David M. Adlerstein is counsel at New York law firm Wachtell, Lipton Rosen & Katz, where he focuses on mergers and acquisitions, corporate, securities law and regulatory matters.
In this opinion piece, Adlerstein highlights a deficiency of many ICOs that he believes has received too little attention – governance and investor rights.
Initial coin offering (ICO) activity remains white hot despite the SEC's finding that tokens can be securities – even China's outright ban appears to be having only a modest overall impact.
Given the spate of ICOs and the manifest regulatory focus, it should be assumed that non-compliant issuers and promoters, unregistered exchange platforms and investors reselling securities will be subject to civil or even criminal liability under federal law (or less familiar, but still potent, state "blue sky" laws).
But while the debate over the treatment of blockchain-based tokens under securities laws has garnered much attention, there has been comparatively little public discussion about the corporate governance model, if any, applicable to ICO tokens.
If ICOs are analogized to initial public offerings, state laws vest responsibility for oversight of a corporation (the entity type of the vast majority of public companies) in a board of directors elected by shareholders and charged with overseeing management. For many years, debate has raged with respect to whether public companies should migrate away from a board-centric governance model (which tends to be more conducive to long-term shareholder returns) to a shareholder-centric model.
But even partisans in this debate would not advocate scuttling some balance of board and shareholder power for either the corporate equivalent of autocracy on the one hand or direct democracy on the other. And public companies are subject to periodic disclosure requirements, independent third-party audits and a suite of other structures that collectively protect shareholders, such as charters and bylaws and stock exchange rules, as well as the long-established fiduciary duties of care and loyalty.
If ICOs are instead analogized to venture capital investments, while preserving reasonable power for founders, normal venture capital investment documentation provides accredited investors with strong contractual governance rights (e.g. consent rights over fundamental corporate actions, anti-dilution protection, liquidity rights, etc.).
And even in the case of investments by a limited partner in a limited partnership or a non-managing member in an LLC, such as in a typical hedge fund, limited partners or members normally enjoy substantial contractual rights, such as priority return of invested capital through the investment vehicle's waterfall, and reasonable information rights.
All not created equal
An irony of the SEC's finding on The DAO is that — the infamous hack aside — from one standpoint The DAO was an unusually investor-friendly token. Specifically, its governance was structured in a manner akin to a New England town hall: investors would have had voting rights over all potential DAO projects.
Whether or not the "crowd" is wise, at least in the case of The DAO it would have had a voice – The DAO represented the outer bound of shareholder-centric governance.
Conversely, the governance model for many ICOs appears to be structured at the opposite extreme, on the model of an autocracy.
While it would be nice to imagine lands ruled only by benign philosopher kings, pity the ICO investor whose hard-earned funds exist in a cyber Westeros (or, to be charitable, a Kickstarter campaign with no right to a refund in the case of a failed project).
Notable governance shortcomings of many ICOs include the following:
- No system of checks and balances through an elected board with oversight over management.
- No token holder voting rights
- No anti-dilution protection, other than informal comfort that the base code will not permit an increase in the number of tokens outstanding or migration to another token
- No binding contractual commitment to use best efforts to create the platform for which the tokens are being created (only an expression of intent in a "white paper")
- No contractual limits on how raised funds are to be expended (and no limits on compensation), potentially misaligning development team and token holder incentives
- No investor contractual rights, other than the contents of a non-negotiated agreement, with one-sided terms (such as a broad disclaimer of warranties and limitation on liability, and/or purported token holder obligations to provide indemnification)
- Unfair token allocation procedures
- Lack of transparency with respect to large ownership concentrations and associated susceptibility to price manipulation
- No reporting or audit mechanism
- Exclusive submission to a foreign forum for the resolution of disputes.
The foregoing is not to suggest that all ICOs are badly structured from an investor's standpoint or that a "one size fits all" governance model should be adopted.
But, particularly in the case of unregistered tokens that are found to be securities and that find their way to "retail" investors, it is questionable whether a court would give effect to the non-negotiated limitations the "terms and conditions" of an ICO would purport to impose on investors.
Lessons for learning
But in crypto-land, governance matters.
The above-described governance structures outside the ICO context were not foisted on the market: they evolved because it is healthy for investors, and the market, for investors to have information rights (in Brandeis’ words, sunlight is the “best of disinfectants”), and constructs to ensure that managers act in investors' interests (and can be replaced if they fail at this charge).
The ICO space is already learning that securities laws exist for reasons that should have been evident since 1929.
Unfortunately, many less-discerning ICO investors will learn the hard way that long-established corporate governance norms exist for a reason as well.
For all the innovativeness that ICOs offer, clear and thoughtful governance structures are likely conducive to the long-term success of projects, and the space would benefit from governance best practices more in keeping with corporate norms. Specifically, these are: project oversight with a view to token holders' best interests; structures that align developer and token holder incentives; reasonable token holder contractual rights; and clear and fair disclosure protocols.
Disclosure: The views expressed are the author's and do not necessarily represent the views of his firm.
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