co-authored with Connor Spelliscy
tl;dr While many crypto startups have successfully made their users into owners by following the Progressive Decentralization playbook, a number of founding teams feel compelled to step back from their projects at the time of token launch to reduce the risk that their tokens will be deemed securities. An alternative path may allow founders to stay involved confidently by building their platforms to mirror the democratic structure of member-owned cooperatives. This approach may allow teams to improve stakeholder equity, community decisions making, and product quality, all without sacrificing founder leadership.
I. The problem: founders step back from leadership, hindering innovation
Founding crypto teams often feel compelled to step back from their projects at the time of token launch, in part, due to fear that their continued involvement in such projects will increase the risk that their projects’ tokens will be deemed securities.
Why is a founding team’s continued involvement potentially a problem? Because their token is more likely to be deemed a security if a tokenholder expects profits derived from the managerial or entrepreneurial efforts of others. Thus, in order to reduce the risk that a regulator might find that tokenholders purchased tokens expecting to profit from the efforts of the founding team, the team distances itself from specific parts of the project—for example, refraining from discussing the token publicly, hosting UIs, or participating in protocol governance.
Founders stepping back from a project offer an opportunity to decentralize leadership and provide an open source tool to the community, which is an applaudable objective given that decentralized control and ownership are key principles of crypto networks and The Ownership Economy. That said, when a founding team steps away, users risk the loss of their institutional knowledge and leadership. We believe policymakers would likely prefer that founders stay involved to help steward the overarching policy goals of consumer protection, yet the guidance remains unclear and pushes many teams to reduce their involvement.
Where a network is sufficiently similar to a cooperative (aka co-op), however, we believe the team could launch a token and decentralize ownership, while continuing to lead their project without fear of violating securities regulations.
This model will not be for everyone! It won’t even work for most! But many networks already unknowingly share key similarities with cooperatives that might allow for them to make the argument that, like cooperatives, the control/ownership rights that they convey to users are not securities. And where a network is not sufficiently similar, the founders should consider whether certain trade-offs might make their network sufficiently similar, and thereby allow them to continue playing leadership roles at, or make meaningful contributions to, their project after token launch.
For this to work, a founding team must be dedicated to integrating the values and processes of a cooperative into its structure (though they do not necessarily need to legally incorporate as a cooperative). Courts place an emphasis on economic reality and disregard form when assessing securities, so they will look through attempts to set up cooperatives that lack substance. In mirroring the structure of a cooperative, projects will also benefit from an organizational structure that has been designed over generations to prioritize stakeholder equity and collective participation.
In this post we’ll focus on U.S. law and cooperatives but founding teams should also consider the benefits of similar organizational structures in different jurisdictions. For example, Nexus Mutual has organized its decentralized insurance alternative as a discretionary mutual, a type of cooperative in the U.K. and Australia which does not have a direct equivalent in the U.S.
This post does not provide a comprehensive legal analysis. We are flagging this argument for further consideration and these alternative structures in the hopes that founding crypto teams consider them with counsel. If you think this structure might work for you, discuss it with counsel who has a strong understanding of blockchain law and relevant organizational structures.
II. Potential solution: code rules that make the network analogous to a cooperative
(a) What is a cooperative?
A cooperative is an autonomous association of persons (“members”) united voluntarily to meet their common economic, social, and cultural needs and aspirations through a jointly-owned and democratically-controlled enterprise. (source)
Unlike with typical stock ownership, distributions of the benefits to a cooperative’s members are not proportional to those members’ initial investments, but are instead determined by their labor, efforts and success in using the cooperative, also known as “patronage.” The more a member patronizes a cooperative, the more services that member receives and/or the more of the cooperative’s earnings are allocated to that member.
Cooperatives can resemble traditional corporations in that they have similar functions and follow similar practices: including electing a board of directors to set policy and hiring a manager to run the operations. Cooperatives can be incorporated under state law or operated as unincorporated associations. Some states have established themselves as leaders in cooperative governance, and places like Wyoming and Minnesota are considered to be the “Delaware of cooperatives.”
Two common forms of cooperatives are consumer cooperatives, which are owned by consumers who buy goods or services from their cooperative (e.g., REI, Navy Federal Credit Union, Pedernales Electrical Coop) and producer/marketing cooperatives which are owned by the producers of commodities or crafts who have joined forces to process and market their products (e.g., Sunkist, Dairy Farmers of America).
Despite the similarities, cooperatives are fundamentally different from typical corporations in their ownership/control and distribution of benefits. For our purposes, some of the key distinctions include (source):
- Cooperatives are owned and controlled by members, not shareholders — The leaders of a cooperative are generally elected by its members, who are the users of its products or services. Unlike in a corporation, each member usually has only one vote in selecting directors, rather than having voting power based on the amount of shares they hold.
- Earnings are allocated to members based on the amount they use the cooperative — By contrast, in a corporation, earnings are allocated to shareholders based on the amount of equity they hold. Use of a cooperative includes activities like buying or selling to, or marketing goods through, a cooperative.
- Members form a cooperative to receive a service, not a financial return from a liquidation event — Unlike shareholders in a corporation, members of a cooperative want to obtain a service, like a market for products or the performance of a specialized function. However, members can also be motivated to join, in part, for a financial return. For instance, members may join so as to participate in the financial upside of buying at a discount by leveraging the greater purchasing power of a cooperative. See below for a further explanation of the financial upside in cooperatives.
- Capital is generally contributed by members and debtholders, rather than by equity investors — Cooperatives generally raise capital by direct contributions through membership fees, by agreement with members to withhold a portion of net income based on patronage, or through retention of a portion of sales proceeds for each unit of product marketed. More recently, cooperatives have started employing a variety of financing mechanisms, including the sale of preferred shares, which function as a mix of debt and equity. Preferred shares are considered to be debt because they often come with an interest rate and are eventually redeemable for their par value, and equity because they provide the holder with certain other rights (e.g., pro-rata rights, rights of first refusal, etc.). (source)
(b) Why do cooperatives provide a useful framework for crypto token securities analysis?
Co-op rights to ownership are not securities
Based on the rulings in United Housing Foundation, Inc. v. Forman, and B. Rosenberg and Sons, Inc. v. St. James Sugar Cooperative, Inc., we believe tokens representing ownership rights similar to membership or stock in a cooperative are not securities under U.S. law. In both decisions, the courts held that “stocks” representing membership and ownership in cooperatives, were not securities.
In reviewing United Housing and B. Rosenberg, one legal commentator provided that: “Securities law views the cooperative member as unique. Relationships established by cooperative principles are the very reason for the investment instrument’s identity as something other than a security despite similarities in name and form.” (source)
In United Housing, the U.S. Supreme Court found that “shares of stock” which entitled the buyer the right to occupy an apartment in a housing cooperative were not securities. The decision was made, in part, because the stocks did not possess the characteristics traditionally associated with stock, namely that they could not be transferred to a non-tenant, they conferred no voting rights in proportion to the number of shares owned, and they could not appreciate in value. Further, the co-op did not seek to attract investors; on the contrary, they emphasized the “non-profit” nature of the cooperative.
In B. Rosenberg, the court found that “stock” in a co-op marketing agency was not a security, in part, because the stock could not be transferred, bore no dividends, and entitled each member to only one vote. In holding that the stock was not a security, the court found that the “distinguishing feature of a security transaction is that the investor is motivated solely by the prospects of a return on his investment from the efforts of third persons. However, when a purchase is motivated by a desire to use what he has purchased, the securities laws do not apply.”
The courts in both decisions evoked the “efforts” test of Howey, and found that “investments in a cooperative do not reflect investments of money in a common enterprise with profits to come solely from the efforts of others. It is the efforts of the membership itself that sets the course of the cooperative.” (source). Where members have an appropriate level of control over an organization (i.e., the expectation of profit depends on the members’ own efforts, rather than the efforts of others) it supports the argument that they were not investing in securities.
For further insight on judicial treatment on the “efforts of others” prong of the Howey Test, see Foxfield Villa Associates LLC v. Robben. While this case explores LLC interest, the key conclusions and use of the Schaden Test should apply equally to co-ops.
Crypto networks may not need to formally become co-ops to benefit from favourable securities treatment
Your project may not need to incorporate as a cooperative to benefit from the favourable securities analysis courts provide to co-ops. Instead you may just need to incorporate elements of the co-op structure, such that the economic substance of the sale of your tokens is analogous to that of co-op stocks.
In B. Rosenberg, the court held that in “searching for the scope of the word ‘security,’ name or form should be disregarded, and the emphasis placed on economic reality.” This principle is often discussed and applied by courts and regulators in the context of cryptocurrency. For instance, in discussing cryptocurrency, SEC Director William Hinman provided “…I recognize that the Supreme Court has acknowledged that if someone is purchasing an asset for consumption only, it is likely not a security…But, the economic substance of the transaction always determines the legal analysis, not the labels” (source)
As mentioned previously, we have by no means completed an exhaustive legal analysis of this topic, and we welcome others to dive deeper and fill us in on their learnings.
(d) How should token projects apply these lessons?
Founding teams of projects that are launching tokens should consider whether their organizations have incorporated, or can incorporate, enough features of a cooperative to benefit from its unique structure and securities treatment. In this context, their tokenholders would be entitled to membership in a network, to a certain amount of use of a cooperative, and/or other benefits. Below are brief explorations of how some features of cooperatives might be applied in the context of crypto projects:
(1) Democratize decision making
Democratizing decision making could include allowing tokenholders to have equal votes in selecting management, board members or making decisions about protocol upgrades. Many networks already allow for tokenholders to contribute to network governance but the decision-making rights of those tokenholders is usually proportionate to the number of tokens held, rather than equal voting rights for each person/entity regardless of the number of tokens they hold.
While democratic, cooperatives can still operate efficiently when members elect professional and effective leadership, whose day-to-day roles can be similar to executives at corporations. Founding crypto team members could maintain formal leadership roles by being elected to board positions or appointed to managerial positions, or informal leadership as members of the cooperative.
Cooperatives likely require some form of KYC protocol, so you can verify the unique individuality of your users (KYC may also potentially solve other problems with governance, such as Sybil attacks).
(2) Limit token transfer and focus on utility, not price
Crypto projects could structure and market their organizations such that tokenholders have no expectation of profit, and are only incentivized to buy tokens in order to receive a service. This would likely include making tokens non-transferrable, except to other members who intended to use the co-op. In practice, this could be achieved in the same way Nexus Mutual has done it—by using a whitelisted DEX or AMM (Automated Market Maker) that only allows verified members to trade. Presumably this enables liquidity to scale with the size of the network and membership base.
In both Union Housing and B. Rosenberg, the courts held that the stocks representing membership rights in co-ops were not securities in part because they could not appreciate (at least materially) in value, and that they could only be transferred to others who would use the services of the co-op. However, in practice, it is unlikely that the value of the assets held by co-ops will remain stable, and changes in value will ultimately be passed on to members.
If there’s a possibility of gains from purchase of the token, you may still be in the clear. Federal courts have recognized that a cooperative’s stock is not necessarily a security where there is a possibility of gains from appreciation in the value of a member’s stock because the possibility of such gains may be incidental to the member’s primary purpose of obtaining goods and services from the cooperative. (source) Moreover, the SEC has granted favorable “no-action” letters to several cooperatives whose stock has the capacity to appreciate or depreciate in value. (source)
This requirement does not preclude cooperatives from running efficient marketplaces, or allowing for members to benefit financially from their participation in a cooperative. For instance, while Nexus Mutual has a clause in its Articles of Association that prevents the mutual from making a profit when considered across all members over time until it shuts down, individual members can profit by underwriting coverage in the Nexus Mutual marketplace. On average, members buying coverage take a loss and members underwriting coverage make a profit, but the class as a whole does not realize a profit.
An obvious note on the above is that the members may collectively benefit if the assets held by the cooperative appreciate in value against other assets (e.g., the cooperative holds ETH, and the price of ETH goes up against the USD).
(3) Allocate earnings to tokenholders on the basis of their patronage of the network
Many networks already allow for a variation of this principle by, for instance, allowing tokenholders to be compensated by lending or staking their tokens. One of the best examples of patronage in the context of crypto may be UMA’s Developer Mining, where developers are rewarded based on the total value locked in the financial contracts they design. Said differently, developers are rewarded based on their use of the network.
Crypto offers cooperatives the opportunity to improve on legacy approaches to patronage. For instance, a crypto network will likely be able to more easily track patronage or launch a token with an inflationary supply, aimed at rewarding those members who use their tokens earlier.
(4) Rely on financial contributions from members, debtholders, preferred shareholders… and others?
Cooperatives can raise financing through member contributions (a distant cousin of crowdfunding), debt financing, and sales of preferred shares. For instance, Nexus Mutual raised capital through a sale of its NXM token to members, which those members could use to stake smart contract coverage and participate in the marketplace. A similar approach has not been tested in the U.S., but it’s encouraging to see innovation that has the potential to bring the cooperative model into the digital age.
(5) Provide consistent disclosure of project information
Transparency and consistent disclosure of project information to tokenholders may also be favourable in a securities analysis, which is convenient for open source crypto projects. In Minn-Dak Farmers Cooperative’s successful 2012 request for a no-action letter from the SEC, their counsel argued that that the cooperative should be exempt from securities registration, in part, because the cooperative already provided sufficient information to members.
Further, the most important factor in the Schaden Test, which is employed by courts when considering the “efforts of others” prong of the Howey Test, is whether investors have “access to information.” The more accessible the information, the better the argument that the instrument in question is not a security. The logic here is that the “principal purpose of the securities acts is to protect investors by promoting full disclosure of information necessary to informed investment decisions.” (source)
For a further discussion of co-ops and crypto, see Jesse’s previous post Past, Present, Future: From Co-ops to Cryptonetworks. For a further discussion of compliant token distribution see Connor’s previous post Compliant Decentralization?: Exploring a Novel Approach to Token Distribution. DMs are open for anyone thinking creatively about building projects using these structures (@c_spelliscy and @jessewldn).
Thanks to Brian Brooks for prior conversations that inspired this post and to Jonathan Dotan, Nathan Schneider, Jake Chervinsky, Marvin Ammori, Hugh Karp, Jelena Djuric, Addison Cameron-Huff, Jason Somensatto, John Neufeld, Sam Zadeh, and the Blockchain Association team for their contributions and input.
This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. You should consult your own advisers as to those matters. References to any securities or digital assets are for illustrative purposes only, and do not constitute an investment recommendation or offer to provide investment advisory services.