Crypto Associations

Standing behind every crypto asset is a crypto association. Blockchains are typically not organized as traditional legal entities such as a corporation, partnership, or LLC. Instead, they operate through a decentralized network of participants who are bound together by economic incentive to collectively run the blockchain. A Developer typically starts the blockchain, writing the computer code that creates a digital ledger and sets the rules that govern it. The Developer recruits Validators who will verify the transactions recorded on the blockchain in return for compensation in the form of crypto assets. Purchasers of the crypto asset are also necessary to initially fund the creation of the blockchain and provide a liquid secondary market that helps ensure that the Developer and Validators are compensated for their work.

Many crypto associations maintain that they operate differently from entities. They do not have a central decisionmaker such as a board of directors or partnership management committee. This position has been crystallized in litigation where crypto defendants have taken on the startling position that crypto associations owe no contractual or other legal obligation to Purchasers of crypto assets. If investor funds are diverted by Developers for their own enrichment, or crypto assets become worthless because Developers do not follow up on their promise to build a network, the Purchasers have no legal remedy against the Developer or any other party.

Courts and the SEC thus far have not found this argument persuasive. They have often concluded that crypto associations are no different than traditional entities such as general and limited partnerships. There is ample common law holding that partnerships can be formed without a written agreement. Some crypto associations resemble general partnerships, where owners of crypto assets invest collectively and vote on decisions for the partnership. Others resemble limited partnerships, where passive investors rely on the efforts of a general partner who makes decisions for the entity. Partners owe legal duties to each other and general partners owe legal duties to limited partners. In their decisions concluding that crypto associations are entities, courts have understandably shown a preference for standard legal arrangements that provide mandatory protection for investors.

In arguing that they owe no duties to investors, crypto associations are essentially advancing a strong form of contractualism. A contractualist believes that enterprises are the product of negotiations between investors and managers rather than state creations defined through mandatory government rules. If Purchasers are willing to buy crypto assets without any assurance of a remedy from Developers or any other party, a contractualist would contend that they do so out of preference and should be able to agree to that contract without governmental interference.

A standard response to contractualism in the corporate law literature, the problem of midstream governance changes, is particularly relevant to crypto associations. Even if investors can price the impact of an unfair governance arrangement when they initially invest in an enterprise, it is difficult for them to price the impact of subsequent changes to governance that reduce an enterprise’s value. Once they are invested, they are vulnerable to corporate governance abuses that reduce the value of their investment. Because they are not structured by contract, crypto associations have a unique tendency to shape-shift. They can change from dictatorships to democracies and back again. Crypto asset investors may find that their initial investment, which was priced based on one governance structure, can be adversely affected by such changes.

The issues raised by crypto associations highlight a broader point about the purpose of entities. Corporate law theorists such as Henry Hansmann, Reiner Kraakman, Richard Squire, and Margaret Blair have argued that legal entities are essential because they help lock in capital that can be invested in long-term projects. Legal entities are necessary because they separate capital from the needs of their individual investors in a way that is difficult to achieve by contract alone. My Article argues that the problems raised by crypto associations highlights an additional reason for entities. In addition to facilitating long-term investment, entities are useful because they segregate capital to ensure it is available to comply with legal obligations imposed by society. Without an entity, it is difficult to prevent and remedy social harm caused by a business association.

My Article concludes by arguing that crypto regulation must find a substitute for the entity for crypto associations to be viable in a society that demands accountability of business enterprises. I propose that federal regulation require that Developers that raise substantial funds by selling crypto assets are Controllers of the crypto association. Such a Controller would be obligated to set aside capital to comply with disclosure obligations and cover the crypto association’s legal liabilities. The identity of the Controller could change over time as the crypto association evolves.

Crypto associations have shown that a decentralized group of actors can create economic value for a significant time. A combination of incentives and technology can create an association with a valuation on par with the largest public corporations. The main challenge in regulating crypto associations is ensuring that they are accountable for the harm they may cause. Regulation can substitute a Controller for an entity to lock in capital that can be used to fulfill a crypto association’s social obligations.

 

Article link:
https://ssrn.com/abstract=5254379