The Foundation Problem
Pongo Points:
• Many cryptocurrency protocols enjoy continued development from a centralized team, typically in the form of a non-profit organization or a coordinated group under the guidance of a decentralized autonomous organization (DAO). While this is great for making sure consistent progress and growth is achieved, it poses the question: Are these organizations using the cover of "non-profit" to mask the fact that they're effectively companies developing products, and therefore possibly subject to securities laws?
• Cryptocurrency foundations share many similarities with for-profit companies and very few with charities or business leagues (at least in the US). If one drops the rose colored crypto glasses, it's not unreasonable to understand why the SEC believes that most cryptocurrencies are unregistered securities.
• If these foundations are using "non-profits" or DAOs as means to evade regulation, it suggests that they are, in fact, companies offering tokens akin to securities. In that case, the SEC's argument that most cryptocurrencies are indeed unregistered securities may hold some merit - i.e. an investment in a common enterprise with some expectation of profit that is derived from the effort of others.
Too Many Opinions Sink the Boat
Coding takes time. Coding takes effort. Coding takes money. It’s for these reasons that Bitcoin, while certainly upgraded from its initial release in 2009, has not grown nearly as fast as the rest of the cryptocurrency ecosystem, since it lacks a centralized entity to coordinate its development. In the time it took Bitcoin to implement Taproot (which streamlines basic transactions processing), we’ve seen the industry adopt proof-of-stake blockchains, decentralized finance protocols, NFTs, and more.
Why? Bitcoin is an orphan: Its anonymous founder, Satoshi Nakamoto, disappeared over a decade ago and has not returned. Ethereum’s founders, namely Vitalik Buterin, remain as key visionaries (and stakeholders) for Ethereum under the umbrella of the Ethereum Foundation, a non-profit organization. Solana has the Solana Foundation, Binance Chain has its foundation, and the pattern repeats with most major blockchains. For DeFi apps and NFTs, the theme switches to DAOs, but the major characteristics of coordination and commonality remain largely the same.
Of course, Bitcoin has a foundation too, but its history is rife with scandals and it holds virtually no power over Bitcoin’s development - certainly not in the same capacity as Ethereum’s or Solana’s foundations do for their respective blockchains. A core ethos of the crypto community is decentralization and permissionlessness, so naturally Ethereum and Solana also accept outside input from any user with respect to updating the code (just like Bitcoin), but the foundations are the unspoken leaders making changes to the protocol.
An issue that is likely to come up in the near future is that of crypto “foundations.” We all appreciate them supporting their project’s development, but that simultaneously makes them targets for regulatory agencies seeking to reign in crypto. If nearly everyone looks to the “Whatevercoin” Foundation for development updates on “Whatevercoin,” is the foundation’s non-profit status real or just a vehicle to protect teams from securities laws? Let’s play devil’s advocate and review through the eyes of the SEC.
Being as You Wish to Seem
Many of these foundations are legally incorporated in Switzerland, which has a loose definition of “foundation” by most standards, however it’s not totally unusual considering the global nature of blockchain projects. These foundations are typically headed up by individuals who had a strong connection to the group that developed the blockchain by the same name, such as founders, engineers, directors, or investors. Again, that makes sense since those individuals have intimate knowledge of the blockchains they intend to support through the foundation. The primary purpose of these foundations is to promote the development and application of new technology, particularly of the blockchain that shares its name with the foundation.
To the average individual, those reasons alone might bring into question the “arms-length” nature of the relationship between foundation and protocol, but let’s assume that these cryptocurrency foundations are honestly functioning as non-profit organizations. In the US, a foundation is established for a benevolent purpose, such as charity, education, or research, but there is specific language that differentiates charitable organizations (501(c)3) from business leagues (501(c)6).
It’s likely that if these cryptocurrency foundations registered in the US, they would attempt to do so under the 501(c)6 exemption. That’s what the Bitcoin Foundation did, even though it’s license was revoked in 2022. Here is a snippet of the IRS’s definition of a business league:
A business league is an association of persons having some common business interest, the purpose of which is to promote such common interest and not to engage in a regular business of a kind ordinarily carried on for profit…It does not include a group composed of businesses that market a particular brand within an industry.
The full language is available here, but the obvious standout line is that of “don’t market a particular brand.” Naturally, Switzerland’s looser language lends itself more easily to a cryptocurrency foundation marketing a particular brand rather than taking the more industry wide approach required by IRS guidelines.
While certainly essential to the rapid development of a blockchain, many cryptocurrency foundations likely wouldn’t qualify as non-profits in the US. As a result, it’s very likely that their vested participation in the support and development of one particular blockchain effectively makes them companies, and suggests that their blockchain’s tokens may be securities. Thus, the SEC’s latest critiques of the industry may hold true: Many cryptocurrencies are unregistered securities.
If You Can’t Go Over, You Must Go Under
The all-important “Howey Test” is cited by both crypto advocates and opponents alike, as it points to four relatively simple to understand prongs to indicate what might be considered a security. If an asset’s characteristics fall under each categorization, then the Howey test suggests that the asset is a security and must comply with applicable securities laws. (Personally, the Howey Test isn’t an all-encompassing review, so “failing” it doesn’t necessarily imply that an asset isn’t a security per every definition of a security under US law.)
One could argue that the tokens crypto foundations sell upon launching their blockchains are securities. No outside teams are participating in the development of the blockchain or its ecosystem, thus making the “foundation” the common enterprise to satisfy the Howey Test - disarming the “decentralized” argument that crypto proponents rely upon to protect crypto. Of course, products and services built on a blockchain might eventually require the use of the blockchain’s token to function - which does abstract away some of the “security-like” features - but is the cryptocurrency a security until that ecosystem develops?
It’s no surprise that the second largest cryptocurrency was aware of these potential liabilities when launching their token sale. Ethereum’s founder, Vitalik Buterin, wrote a note leading up to the initial offering of Ether tokens:
Ether is a product, NOT a security or investment offering. Ether is simply a token useful for paying transaction fees or building or purchasing decentralized application services on the Ethereum platform; it does not give you voting rights over anything, and we make no guarantees of its future value.
Naturally, the proceeds of the raise were for the development of Ethereum. To outside eyes, this looks like a typical venture capital investment - but thankfully the founder clarified that the tokens are only useful for using the platform and don’t constitute voting rights! (Now, with proof-of-stake, you’re required to hold tokens in order to run a validator node, which does give you voting rights on how the platform operates, but I digress...)
At the risk of sounding like a crypto-bear, it might be prudent for blockchain foundations to distance themselves from the development of the protocols they released and focus more on general crypto ecosystem education or charity. A major question moving forward will be: If the “Whatevercoin” Foundation mostly subsidizes the growth of “Whatevercoin” (and stands to benefit from it), is it truly a non-profit? Registering as a non-profit organization is dubious if your directive is supporting the development of the product you released, but it’s certainly a creative way to avoid securities laws.