It can be difficult, bordering on impossible, for peer-to-peer blockchain projects to comply with laws drafted on the assumption of a hub-and-spoke world where middlemen exist that can be regulated and deputised police their clients. This post is going to explore one such example: managed investment schemes under Australian law, what Americans call investment contracts.
If you are launching a blockchain project in Australia, you don’t want your tokens classed as financial products. Like other jurisdictions, Australian law contains extensive restrictions and licensing requirements for people dealing in financial products. Meeting these requirements is impossible for a genuinely P2P, decentralised blockchain.
Among the many ways you can inadvertently find yourself dealing in financial products is if your token is an interest in a managed investment scheme. A managed investment scheme is a scheme that has the following features:
(i) people contribute money or money’s worth as consideration to acquire rights (interests) to benefits produced by the scheme (whether the rights are actual, prospective or contingent and whether they are enforceable or not)
(ii) any of the contributions are to be pooled, or used in a common enterprise, to produce financial benefits, or benefits consisting of rights or interests in property, for the people (the members) who hold interests in the scheme (whether as contributors to the scheme or as people who have acquired interests from holders)
(iii) the members do not have day-to-day control over the operation of the scheme (whether or not they have the right to be consulted or to give directions).s9 Corporations Act 2001 (CTH)
Prima facie, it does not appear easy for a blockchain project to fall outside these tests.
A “scheme” has a broader definition than “enterprise” or “business”. All that is required is a program or plan of action. There is little doubt that multiple machines operated by multiple people all running sufficiently compatible code with some kind of consensus mechanism so as to create a blockchain would constitute a scheme.
“Contribute Money’s Worth”
“Contribute money’s worth” requires that multiple people provide something of value in accordance with the scheme in return for interests in the scheme. It seems highly likely that providing a validator or server to run compatible code and a canonical database is a contribution, and the actual or contingent ability to earn token rewards would be the benefit acquired through this consideration.
“Pooled or Used in a Common Enterprise”
Even though my server is not being pooled – it always remains my server – the overall blockchain would probably constitute a “common enterprise”. The blockchain needs many people like me running servers all of which can talk to each other and maintain a canonical state. Having many people run nodes is part of the scheme. And the interests being produced – tokens or the chance to earn tokens – are almost certainly a benefit in the form of a financial gain or form of property.
Two Out of Three is Not Good
So, in launching a blockchain project, I’ll almost certainly have a scheme that requires multiple people to launch validators that run the same code and database so as, together, to form a useful blockchain in return for digital tokens that have value or are a form of property.
At this point, I am almost certainly launching a managed investment scheme.
But What About “Day-to-Day Control”?
The remaining prong is that members of a managed investment scheme do not have day to day control over the scheme. This is where, if anywhere, the use of blockchain technology is supposed to provide a benefit. By obsoleting middlemen and minimising non-code-enforced co-ordination tasks, it is possible that members exercise direct day-to-day control over the running of the chain through the act of running a validator. There simply isn’t much to do other than run the code and monitor the machine.
“The Scheme” Matters
I say possible because the law is far from certain and individual facts can matter. Australian courts do not consider you have “day-to-day control” if you have the right to excise control but delegate that right to a manager or a committee. The members “as a whole” must be involved in the day-to-day management, not through an agent or through a committee. And that managerial control must exist in action, not as a theoretical right. So, in considering whether members as a whole are involved in the day-to-day decision making, we come full circle to the importance of defining the scope of the scheme.
Is “The Scheme” Just About Machines?
To the extent the scheme consists simply of running sufficiently compatible code on my server in return for token rewards as determined by the open-source code, I am probably involved in the day-to-day operation of the scheme to a sufficient degree for a court to find that it is not a managed investment because no one is managing the scheme on my behalf. But a court might be convinced to define the scheme more broadly or the blockchain may have quirky governance that reintroduces quasi-managerial middlemen.
Does “the Scheme” Include Coding?
For example, does “the scheme” include the process by which the code is evaluated, tested, de-bugged, and updated? While the code base might be open source and, in theory, anyone can work on it, there is little chance that the members as a whole are involved in this day to day. So it would be important for validators as a group to retain control of the code they run. Functions like auto-updates that compel machines to run canonical code should probably be avoided.
Who Are The Members of “The Scheme?”
Who are the members? If the members include users or holders of tokens, then there is little chance they are involved in day to day running of the blockchain. They rely upon the coders and the validators. So it would be important to, as far as possible, limit members to whom the protocol issues tokens to those who run validators. Mechanisms like staking rewards to mere token holders should be avoided.
Is There a DAO?
Does the chain have a DAO? If so it is possible the DAO is part of the scheme, raising further problems. Who are the members of the DAO? If all holders of tokens are DAO members then they are probably scheme members, too. The broader the membership of the DAO the more likely it is that those members as a whole do not have day-to-day control of the scheme.
Many have noticed that a common problem with blockchain governance is the vast majority of members don’t participate. This is a problem given Australian courts consider actual day to day control not a theoretical right of control. If the majority of DAO members leave the DAO operations to a select few, then it increases the likelihood of the project being a managed investment scheme. This is even more likely where a DAO, in response to this reality, has adopted a traditional board and membership type structure. Then it is likely to contribute to the perception that members as a whole do not have day to day control.
Further complications arise if the DAO works on the basis of governance tokens because these are now a wholly new type of interest ether complicating the analysis of the main chain’s status or, worse, constituting the DAO as its own managed investment scheme independent of the chain itself.
Is There a Foundation?
Does the blockchain have some kind of Foundation – DAO or not? This will need to be carefully designed so that the Foundation does not become a part of the scheme, or the leading mechanism by which the blockchain is managed and promoted. An overly dominant or activist Foundation, particularly one that manages a significant treasury or one that mints/burns tokens, increases the likelihood that members as a whole are not the ones managing the scheme day-to-day. Worse, the scheme now has a recognisable promoter who should preparing and filing the necessary prospectuses and product disclosure statements.
Governance – It’s a Trap!
Given all these considerations it is reasonable to wonder why many of the existing blockchain projects are not managed investments under Australian law. Time will tell, after the courts and the regulators have been forced to address the issues specifically. But, it is clear Nick Szabo is right about his “ruthlessly minimized” approach to blockchain governance:
“Blockchain governance generally comes in only three varieties:(1) Lord of the Flies, (2) lawyers, or (3) ruthlessly minimized.” Someone asked, “Why ruthless?” and Szabo wrote, “Otherwise the children or the lawyers will win.”Paumgarten, Nick (October 22, 2018). “The Prophets of Cryptocurrency Survey the Boom and Bust”. The New Yorker.
The point is the more “governance” the blockchain project has the more likely it is a scheme with members earning benefits by making contributions to a common enterprise over which they do not exercise day to day control. And then you’re going to need good lawyers…
You might also be wondering “So what?”. If you’re a managed investment scheme, then comply with the law and get on with life. Well, let’s leave that for the next post…