I get a lot of questions about the legality of Decentralized Autonomous Organizations (“DAOs”). Usually They come from community members who want a project they support to form a DAO, and that project team pushing back because of legality reasons. I will start by saying that if you are in a project which is hesitant to rush into forming a DAO because of legal concerns, you have a very smart group of developers on that project. The intersection between NFTs, Crypto, and securities law is super complicated. Way too complicated to explain in a single blog. But hopefully this can give you at least a little background on this issue so you can discuss it intelligently when the topic comes up.
What Is a DAO?
There is simply no way I can explain what a DAO is in this article, both because of space and my own mental limitations. Far smarter people than me have tried to explain it in a cogent manner and failed. But think of a DAO as a governance mechanism, where holders of certain tokens (such as a particular NFT) can vote to decide a project’s financial and other decisions. DAOs fill similar roles to things you are probably more familiar with like corporations, cooperatives, non-profits, etc.
If you want to learn more about DAO’s and the intersect between decentralized finance (“Defi”) and NFTs, some articles I found helpful can be found here, here, and here. Or go down the Google and Twitter rabbit hole yourself. Just have some Advil ready for the virtually certain headache you will get trying to figure it all out.
What Is a Security?
Securities are even more difficult to define, as they can come in many shapes and sizes. Typically, when people think securities, they think stocks, bonds, options, etc. Initial Coin offerings (“ICOs”) have already been held to be securities by the SEC, including, aptly, a 2017 investigative report which found an organization called “The DAO”‘s ICO was a security. The DAO was subsequently ordered to follow all associated financial reporting and approval laws.
Securities also include what are commonly referred to as investment contracts, which is what we will focus on here. What classifies as an investment contract (and thus subject to disclosure and registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934) is a little tricky. The one thing which is certain is that a project or DAO disclaiming it is “not a security” has precisely the same legal weight as Michael Scott yelling “I Declare Bankruptcy!”
Whether something is an investment contract is determined using the Howey Test (named after a 1940’s Supreme Court decision). Under the Howey Test, something is a security if:
- There was an investment of money, in;
- A common enterprise, with;
- The expectation of profit; and
- The profit is primarily from the efforts of others.
In Howey, the investment was in an orange grove. The scheme was that the Howey Company sold investors parcels in its orange grove. The purchaser would pay an annual fee and lease the land back to the Howey Company, which would grow the oranges, pick the oranges, sell the oranges, and the owner of the parcel would get some percentage of those profits. The Howey Company argued “this is a land contract, not a security” but the Supreme Court ruled that, because it satisfied the above factors, it was a security. So the question becomes: is your project a piece of land or is it an investment contract that happens to have a land purchase component?
Securities regulations are COMPLEX. There is a reason corporate attorneys at major law firms get billed out at +$1,000/h for this type of work. To sell securities, you need to pass certain background checks and receive authorization, the assets can only be sold after certain KYC steps are taken, and there are limits on those sales. All of this would be bad news in the often anonymous and wild west of NFTs.
How This Effects NFT Projects
Lots of assets give profitable perks to their owners without being considered a security. For example, people who own season tickets to a football team often get associated perks, such as reduced additional ticket rates, giveaways, etc., but I am not aware of any decision ruling season tickets to be a security. The same is true of country club memberships and associated perks they come with. Often, these perks include voting rights to determine the future of the organization (be that a baseball team, country club, fraternity, or whatever else). These purchases are not securities, though, because of the consumption test.
In United Housing Foundation v. Forman, the Supreme Court ruled that “when a purchaser is motivated by a desire to use or consume the item purchased . . . the securities laws do not apply.” So when you buy a Zed.run horse or a Ghxst piece of art, this is very clearly to use or view that asset, and it thus falls outside of securities law. Those projects can do giveaways and airdrops because those are side benefits. They can also release governance tokens to let people vote on the future of the projects or upcoming events/giveaways. But the more the NFT looks like just a token into an investment pool, the more likely it is to be classified as a security. Airdrops and presales are fine, but when projects start talking about using roadmap funds to invest in assets to be held in a community chest, that starts looking less like a .jpg and more like a stock.
We are still likely years away from any sort of securities regulations hitting the NFT space, so if you are into NFTs for a good time and not a long time, you probably don’t need to concern yourself with DAO regulations. However, it is certainly possible that third-party secondary markets (like OpenSea or Rarible) start taking these listings down in an abundance of caution. Additionally, if you are investing in projects you plan to hold for years and not weeks or months, you need to be aware that regulation IS going to come eventually, and if you don’t want your investment to be wrecked by the long arm of the law (and associated expenses), then be conscious of the line between consumable and security.
The SEC and related foreign financial regulatory authorities are coming to NFTs. It is just a matter of when, not if. The smart investors will position themselves to quickly adopt to regulation without needing to try to unwind decisions made from when NFTs were the wild wild west (i.e., right now). The dumb investors will see their investments die before their eyes. Be smart, not dumb.
If you have any questions or would like me to write about anything else, let me know on either of my twitter pages! As always, I am an attorney, I am not your attorney. For legal advice, you should always consult (and pay for) an attorney.