly lengthy analysis on the English law in this area back in the day, which, annoyingly, I have since lost. TL;DR, if an attacker fraudulently obtains a private key, English law provides a a remedy, but if an attacker should stumble upon a key by accident or by brute force, it probably doesn’t. This is unsatisfactory but it’s what we’ve got.

Contrast this with the U.S. position, where the courts have found that property rights can subsist in pure information such as unpublished or recently-published news (INS v. Associated Press, 248 U.S. 215 (1918)) or straightforwardly analogize doctrines such as relativity of title as a hack/workaround (e.g. Popov v. Hayashi, WL 31833731 Ca. Sup. Ct. 2002). Incidentally, a relativity-of-title-theory approach would also solve, for most practical purposes, what the inimitable Izabella Kaminska described as “Bitcoin’s Lien Problem” in 2015; it strikes me that that theory of ownership should be fairly good fit with UTXO-based systems where one can trace title to a given coin perfectly, give notice of theft or fraud efficiently, and prove current “possession” with a high degree of precision. Crucially, it might prevent an attacker – even an accidental one – from getting superior title to the Bitcoin he obtains, as long as the courts or the legislatures decide that’s how they want to crack that nut.

Equally, and another idea I have noodled on, is that Bitcoin’s code is really the first “smart contract” in that the code embodies a binding contractual understanding among the users. However, the fact that the code can be forked by consensus of the users to say anything at any time suggests to me that a court would likely conclude that there was not a clear intention to create a contract by running the code and so might refuse to enforce a particular mode of operation on the users of the network (see e.g. Jones v. Padavatton, [1968] EWCA Civ 4). Incidentally this absence of a contractual understanding/effective ousting of the jurisdiction of the court is why Bitcoin cannot and should not be described as a chose in action.

Wrapping up, the reason that the matter of Bitcoin’s ultimate classification as property hasn’t come up yet is because, in common practice, ownership  disputes are resolved at a higher conceptual level than inquiring about the “nature of a bitcoin itself” – when I deposit coins at an exchange, e.g., it ought to be pretty clear from the exchange’s TOS that if I have a balance on the exchange, I can ask the exchange to spend an amount equal to that balance back to me on request and, if they fail to do so, I can ask a court to force the exchange to render specific performance or pay damages. A dispute of that kind, of which there have been many, doesn’t ask at what point title transferred and what the fundamental nature of that title is, because it doesn’t have to. It looks instead at the contractual obligations between the counterparties and whether those obligations were satisfactorily performed.

One could write chapter and verse comparing these two jurisdictions and their treatment of Bitcoin as an asset. That said, it’s a Friday night and I have places to be, so for now it will have to suffice to say only that the question has no answer and at some point, probably sooner rather than later, there is going to be a case that explores these fundamental issues (I am frankly shocked that Oxford v. Moss hasn’t been raised yet in any of the UK-based Bitcoin fraud prosecutions).

I look forward to reading those decisions.

Postscript

Too good not to share.

The FCA/Cryptoassets Task Force Report: mostly boring

So the FCA’s Cryptoassets Task Force Report is out today. Compared to the last time the FCA chimed in on crypto, there are few surprises/not a lot to write home about.

For this reason, rather than writing a blog post, I have decided to go all “Web 2.0” on everyone by writing a Twitter thread instead.

Highlights include:

Enjoy!