Thursday, November 2, 2023

Limited Liability

Regulation works by assigning liability for actions to specific actors. The whole idea of decentralization is that by diffusing responsibility among a large number of participants the system could evade regulation. Each participant would bear such a small part of the responsibility for the system's actions that enforcing liability for the actions to each of them would be infeasible. The problem with this is that, for economic reasons, the Gini coefficients of cryptocurrencies are extremely large. It is true that most of the participants have only a small part of the responsibility, but there are always some who have a large share and are thus worth enforcing liability against.

In Piercing The Veil I discussed a Commodity Futures Trading Commission enforcement action in which the bZeroX exchange converted itself into a DAO:
By transferring control to a DAO, bZeroX’s founders touted to bZeroX community members the operations would be enforcement-proof—allowing the Ooki DAO to violate the CEA and CFTC regulations with impunity, as alleged in the federal court action. The order finds the DAO was an unincorporated association of which Bean and Kistner were actively participating members and liable for the Ooki DAO’s violations of the CEA and CFTC regulations.
Below the fold I discuss a post in which Matt Levine reports on a more recent lawsuit making the same argument.

In List And Dump Schemes, based on Fais Khan's "You Don't Own Web3": A Coinbase Curse and How VCs Sell Crypto to Retail, I described how A16Z and other VCs exploited crypto tokens. Levine recaps this concisely:
In the crypto boom, VC firms discovered a different way to invest in startups. The startup would be a crypto project, and it would issue tokens, and the VC firm would buy the tokens. The tokens might have some governance rights: The crypto project might be a DAO, a decentralized autonomous organization, whose token holders get to vote on what it should do.

The advantages of this structure, for VCs, were:
  1. Crypto tokens, DAOs, web3, etc. got a lot of hype, so in 2021 you could buy these tokens and resell them for more of a profit than you might get by investing in normal stock in normal startups.
  2. You could sell faster: Crypto tokens lived, or seemed to live, in a weird regulatory gray area, so you could buy the crypto project’s tokens, say to yourself “ahhh these tokens are not securities, they are ‘little more than alphanumeric cryptographic sequences,’” and sell them to retail investors on some crypto exchange. Instead of buying stock and waiting for years for a startup to be successful enough to do an initial public offering, you could buy tokens and flip them quickly while the hype was strong.
Then Levine turns to the liability issue:
But there is another problem with the token approach, which is that, while these tokens might be functionally stock, and while the SEC thinks ... that they are therefore securities, they are not literally stock, and these crypto DAOs are not literally corporations. Specifically, they are not incorporated. Nobody filed a form with the Delaware secretary of state to incorporate the crypto DAO as a corporation.

This seems like a small technicality, but one important benefit that you get, from filling out a form and paying a fee to incorporate a corporation, is limited liability. If you have a business entity that is not incorporated, then it is often, by default, a general partnership. Which means that the investors who fund and participate in running it are, arguably, general partners. Shareholders of a corporation are not generally liable for the corporation’s actions, but general partners of a partnership generally are. For instance, they might be liable for its unregistered sales of securities.
The recent lawsuit is about the governance token for Compound:
Late last year, some holders of Compound DAO’s COMP tokens sued the venture capitalists backing Compound for unregistered securities sales. The idea is:
  1. “Compound is a business that allows users to borrow and lend crypto assets, in much the same way that a traditional bank allows customers to borrow and lend traditional currencies.” ...
  2. Compound is governed by a DAO, and “Compound DAO is governed by the holders of a security called COMP.”
  3. Compound issued some COMP tokens to its early investors and founders. It issues others to people who use the Compound smart-contract protocol: If you deposit or borrow on Compound, you can earn COMP tokens ....
  4. COMP trades publicly on crypto exchanges: If you use Compound and get some tokens, you can sell them for cash, and people do.
  5. “Nine people control at least 51.56% of the COMP currently issued,” including the co-founders of Compound and venture capital firms including Bain Capital Ventures, Polychain Alchemy, Andreessen Horowitz and Paradigm.
  6. Those people and firms are general partners of Compound, liable for any bad stuff that it does.
  7. One arguably bad thing that Compound does is list the COMP token on crypto exchanges, where people can buy it.
  8. The plaintiffs in this case bought some COMP on the exchanges — not from Compound or its venture investors — and are now suing, arguing that this was an unregistered sale of securities and that the venture capitalists are responsible for it.
The reason the plaintiffs are unhappy with the VCs is obvious from the "price" chart. COMP peaked on 3rd May 2021 at $831; it currently trades around $45, down 94% from the peak. It wasn't a typical list-and-dump scheme, because it actually went up from its launch for about a year before peaking.

So far, things don't look good for the VCs:
The VCs moved to dismiss the complaint, and last month a federal judge denied their request, finding “that there are sufficient allegations against each of the Partner Defendants to allow the Securities Act claim to go forward at this juncture.”
Levine eloquently summarizes the problem:
One thing that crypto enthusiasts and venture capitalists liked to say was that crypto was a new way of organizing human economic behavior, that crypto would enable a new “Web3” in which technology was organized collectively and belonged to its users instead of being owned by big corporations. This could seem pretty cynical, as VC firms often owned big stakes in (the tokens of) these web3 projects.

But also it was just a big factual mistake! Crypto and DAOs and web3 were not a new way of organizing human economic behavior; they were an old way, the general partnership. They were a technological step backward: Ages ago, lawyers and financiers and governments figured out a new way to organize human behavior, the corporation, which allowed people to pool their capital in a new venture in ways that limited their risk and thus encouraged more and safer capital formation. And then crypto came along and people forgot.

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