In the first part of this series, published in February 2022,1 I wrote that the promise of blockchain lies in its ability to decentralize and automate the world we live in. Nonfungible tokens (NFTs) decentralize and automate property ownership, utility tokens have the potential to decentralize and automate financial services, and security tokens have the power to decentralize and automate collective investment.
Part 2, using three case studies, looks at some of the ways in which these movements in decentralization and automation are putting strains on the legal frameworks that structure property ownership, organization, and securities. First, the distinction between utility tokens and security tokens is illustrated by looking at a current enforcement action against Ripple Labs Inc. Second, automation of property ownership and licensing at the heart of NFTs is exemplified by the Bored Ape Yacht Club. The piece ends with an examination of the short-lived ConstitutionDAO and issues related to structuring decentralized organizations.
Fraud does plague the blockchain space,2 but such issues are not unique to blockchain and they aren’t a focus here. In the late 1990s, the U.S. Department of Justice was concerned about fraud on a new technology called “the internet” in what we now recognize as garden-variety phishing. By the 1970s, people had learned how to hijack telephone systems for their own, occasionally nefarious, purposes. The early 1900s saw hucksters shilling radio waves to cure, for example, infected fallopian tubes.3
Security Versus Utility
Founded in 2012, Ripple Labs Inc. is an early innovator in blockchain technology. The heart of Ripple’s technology is RippleNet, a “high-performance global payments” system. The company claims that the network can settle in seconds cross-border payments that normally take 3-5 days. Much of RippleNet’s function is accomplished by a related blockchain-based token called XRP. The network ensures its speed by constraining the number of XRP tokens available to use the system, thus preventing the system from being overwhelmed. XRP itself is used to transfer value within RippleNet and reduce reliance on complex inter-bank lending relationships.4
Ripple Labs Inc. and its founders are currently the targets of a Securities and Exchange Commission (SEC) lawsuit related to XRP and the RippleNet infrastructure.
“From at least 2013 through the present, Defendants sold over 14.6 billion units of a digital asset security called ‘XRP,’ in return for cash or other consideration worth over $1.38 billion U.S. Dollars (‘USD’), to fund Ripple’s operations and enrich [the founders]. Defendants undertook this distribution without registering their offers and sales of XRP with the SEC as required by the federal securities laws, and no exemption from this requirement applied.”5
For its part, Ripple and its founders are arguing that XRP is not a security token but a utility token – that is, it is a digital asset used to make the network work, not an investment.6 Thus, it is apparent that this distinction, between security and utility tokens, is a point of major legal significance.
The SEC first identified the security token-utility token distinction in a report of investigation related to an organization called The DAO. While the full story of The DAO is beyond the scope of this article, the short version is that The DAO raised more than $150 million through the sale of digital tokens; the organization would then use the money to invest in startup projects. The question before the SEC was whether the sale of tokens by The DAO was an unregistered issuance of securities. The SEC found that The DAO’s token sale constituted an “investment contract,” and thus a security, because users invested money with a reasonable expectation of profits derived from the managerial efforts of others.7 The SEC chose not to bring an enforcement action, but it was clear that token sales that represent an investment are securities.
In the years since the investigation into The DAO, the SEC has clarified its guidance. The SEC focuses on several factors including, for example, whether the token has more utilitarian uses.8 Some of those factors include whether the token is “offered broadly to potential purchasers as compared to being targeted to expected users of the goods or services or those who have a need for the functionality of the network[,] … [t]he digital asset is offered and purchased in quantities indicative of investment intent instead of quantities indicative of a user of the network[,] … [and] the digital asset can only be used on the network and generally can be held or transferred only in amounts that correspond to a purchaser’s expected use.”
If defendants (including Ripple Labs) only sold XRP to customers for use as a transfer of value within the network, or did not use the money to fund the operations of the company, or only made available an amount of tokens sufficient to use within the network itself at its then-current capacity, there could be a case that XRP is not a security token.
However, the SEC alleges that despite the token’s later-developed utility, the fact that XRP was used as a security is crucial: “Ripple was able to raise at least $1.38 billion by selling XRP …. Ripple used this money to fund its operations without disclosing how it was doing so, or the full extent of its payments to others to assist in its efforts to develop a ‘use’ for XRP and maintain XRP secondary trading markets.”9 There is not a final adjudication in this matter yet, and Ripple disagrees with the SEC. But it nonetheless seems clear that to avoid violating securities laws (or at least being sued by the SEC), companies must not use tokens as securities, even if the tokens ultimately serve utility token functions.
The Bored Ape Yacht Club
To be a member of the Bored Ape Yacht Club, a person must own at least one of the 10,000 drawings of apes that are bored with the world and want to live that sweet yacht life. Members get to participate in exclusive events with the likes of Eminem, Snoop Dogg, and Steph Curry.10 It’s akin to being required to own one of the artworks inside before being allowed into the Louvre.
The art world is rife with looting and fakes, as well as fights between artists and their recording companies and their distribution networks.11 Even worse (from the viewpoint of artists), when art is sold by an artist and the art then increases in value, the owner of the artwork, not the artist, realizes that gain. Content creators are tired of being exploited and they don’t want to take it anymore.
One solution is absolutely provable provenance and title to each work of art. If the artist can even control downstream uses,12 then the need for publishers, distributors, and even the “first sale doctrine” goes away. In this way, artists can capture a greater percentage of the revenue generated by their art and can also capture new revenue that the law previously denied them.
When an artist releases a drawing of an ape and wants to monetize that art, the artist can attach a piece of software code, a token if you will, that travels with the work; the token is fixed at the time of creation or publication and cannot be removed. In this way, each work released is absolutely unique – it is, in the language of the internet, nonfungible – and its token proves it. Register the token on a blockchain, and voila! An NFT is born.
At its simplest, an NFT is simply a title or deed. Because it is registered on a blockchain, it is immutable (unchangeable) and thus can’t be tampered with. Someone can fake the art, but they cannot fake the blockchain.13 Many NFTs are limited to simply representing title to the content. Just as with a work of art, ownership of the NFT does not convey the right to make copies, or derivative works, or any other license of copyright. If ownership of the work does not transfer but the purchaser is merely given the right to possession without any additional rights of ownership, the purchaser has a right to use or a “license.” A license does not confer the benefits of ownership.14
In the normal course, upon the first sale of the art, the artist’s right to control what the new owner does with the work of art is severed. The first sale doctrine is codified in the Copyright Act.15 The artist cannot compel the owner to publicly display the work of art, nor can the artist prevent the owner from selling it. If the owner sells it for a profit, the artist receives none of that gain even though it is, likely, the artist’s reputation that is a major source of that gain. But these rights only attach to ownership.16
NFTs allow artists to fundamentally change the relationship of the possessor to the thing possessed. No longer must the artist sell title (ownership) in their creations; instead, the content creator can license possession. In this way, NFTs can be used to subvert the first sale doctrine and control downstream uses. In this author’s opinion, this control is great for the content creator, but bad for secondary markets and users.17
Decentralized Autonomous Organizations
In mid-2021, two Atlanta residents decided they wanted to purchase one of the 13 original prints of the U.S. Constitution going up for sale with Sotheby’s Auction House.18 They needed money, and they needed money fast. They did what any investment fund would do – they formed an organization and went out and raised money. They didn’t care who the money came from, only that everyone who put money into the organization understood that it would be used for this investment. The investors did not need to manage the investment; the organization itself would handle the bidding, the holding of the money, and the disbursement of profits when the asset was eventually sold. They raised more than $40 million; sadly, they did not win the bidding war. Why is perhaps even more interesting than the how.
In many ways, running this investment business does not require human intervention. Accepting money into a bank account, reconciling that bank account, issuing tax notices, and disbursing money are all actions that can be triggered by outside events and accomplished automatically with relative ease by software. On Jan. 1, for each investor, send tax statements; if sale, then disburse; and so on. Want to decide when to sell? Investor polls other investors, upon majority vote, sell asset. If this were a human-run operation, someone would file to create a limited liability company, limited partnership, or limited liability partnership and manage all of this themselves. It’s not much work. With the right software, it’s even less work.
Indeed, a simple software program could handle almost all the effort of managing the organization with little human input. If the software program sits on a blockchain, it can be accessible by anyone in the world – opening up the opportunity for investment significantly more than two people from Atlanta might otherwise have. In this way, the software running the organization inside an entry on a blockchain is a decentralized autonomous organization (DAO).
In the absence of a formal, registered corporate entity, this informal organization of investors is a partnership. Wisconsin, like many states including Georgia, has implemented the Uniform Partnership Act. Wisconsin’s version is codified at Wis. Stat. chapter 178. The Act defines a partnership as “an association of 2 or more persons … to carry on as co-owners a business for profit.”19 The banding together of investors in a DAO meets this definition, of course. In this case, the business is investing, and although the profit is speculative, everyone is putting in cash with the expectation of getting more cash out. One very large problem with partnerships is that the partners20 are personally and jointly and severally liable for the actions of the partnership.21 With 8,000 partners spread around the globe collectively owning22 a 235-year-old historically significant document, what could possibly go wrong? Which of the 8,000 investors wants to be on the hook for that? Surprise: All of them would be liable!
Lawyers in Wisconsin and other states have developed statutorily recognized organizations that limit the personal liability of owners. However, to take advantage of these statutes, one must register the company with the relevant jurisdiction and maintain organizational charter documents such as articles and operating agreements that often require potential owners to read, understand, or even negotiate the terms of their relationship to the organization. These organizational types have a big disadvantage to the kind of activity contemplated by ConstitutionDAO: they are neither decentralized nor particularly autonomous.
Limiting Personal Liability. The perplexing, and as yet unsolved, question then remains: how can a DAO effectively limit the personal liability of its owners? It is not an easy question to answer, but three major trends are developing.
The first major trend is somewhat obvious: gloss over the “decentralized” and “autonomous” prescriptions and simply form a limited liability company and pretend it’s a DAO.23
The second major trend involves a hotbed of blockchain and cryptocurrency innovation: the state of Wyoming.24 Under Wyoming law, an organization can register as a DAO with Wyoming’s Secretary of State; it is a variant of their limited liability company statutes.25 The Wyoming-based DAO may be either “member managed” or “algorithmically managed” but “an algorithmically managed decentralized autonomous organization may only form under this chapter if the underlying smart contracts are able to be updated, modified or otherwise upgraded.”26 The statute relieves members of fiduciary duties that might otherwise exist by operation of law.27 By default, members vote pro rata in accordance with the member’s contribution of digital assets to the organization; if no contribution of digital assets is required to be a member, then the system is one member one vote.28 The statute also relieves members of their rights to be provided information about the operations of the company.29 While these are the major substantive provisions, the statute contains more details; a Wyoming DAO is otherwise treated as a Wyoming LLC. Again, not particularly decentralized, nor particularly autonomous, but it at least recognizes that organizations may exist that will be run completely by smart contracts.30
The third major trend that is developing is an obscure entity not found in every state but pioneered here in Wisconsin: the unincorporated cooperative association.31 The unincorporated cooperative association does require a filing of articles of organization with the state32 and importantly also provides for the limitation of liability of its members.33
“Where it differs from an LLC is in the distribution of financial returns based on patronage activity, voting based on membership (one-member, one vote) or based on patronage, which allows for the integration of DAO based governance principles, such as rage quittingand quadratic voting.”34
Not every state has this entity option and not many lawyers are well versed in the details of cooperative organizations.
So, why did ConstitutionDAO lose its bid for the U.S. Constitution? It was not for lack of money to purchase the asset. Rather, “it lost because it had not raised enough money to establish a reserve required to maintain and care for the document on an ongoing basis.”35 In other words, it lost because it wasn’t a centralized organization. As the kids say these days: “womp womp.”36
Technology is running faster than the law. As blockchain technology moves closer to the mainstream and more public-use cases are coming to light, its global, decentralized nature is disrupting long-standing legal frameworks. Lines continue to be blurred over whether, when, and how money raised by the sale of tokens used to operate a blockchain application are securities and subject to oversight by the SEC. Long-standing, court-developed bargains between the users and owners of copyrighted works are being sidestepped. The very nature of organizations, first popularized in 1602 by the Dutch East India Company to manage risk and liability for shipping goods from the Netherlands to India, are, ironically, wholly insufficient for global ownership of decentralized and fully automated organizations. There are not a lot of answers today, so lawyers must help clients identify and manage these risks.
Meet Our Contributors
What famous person would you like to have dinner with? Where would you dine and what would you talk about?
I would like to have dinner with Elon Musk to discuss that Moon versus Earth soccer match that he gave me free tickets to at the end of the last article I wrote (Wisconsin Lawyer, Feb. 2022). We’d have a salad of rocket, sunchokes, and starfruit.
Jeffrey M. Glazer, U.W. Law & Entrepreneurship Clinic, Madison
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1 Jeffrey M. Glazer, Cryptocurrency and Blockchains: Smart Contracts – Part 1, 95 Wis. Law. 14 (Feb. 2022).
2 See, for example, Steven Spoerl,Scammy NFT Site Sweeps Up Some Madison Musicians, www.tonemadison.com/articles/scammy-nft-site-sweeps-up-some-madison-musicians (Feb. 2, 2022), regarding recent NFT fraud involving Madison-area musicians.
3 Jonathan J. Rusch, The “Social Engineering” of Internet Fraud, https://web.archive.org/web/20080617150031/http://www.isoc.org/isoc/conferences/inet/99/proceedings/3g/3g_2.htm (last visited March 9, 2022) (“Another situation involved Yahoo email users who reportedly received emails from a person who falsely identified himself as a Yahoo employee. The ‘employee’ told each recipient that he had won a 56K modem from Yahoo, but that he would have to supply his name, address, telephone number, and credit card number to pay for shipping. A number of recipients did so before Yahoo learned of the false email and contacted everyone who had responded to it.”); Ron Rosenbaum, Secrets of the Little Blue Box, Esquire (Oct. 1971), www.lospadres.info/thorg/lbb.html (“But with your beeper box, once you hop onto a [phone] trunk, say from a Holiday Inn 800 [toll-free] number, they don’t know where you are, or where you’re coming from, they don’t know how you slipped into their lines and popped up in that 800 number. They don’t even know anything illegal is going on. And you can obscure your origins through as many levels as you like. You can call next door by way of White Plains, then over to Liverpool by cable, and then back here by satellite. You can call yourself from one pay phone all the way around the world to a pay phone next to you. And you get your dime back too.”); Randy Dotinga, Americans Fell for a Theranos-Style Scam 100 Years Ago. Will We Ever Learn? Leaps.org (Feb. 19, 2020), https://leaps.org/americans-fell-for-a-theranos-style-scam-100-years-ago-will-we-ever-learn/ (“Enter radionics, the (supposed) science of better health via radio waves. … Detecting illness and fixing it required machinery – Dynamizers, Radioclasts and Oscillocasts – that could cost hundreds of dollars each. Thousands of physicians bought them. Fortunately, they could work remotely, for a fee. The worried-and-potentially-unwell just needed to send a blood sample and, of course, a personal check.”).
4 Ripple, Our Story, https://ripple.com/company (last visited March 9, 2022); Your Questions About XRP, Answered, https://xrpl.org/xrp-overview.html (last visited March 9, 2022);Cointelegraph, What is XRP? And What Does It Have to do with Ripple?, https://cointelegraph.com/altcoins-for-beginners/what-is-xrp-and-what-does-it-have-to-do-with-ripple (last visited March 9, 2022) (“Ripple’s XRP-powered solution helps network members process payments with real-time settlement and improve payment efficiency and certainty. XRP itself is used to source liquidity on-demand and reduce the amount of nostro accounts required to make global payments.”).
5 SEC v. Ripple Labs Inc.,No. 20 CIV 10832 (S.D.N.Y. 2020), www.sec.gov/litigation/complaints/2020/comp-pr2020-338.pdf, and accompanying press release: https://www.sec.gov/news/press-release/2020-338.
6 See Ripple and XRP websites, supra note 4. Throughout this article, XRP is repeatedly referenced as a “digital asset.”
7 SEC, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Release No. 81207 (July 25, 2017), www.sec.gov/litigation/investreport/34-81207.pdf. See id. at 5-6 (“A DAO Token granted the DAO Token holder certain voting and ownership rights. According to promotional materials, The DAO would earn profits by funding projects that would provide DAO Token holders a return on investment.”); id. at 11-15 (this is called the “Howey Test” and it is commonly applied to determine the existence of securities).
8 Bill Hinman, Framework for ‘Investment Contract’ Analysis of Digital Assets 6-7 (April 3, 2019), www.sec.gov/files/dlt-framework.pdf; Bill Hinman & Valerie Szczepanik, Statement on “Framework for ‘Investment Contract’ Analysis of Digital Assets,” www.sec.gov/news/public-statement/statement-framework-investment-contract-analysis-digital-assets.
9 SECv. Ripple Labs, www.sec.gov/litigation/complaints/2020/comp-pr2020-338.pdf, at 2.
10 https://boredapeyachtclub.com/#/. See Samantha Hissong, The NFT Art World Wouldn’t Be the Same Without This Woman’s ‘Wide-Awake Hallucinations,’ Rolling Stone (Jan. 26, 2022); www.rollingstone.com/culture/culture-features/seneca-bored-ape-yacht-club-digital-art-nfts-1280341/; Van Isle Marina, Yacht Life: 8 Things You’ll Love About Living on a Yacht, https://vanislemarina.com/yacht-life-8-things-youll-love-about-living-on-a-yacht/ (last visited March 9, 2022); Adlan Jackson, How to Sneak Into a Bored Ape Yacht Club Party, The Verge (Dec. 13, 2021), www.theverge.com/22824387/bored-ape-yacht-club-nft-party-new-york; David James Young, Eminem Reportedly Spent $450,000 on a Bored Ape NFT That Looks Like Him, NME (Jan. 4, 2022),www.nme.com/news/music/eminem-reportedly-spent-450000-on-a-bored-ape-nft-that-looks-like-him-3129215; NBA Star Steph Curry Aped Into the BAYC. All the Details (Aug. 28, 2021), www.theboredapegazette.com/post/nba-star-steph-curry-aped-into-the-bayc-all-the-details; @spencerXsays, Twitter, https://twitter.com/spencerxsays (last visited March 9, 2022).
11 Tom Mashberg, Cambodia Says the Met Museum Has Dozens of Its Looted Antiquities, N.Y. Times (Oct. 24, 2021), www.nytimes.com/2021/10/24/arts/cambodia-met-museum-looted-antiquities.html; Daniel Cassady, New York Gallery Faces Multi-Million-Dollar Lawsuit Over a Rothko’s Mystery Provenance, The Art Newspaper (Feb. 2, 2022), www.theartnewspaper.com/2022/02/02/rothko-lawsuit-edward-tyler-nahem-fine-art-galerie-jacques-de-la-beraudiere; Will Butler, The Joe Rogan Controversy Has a Deeper Cause, The Atlantic (Feb. 6, 2022), www.theatlantic.com/ideas/archive/2022/02/neil-young-spotify-joe-rogan-musicians/621503/.
12 “[D]ownstream uses” means “what later purchasers do with the art.”
13 See part I of this series, supra note 1.
14 Vernor v. Autodesk Inc., 621 F.3d 1102 (9th Cir. 2010) (“We … prescribe three considerations that we may use to determine whether a software user is a licensee, rather than an owner of a copy. First, we consider whether the copyright owner specifies that a user is granted a license. Second, we consider whether the copyright owner significantly restricts the user’s ability to transfer the software. Finally, we consider whether the copyright owner imposes notable use restrictions.”).
15 17 U.S.C. § 109.
16 17 U.S.C. § 109(a): “the owner of a particular copy … lawfully made under this title … is entitled, without the authority of the copyright owner, to sell or otherwise dispose of the possession of that copy … .” Compare Vernor, 621 F.3d at 1111 (“a software user is a licensee rather than an owner of a copy where the copyright owner (1) specifies that the user is granted a license; (2) significantly restricts the user’s ability to transfer the software; and (3) imposes … use restrictions.”).
17 Casey Newton, Why Gamers Hate Crypto, and Music Fans Don’t, The Verge (Feb. 4, 2022) www.theverge.com/22917126/nfts-crypto-gamers-music-fans-fandoms.
18 www.constitutiondao.com/ (last visited March 9, 2022); Anita Ramaswamy & Natasha Mascarenhas, ConstitutionDAO’s Bold Crypto Bid for US Constitution Falls Short, TechCrunch (Nov. 18, 2021), https://techcrunch.com/2021/11/18/constitutiondaos-bold-crypto-bid-for-us-constitution-falls-short/.
19 Wis. Stat. § 178.0102(11).
20 Wis. Stat. § 178.0102(10).
21 Wis. Stat. § 178.0306(1).
22 Wis. Stat. § 178.0204.
23 Flamingo, Organization, https://docs.flamingodao.xyz/Organization.html (last updated Sept. 23, 2020) (“Flamingo is organized as a Delaware limited liability company.”).
24 Elena Botella, Wyoming Wants to Be the Crypto Capital of the U.S., Slate (June 28, 2021), https://slate.com/technology/2021/06/wyoming-cryptocurrency-laws.html; Cryptopedia, Wyoming Laws Regulating Blockchain Businesses, www.gemini.com/cryptopedia/wyoming-blockchain-bill-law (last updated Dec. 7, 2021).
25 Wyo. Stat. § 17-31-104 (“A decentralized autonomous organization is a limited liability company whose articles of organization contain a statement that the company is a decentralized autonomous organization …”).
26 Wyo. Stat. § 17-31-105.
27 Wyo. Stat. § 17-31-110 (subject to the “implied contractual covenant of good faith and fair dealing”).
28 Wyo. Stat. § 17-31-111.
29 Wyo. Stat. § 17-31-112.
30 Wyo. Stat. § 17-31-102 (“‘Smart contract’ means an automated transaction … or any substantially similar analogue, which is comprised of code, script or programming language that executes the terms of an agreement and which may include taking custody of and transferring an asset, administrating membership interest votes with respect to a decentralized autonomous organization or issuing executable instructions for these actions, based on the occurrence or nonoccurrence of specified conditions.”).
31 Dorsey & Whitney LLP, Wisconsin Adopts Second Cooperative Statute: The Wisconsin Cooperative Associations Act (March 2007). Wisconsin adopted its cooperative act, Wis. Stat. chapter 193, in 2007; at that time only Wyoming, Minnesota, Iowa, and Tennessee had such statutes and all were adopted since 2001.
32 Wis. Stat. § 193.215.
33 Wis. Stat. § 193.505.
34 HAUS, Members, https://daohaus.club/docs/users/membership/ (last visited March 9, 2022) (“Rage Quit allows a member … of the DAO to leave with all or part of their share of the tokens. Imagine a DAO that has 1000 DAI, 50 Shares, and 50 Loot. That means if you own 10 Shares of the DAO and ragequit all of your shares, you’d leave with 100 DAI, or 10% of the treasury.” – in lawyer words: disassociation with mandatory redemption of interest at the election of the member); Snapshot, Voting Types, https://docs.snapshot.org/proposals/voting-types (last visited March 9, 2022) (“Each voter may spread voting power across any number of choices. The results are calculated quadratically, you can test out these calculations here https://wtfisqf.com/” – a form of voting similar to rank choice voting); Jacqueline Radebaugh & Yev Muchnik, Exclusive Report: Solving the Riddle of the DAO with Colorado’s Cooperative Laws, The Defiant (Dec. 16, 2021), https://thedefiant.io/solving-the-riddle-of-the-dao-with-colorados-cooperative-laws/.
35 See Ramaswamy & Mascarenhas, supra note 18.
36 Wompwomp, Dictionary.com(last visited March 9, 2022).
» Cite this article: 95 Wis. Law. 16-21 (April 2022).