Sep 22, 2017

            Distributed ledger technology disrupts traditional business organizations by introducing new business entities without the directors and officers of traditional corporate entities. Although these emerging entities offer intriguing possibilities, distributed entities may suffer significant collective action problems and expose investors to catastrophic regulatory and governance risks. Our Article examines key considerations for stakeholders and argues that distributed entities must be carefully structured to function effectively.

         This Article breaks new ground by critically examining distributed entities. We argue that a distributed model is most appropriate when distributed ledger technology solves a unique corporate governance problem. We caution against ignoring the lessons painstakingly learned through past governance failures.

Introduction

I.  Emerging Distributed Ledger Technology
   A. Distributed Ledger Technology
   B. Smart Contracts
   C. Distributed Governance

II. The Promise and the Perils
    A. Unique Benefits
        1.  New Business and Political Governance Structures
        2.  Decreased Cost of Financial Intermediation
        3.  Selectively Incorporate Stakeholder Communities
   B. Governance Risks
       1.   Difficulty of Smart Contract Coding
       2.   Free-Rider Problems
       3.   Regulatory Risk
       4.   Public Accountability Concerns

Conclusion

Introduction

In 2016, the Decentralized Autonomous Organization (The DAO) raised more than $168 million and emerged as “the largest crowdfunded project ever.^”[1] Its creators pitched a radical business innovation—a leaderless, decentralized venture capital firm that would allow investors to vote on and collectively fund proposals.^[2] Investors purchased digital share tokens, referred to as DAO tokens, with ether, a cryptocurrency designed to enable decentralized applications such as The DAO on the Ethereum platform.^[3]

The DAO offered a novel solution to traditional agency cost problems. In corporate structures, investors suffer when management and directors divert corporate resources to themselves. The DAO sidestepped this problem by substituting code for the directors and officers. Instead of relying on management’s loyalty, The DAO gave investors algorithmic certainty: once investors voted to back a proposal, The DAO would operate and disperse funds as its code specified.^[4] Tokenholders could even vote on governance proposals to shape The DAO’s rules, much like how shareholders now vote on corporate governance matters.^[5]

Investors hoped The DAO would democratize venture capital’s elite processes.^[6] Often, only the wealthiest and most connected place assets with venture capital firms. Even then, investors surrender control to the venture capitalists.^[7] The implicit biases of these venture capitalists (who are largely white males) may even distort the economic landscape for entrepreneurs, causing female founders to behave strategically and obscure their gender.^[8] Backers bet that The DAO could harness the wisdom of crowds, drive innovation, and grant developers access to capital without submitting to the constraints imposed by traditional Silicon Valley venture capital firms.^[9]

More critical voices cautioned against betting on crowd-sourced wisdom. They pointed out that The DAO’s governance structure created a bias toward funding even unwise projects.^[10] When presented with an unwise proposal, a tokenholder faces a critical choice between exiting the governance structure and voicing her opinion.^[11] Rather than voting on an unwise proposal, a tokenholder could simply leave The DAO.^[12] This exit option carries less risk than losing capital to other tokenholders in the grip of foolish manias.^[13] If cautious tokenholders depart instead of voting, funding decisions would show a positive bias.^[14]

Despite the concerns, The DAO raised more capital than its creators had thought possible.^[15] Its runaway success drove significant increases in the value of ether, which is the cryptocurrency that fuels Ethereum (the distributed application platform upon which The DAO was built).^[16] While a single ether traded for approximately $0.90 in December 2015, its exchange rate rose to nearly $15 by May 2016.^[17]

As The DAO collected capital, Christoph Jentzsch, its principal coder, warned that the experiment remained “fraught with risks.”^[18] He explained that if he had known the size it would grow to, “the tester” in him would have said “I need more testing” to check The DAO’s code.^[19] Given the millions at stake, investors and outside critics also scrutinized the code for security vulnerabilities that The DAO should address before moving forward.^[20]

In hindsight, the code needed more testing. On June 17, 2016, an unknown person withdrew ether worth approximately $55 million from The DAO by exploiting flaws in the code.^[21] While most viewed this exploit as theft, a person purporting to be responsible argued that she had rightfully appropriated The DAO’s assets under The DAO’s own terms.^[22] In particular, The DAO’s offering documentation had made clear that The DAO’s governing terms were “set forth in the smart contract code” and that “all explanatory terms or descriptions are merely offered for educational purposes and do not super[s]ede or modify the express terms of The DAO’s code.”^[23] From the hacker’s perspective, she held legal title to funds withdrawn under The DAO’s express terms.^[24]

The broader community disagreed and sought to unravel the transfer. To return the funds, the community implemented a “hard fork”: it created a new version of the Ethereum protocol that allowed The DAO’s tokenholders to recover their funds and collectively abandoned the original version of the Ethereum protocol.^[25] The move required broad consensus, and, at present, not all community members have moved to the new protocol.^[26] The original Ethereum blockchain continues as “Ethereum classic” with its related ether trading at a vastly reduced price.^[27]

This Article aims to learn from The DAO’s failure. What are the potential strengths and weaknesses of decentralized business organizations that distribute corporate governance? This Article considers distributed entities from a corporate governance perspective. While we believe that, if carefully constructed, such entities may succeed, stakeholders should not adopt distributed governance structures merely for the sake of decentralization. Rather, stakeholders should consider distributed governance structures when doing so solves a particular structural or governance problem. Furthermore, stakeholders must structure distributed corporate entities carefully to avoid known pitfalls. To lay the groundwork, we first discuss traditional corporate governance features, as well as distributed ledger technology’s unique characteristics and the move towards distributed applications and governance. We then discuss key considerations for stakeholders considering distributed entities. Ultimately, stakeholders should proceed carefully and only opt for distributed entities when the benefits outweigh the risks.

 I.  Emerging Distributed Ledger Technology

Significant hype surrounds cryptocurrencies and the distributed ledger technology (DLT) upon which they operate.^[28] Many discussions of cryptocurrencies and DLT begin without discussing the technology’s nature, its genuinely new and disruptive aspects, or why those disruptive aspects should be applied to a specific context. Because the DLT’s architecture informs our consideration of disruptive corporate governance, we begin with a concise introduction to DLT and two of the disruptive structures DLT enables: distributed applications and distributed governance.

A.  Distributed Ledger Technology

DLT refers to distributed computer software running on peer-to-peer networks^[29] that offers a transparent^[30] record management system in which transactions are cryptographically signed and validated with timestamps using a consensus mechanism.^[31] In other words, at its core, DLT is a technology that no single entity, person, or computer node owns, controls, or otherwise maintains,^[32] but that nevertheless “permanently records transactions in a way that cannot be later erased but can only be sequentially updated, in essence keeping a never-ending historical trail.”^[33] Although the exact combination of these elements varies among specific DLT implementations, most DLTs employ cryptographic proofs and a consensus mechanism to ensure the accuracy and security of transactions.^[34]

Specifically, DLTs use three concepts from the science of cryptography to secure and confirm transactions. First, DLTs use hashes as “a unique fingerprint that helps to verify that a certain piece of information has not been altered, without the need to actually see it.”^[35] Second, DLT implementations use cryptographic keys to ensure only the owner of an asset recorded on DLT can access the asset.^[36] Cryptographic keys will always exist “in at least a combination of two: a public and a private one.”^[37] The public key serves as an address that anyone can see and send transactions to, while the private key allows the owner of the key pair to decrypt the information sent to that address.^[38] Thus, cryptographic keys allow DLT users to securely transact with persons and entities that they do not know or trust, without using a trusted intermediary.^[39] Third, most DLTs verify entries pushed to the ledger by a cryptographic key pair through a consensus mechanism.^[40] “The basic premise is that all nodes control each other all the time and they can do that because they know exactly what every other node should hold as truth at any given time. If all nodes agree, this is called consensus.”^[41] In other words, “[e]very node in a blockchain stores and computes the same data.”^[42] A variety of consensus mechanisms exist, including the Bitcoin blockchain’s well-known proof-of-work mining consensus process, which

allows participants to add new financial records to the authoritative sequence by demonstrating that they have expended computing power on an otherwise unimportant, repetitive task. This process, known as Bitcoin mining, confers the right to add a record to the sequence (and also, not incidentally, it is rewarded by the creation of new bitcoins, partly as an incentive to participate in the network and partly as a way to manage the initial distribution of bitcoins). In the event of a dispute among different candidate sequences of transactions, the one that is eventually backed by the most computing power wins.^[43]

The Bitcoin blockchain thus relies on the expense and difficulty of proof-of-work to deter cheating and fraudulent verification.^[44] Other consensus mechanisms power other DLT variations, including “unique node list” consensus, proof-of-stake, and several others.^[45] In each case, consensus replaces the traditional trusted third-party intermediary as the method for maintaining the ledger.^[46]

B.  Smart Contracts

In addition to disrupting the traditional centralized ledger model, DLTs also enable complex relationships to be layered into, or on top of, the underlying DLT protocol.^[47] Nick Szabo first named these complex relationships enabled by computer code “smart contracts” in 1994.^[48] Although the term “contract” in the “smart contract” phrase often confuses lawyers, understanding Szabo’s concept requires disassociating smart contracts from legal contracts.^[49] Instead, a smart contract is, at its core, “a computer protocol—an algorithm—that can self-execute, self-enforce, self-verify, and self-constrain the performance of” its instructions.^[50] Szabo himself considered a digital cash protocol to constitute an example of a smart contract.^[51] In other words, the Bitcoin blockchain itself is a smart contract used for the transfer of digital value.^[52] More complex smart contracts can be created,^[53] and often software developers choose to create such complex smart contracts on the Ethereum protocol.

The Ethereum protocol’s creators specifically designed it to enable smart contract functionality.^[54] One writer explains, “Ethereum has its focus on smart contracts instead of being exclusively a digital currency. And as part of that, Ethereum transactions can be ... more sophisticated than Bitcoin’s: full-fledged, high language programs, some many thousand lines long, which can call on each other, almost ad infinitum.”^[55] Smart contracts, whether on the Ethereum protocol or not, need not be limited to use in the realm of digital cash. Instead, smart contracts are tools of general application that offer unique and powerful elements of autonomy, self-sufficiency, and distributed architecture.^[56] Essentially, smart contracts enable parties to structure relationships in a self-enforcing way, such that the parties no longer need a trusted intermediary to carry out the mandates of the relationships or to ensure that the mandates are properly interpreted. In short, complex layers of interacting smart contracts may enable distributed governance.

C.  Distributed Governance

Corporate governance refers to the mechanisms within business organizations for addressing “managerial accountability, board structure and shareholder rights.”^[57] Typically contemplating the default statutory model of a multi-member body that acts collegially rather than a single hierarch,^[58] “the corporate governance industry influences (and in some cases effectively controls) the votes of trillions of dollars of equity.”^[59] Accordingly, it impacts “the governance policies and fortunes of countless companies through proxy voting recommendations and governance ratings.”^[60] The reason for this is that corporate governance is the mechanism by which business organizations oversee, execute, and maintain a complex series of interacting agreements between the organization’s different stakeholders.^[61] In examining these agreements throughout the years, corporate governance scholars have focused considerable attention on attempting to design methods of assessing whether a business organization has good governance mechanisms and agreements in place.^[62]

DLT and smart contracts may disrupt traditional structures for managing these interacting agreements. Smart contracts, embedded in and layered upon DLT, offer the opportunity for autonomously operating software to oversee, execute, and maintain a series of interacting agreements, “not as an intermediary for individuals or companies, but rather, in a functionally meaningful sense, in its own right.”^[63]

Early experiments with this and related (but subtler) forms of distributed governance mechanisms are already underway. For example, the Robin Hood Coop, based in Tampere, Finland, is a legally organized investment cooperative that uses DLT-based software to manage cooperative assets to generate wealth for its members.^[64] The Robin Hood Coop “use[s] financial technologies to democratize finance, expand financial inclusion and generate new economic space.”^[65] In another example, a company based in Germany, KOINA, AG, uses “a proprietary smartchain” to offer a contractual monetary system that “enables producers to issue credit which allows them to finance their future production independently.”^[66] These are examples of attempts to use forms of distributed governance enabled by smart contracts and DLT to radically alter the economic model pursued by current governance structures. Other efforts offer subtler forms of distributed governance. Otonomos, based in Singapore, uses a DLT-enabled platform to offer online business incorporation, capital raising, and governance.^[67] Otonomos’s software replaces each paper process required for incorporation, raising capital, and corporate governance with secure software keys and smart contracts.^[68] Calling a business incorporated through their software a “Blockchain Chartered Company,” Otonomos ensures that the result of the wholly online, DLT-based process is the legally valid incorporation of the company.^[69]

These examples offer insight into the breadth and depth of the disruption that DLT-enabled distributed governance may introduce to the commercial system. However, this disruption should not be pursued for disruption’s sake. Recognizing the potential for disruption but wary of adopting new technology merely because it is new, this Article offers an initial investigation into both the areas where DLT may benefit corporate governance models and the risks inherent in applying DLT in this context.

II. The Promise and the Perils

Much like the Internet before it, DLT may significantly alter law and the business environment. While some skeptics may view focusing on law relevant to DLT as useful as focusing on the “law of the horse,”^[70] we believe that useful insights come from considering how these emerging entities differ and may challenge traditional legal structures.^[71] Specifically, we believe that, like the lessons that have emerged from the study of the interaction between “law and cyberspace,” examining the interaction between existing corporate governance law and DLT-enabled distributed governance mechanisms will teach “about the limits on law as a regulator and about the techniques for escaping those limits,” and it will require us to take a closer look at “the collection of tools that a society has at hand for affecting constraints upon behavior”^[72] of corporations.

A.  Unique Benefits

1.     New Business and Political Governance Structures

Writing about the biased nature of technologies, political scientist Langdon Winner’s controversial thesis, that technologies have politics embodying social relations, has inspired significant debate.^[73] Winner argued that technology both emerges from and creates social foundations.^[74] While some technologies may promote democratic social relationships, others favor autocracy.^[75] Winner's ideas provide a frame for considering how DLT and smart contracts may shape business entities. Under Winner’s thesis, technologies have politics in two ways: either (1) “the invention, design, or arrangement of a specific technical device or system becomes a way of settling an issue in the affairs of a particular community”; or (2) the systems are “inherently political technologies,” which “appear to require or to be strongly compatible with particular kinds of political relationships,” technical arrangements, and social order.^[76]

This is hardly surprising. As people adapt to technologies, their everyday practices, feelings, and even their identities and senses of self may shift, often in unanticipated ways. The most commonly cited example from Winner’s work involves the segregationist politics embodied in the “height ... of the bridges over the park ways on Long Island, New York.”^[77] According to Winner, Robert Moses designed these bridges to “discourage the presence of buses.”^[78] “One consequence was to limit access of racial minorities and low-income groups to Jones Beach, Moses’ widely acclaimed public park.”^[79] Nevertheless, Winner argues that “to recognize the political dimensions in the shapes of technology does not require that we look for conscious conspiracies or malicious intentions.”^[80] There are many cases in which “the technological deck has been stacked in advance to favor certain social interests,” although this stacking was not necessarily consciously designed by anyone.^[81] One example Winner gives for such a situation is the failure to accommodate for disabled individuals that resulted “more from long-standing neglect than from anyone’s active intention.”^[82]

DLT may offer new dimensions to Winner’s paradigm by being both a technology that can be used to settle a community’s issues and a technology that can be shaped and used for any number of political relationships. First, DLT may be used to settle corporate governance disputes by enabling all stakeholders to participate and all leaders to manage and conduct their affairs in broad daylight as a peer among peers. In other words, DLT offers a mechanism for radical transparency that puts governance actions on display in an immutable ledger.^[83] Such transparency can also help change undesired corporate governance norms and culture in business organizations.^[84] Second, DLT may change the way we think about corporate governance decision-making altogether. DLT enables business governance structures that are more transparent, more flat, and more participatory.^[85] For example, Backfeed offers a decentralized protocol based in DLT that allows people to govern, collaborate, and cooperate without a centralized authority or agency.^[86] Backfeed incorporates a peer-to-peer evaluation mechanism called the Reputation Score, and participants earn increasing rewards corresponding to their contributions.^[87] The protocol’s algorithm takes data from these elements and “ensure[s] a fair distribution of the generated value to each individual, according to the perceived value of their respective contribution to the organization as a whole.”^[88] The Backfeed protocol thus enables new business governance structures: they originate among the workers but are objectively valued by management in light of the clear data evidence in the protocol.^[89] Backfeed’s creators believe that working under governance structures of their own design will make people more invested in their work and drive increases in both production and quality.^[90]

New technologies may also promote democratic agendas. For example, solar power may be a particularly democratic technology because of its decentralized nature.^[91] Solar power can operate at multiple sites and needs little monetary investment per site and far less technical expertise than other systems.^[92] Winner argues that no hierarchical social structures need to be created or maintained to deploy solar technology.^[93] It is indeed inherently democratic and populist.^[94] Similarly, scholars have argued that DLT may also promote democratic goals by lowering the social and economic barriers certain populations face. Notably, women in developing countries often lack social and financial freedom.^[95] DLT may grant increased independence to these populations by allowing them to bypass traditional intermediaries and gatekeepers.^[96] Likewise, many believe that the new “technology can be applied to help modernize the democratic process” and “usher in digital democracy” by removing barriers to and improving the governance of voting systems.^[97] For example, distributed governance systems might make it more difficult for management to suppress information, as often occurs through the current shareholder proposal settlement process.^[98]

2.     Decreased Cost of Financial Intermediation

In recent studies, scholars and financial institutions have found that application of “DLT has the potential to transform capital market structure by encouraging new business development, improving operational efficiency, and contributing to cost reduction.”^[99] In early 2016, experts estimated that “IT and operations expenditure in capital markets ... [were] close to [$]100-[$]150 billion per year among banks.”^[100] Additionally, “post-trade and securities servicing fees” were estimated at $100 billion, and tremendous “capital and liquidity costs are also incurred as a result of current delays and inefficiencies within market operations.”^[101] However, many of these costs are the result of “redundant or duplicative systems [and] operational overheads,” which DLT can eliminate or reduce.^[102] Moreover, DLT can enable “cost-sharing across institutions,” which would be financially and operationally efficient and help to lower businesses’ “financial resource requirements” by, for example, minimizing “counterparty credit risk [ ] [so as] to drive down economic costs of business.”^[103]

Overstock.com (Overstock) created the T Zero (T0) distributed ledger platform for capital markets for precisely these reasons.^[104] The platform uses “cryptographically secure distributed ledgers with existing market processes to reduce settlement time and costs, increase transparency, efficiency and auditability.”^[105] T Zero takes its name from the improvement it offers over traditional mechanisms in terms of settlement time. “Equity transactions generally settle three days after trade date,” often referred to as T+3.^[106] Overstock’s platform offers same day settlement, or T+0.^[107] Nasdaq began developing its own DLT-enabled platform, Linq, to “offer efficient, fully-electronic services that facilitate the issuance, transfer, and management of private company securities” in mid-2015.^[108] Meanwhile, any number of companies are pursuing DLT-based solutions for “payments, lending or remittances,” with the aim of reducing market inefficiencies, reducing cost, and increasing access to financial services among the underserved.^[109] For example, in the remittance context, “the cost of remitting money averages 8.4 percent globally, driven in large part by the legacy brick-and-mortar distribution networks and multi-bank settlement chains of incumbents like Western Union and MoneyGram.”^[110] Companies like Abra use DLT-enabled remittance protocols to offer remittances free from sending and receiving fees.^[111] The hope is that such services “will not only lead to more value accretion to remitting customers, but it will also be the kind of radical value proposition improvement that will be required to attract customers and break them from established habits around sending and receiving money.”^[112]

3.     Selectively Incorporate Stakeholder Communities

DLT offers a community-based approach. It grants stakeholders access to a shared content ledger, often revealing all changes made by each party.^[113] This significantly reduces the cost of accessing information for minority stakeholders.^[114] Depending on the elements of corporate governance shifted to DLT, the need for a “books and records” action with distributed entities may diminish.

It is not surprising, therefore, that DLT’s most common applications “require the input and joint effort of multiple stakeholders, such as industrial supply chains and financial services.”^[115] The technology serves “open communities of practice, including open markets or trade platforms, ... collaborative work environments, such as large-scale, multiple-stakeholder and international projects, as well as governmental projects and processes involving many agencies or departments.”^[116] Moreover, the benefit of the DLT “arises mainly from the shared, common ledger or ‘chain of blocks,’”^[117] which allows all stakeholders to be assured that all parties in the chain rely on the same set of verified “shared facts.”^[118] The fact that “all stakeholders [ ] have [ ] access to the chain of events and [its] changes makes the process transparent, which establishes trust while working in a ‘trustless’ environment.”^[119]

Radical transparency may not be useful in all corporate governance circumstances. As such, an entity may choose to adopt DLT-based governance for some areas of its operations but not others. Further, an entity may choose among DLT solutions to find the technology with a level of transparency best suited to its purposes. For example, the entity adopting elements of distributed governance may opt to grant only selective stakeholders access to corporate information and records stored in DLT. Although public blockchains such as the Bitcoin blockchain or the Ethereum platform dominate the discussion, it is possible to code new DLT platforms that are structured to meet specific needs. For example, R3 CEV built its Corda™ distributed ledger for financial transactions to restrict access to data held within smart contracts to only the parties with a need to know such information.^[120] In other words, even entities seeking to increase the level of multi-stakeholder collaboration within its governance structures need not adopt wholesale elements of DLT that would act as a detriment or burden to the entity. It is possible to customize the technology such that its most useful aspects are adopted while its least useful aspects are minimized.

B.  Governance Risks

Counterbalancing the benefits discussed above, distributed business organizations also face significant governance challenges, which should not be ignored. Nevertheless, careful planning and structuring may allow these emerging entities to overcome these challenges and be successful. We detail some of the key governance concerns below.

1.     Difficulty of Smart Contract Coding

As The DAO’s demise illustrates, distributed business entities face significant technical challenges, which, for the most part, are not easily resolved. Writing about their experience in teaching smart contract coding to undergraduate students, a group of University of Maryland professors explained: “In contrast to traditional software development tasks where bugs such as buffer overflows are often benign (except in rare or contrived scenarios), in our lab, we observed several bugs and pitfalls that arise due to the unique nature of smart contract programs and lead to clear and immediate exploits.”^[121] Without the presence of officers or directors to oversee and intervene in the event of a flaw or an exploit, distributed organizations may hemorrhage assets. Most notably, a third of The DAO’s assets escaped shortly after its launch.^[122] To mitigate this risk, future distributed entities may build in additional safeguards, such as phased rollouts or sandboxing that allow for more strenuous testing of the code. Even with such additional precautions, use of a smart contract may be a risky endeavor that investors should carefully assess. Notably, the programmer behind The DAO, Christoph Jentzsch, was himself “an Ethereum veteran with a university degree in theoretical and mathematical physics.”^[123] Jentzsch understood Ethereum and previously worked “as a software tester[,] [b]ut decentralized code can be exceedingly hard to test. That even he can trip up, predicts that a lot of people trying their hands at smart contracts will.”^[124]

Nevertheless, distributed organizations may be well-situated to mitigate risks inherent in building smart contract code structures. In contrast to more traditional firms, the early stage backers of distributed business organizations often possess significant technical sophistication. Their contributions give them a stake in the organization’s continued success and a strong incentive to test and prove the entity’s code. Importantly, traditional business entities also face hacking risks and may have more vulnerable points than distributed entities.^[125] Traditional organizations also face continual threats from social engineering or social hacking, where hackers manipulate human personnel to gain critical information and access.^[126]

2.     Free-Rider Problems

Distributed organizations may face free-rider problems.^[127] A diffuse entity with many small stakeholders may not function effectively without managing small stakeholder incentives.^[128] If small stakeholders reap small benefits from exercising governance rights, it may be irrational for them to incur the information gathering and analysis costs necessary for the organization to function effectively.^[129]

Smart contracts may create incentives for stakeholders to mitigate free-rider problems. One possibility might be to offer reputational benefits or other rewards for stakeholders incurring governance costs.^[130] For example, if stakeholders discuss decisions through forums, the community could implement mechanisms to recognize and appropriately reward insightful contributions.^[131] Another possible strategy might be to adopt a structure with a mix of large and small stakeholder blocks. The owners of larger stakes would face stronger incentives to devote resources to governance issues and somewhat mitigate free-rider problems.

Still, the extent to which the free-rider problem will affect distributed organizations may depend on their business environments. In businesses demanding constant attention and decisions, distributed organizations may struggle because these entities must make frequent decisions. These elevated decision-making costs may either cause small stakeholders to sell their stakes, or shirk their decision-making responsibilities and free ride on the decisions made by others.^[132]

Distributed entities might also seek to mitigate collective action problems by relying on predictive algorithms to generate recommendations. In one notable example, a venture capital fund appointed a predictive computer algorithm to its board, giving it the authority to vote on funding decisions.^[133] Still, relying on predictive algorithms carries significant risk as well: using predictive algorithms to guide decisions may simply elevate the biases of the persons that designed the predictive algorithms.^[134]

3.     Regulatory Risk

Paradigm-breaking distributed organizations also face significant risks from existing regulatory frameworks, such as federal securities laws.^[135] Created in the aftermath of the Great Depression, the federal securities laws sought to increase transparency in the marketplace and to protect investors from the worst of the Depression-era abuses.^[136] Unless authorized to be sold under an exemption, securities must be registered with the federal government—something that adds substantial expense to any offering.^[137]

Interests in a distributed organization may qualify as securities.^[138] The answer in particular cases will depend on how courts and regulators apply the well-worn Howey test to the new offerings.^[139] An investment contract qualifies as a security if: (1) “individuals were led to invest money”; (2) “in a common enterprise”; (3) “with the expectation that they would earn a profit”; (4) “solely through the efforts of the promoter or of some one other than themselves.”^[140] Judicial decisions have added a substantial interpretive gloss to the test.^[141] Importantly, to avoid classification as a security, offerings to join distributed business entities only need to avoid one of the elements.^[142] Analysis of whether such offerings successfully avoid one of the elements

is complicated by the fact that the issuance of digital tokens is often not accompanied by a legally binding document that clearly spells out the various rights of the token buyer, meaning the character of the relationship between a token issuer and a token owner may be governed in large part by disparate representations, by implication or by common usage.^[143]

In the context of The DAO, for example, the code that operated The DAO was said to be the contract between The DAO token holders.^[144] That computer code may or may not be useful for determining whether the elements of the Howey test are present in The DAO’s token offering.

Without a written agreement to turn to, the analysis will center on other facts. In some instances, distributed entities may be able to solicit new members without requiring them to invest “money.” While the exchange of a cryptocurrency for a token would likely qualify as an investment of money, a contribution of computational power might not.^[145]

While the common enterprise and expectation of profit elements may be more difficult to avoid, distributed entities with substantial stakeholder participation may not qualify as securities. The Howey test requires that expected profits derive “solely from the efforts” of another.^[146] Despite the use of the term “solely,” subsequent decisions have clarified investment contracts that call for marginal amounts of investor participation will still qualify as securities.^[147] The more involved stakeholders become, the less likely it will be that a court will treat an offering as a security.^[148]

4.      Public Accountability Concerns

DLT poses unique challenges to traditional government enforcement mechanisms. While a court can order an officer or a director to take an action, courts may struggle to enforce rulings against distributed entities.^[149] When a distributed entity spans the globe and operates on a consensus basis, an order from one jurisdiction may not be followed by nodes outside that jurisdiction.^[150]

This creates issues for distributed entities seeking to do business with more traditional entities. While traditional entities trust that courts possess the power to enforce most agreements with most counterparties, distributed entities may share characteristics with sovereign states.^[151] If a distributed entity declines to comply with a court order, it may be difficult to compel its compliance through ordinary processes.^[152] Of course, traditional processes with jurisdiction over individual members of a distributed entity may compel the individual members to act in particular ways.^[153]

Limited access to public enforcement will not affect all distributed entities equally. The concern for enforcement applies with less force to distributed entities that primarily interact with other DLT-driven counterparties.^[154] Because these entities interact on even terms, they may experience lower transaction costs.^[155] Distributed entities may face higher costs when interacting with more traditional organizations because traditional entities may demand a direct means to seize collateral.^[156]

Conclusion

As DLT and smart contracts continue their rapid development, more distributed business organizations will undoubtedly emerge. Their success will depend on their ability to draw upon the unique strengths of the model while mitigating the significant governance and enforcement risks posed by broad diffusion of power. After all, traditional corporate governance principles have served our society for years in part to accommodate the corporate form within contract law and, in substantial part, to address the agency problems that are associated with the agreements that enable the creation of the corporate form. Distributed business organizations should therefore consider the role of traditional corporate governance principles in structuring corporate affairs to achieve these goals.

Such goals should also be kept in mind because, as these technologies change the business environment, they will also alter the larger social and political environment. While DLT offers significant pro-democratic advantages, the technology may also carry unforeseen political risks. For example, Bitcoin’s critics have characterized it as a tool for amplifying and empowering right-wing extremism and charged that it is designed to instantiate the forms of social power that make the rich more powerful and keep the poor powerless.^[157] Even if not specifically driven by right-wing extremism, some scholars recognize that society always pays a price for technology; the greater the technology, the greater the price.^[158]

Importantly, significant technological changes may be more ecological than additive.^[159] Instead of simply adding a new tool to the box, DLT may shift social development into different directions. Given the risks, policymakers and stakeholders should carefully consider the different types of worlds DLT might create. These decisions must be made at the outset. Technology tends to become mythic as time passes because it is perceived as “part of the natural order of things,”^[160] and then it is almost impossible to go back and run our lives the way we did before the new technology was adopted.

* Visiting Assistant Professor, Stetson University College of Law; Faculty Associate, Berkman Klein Center for Internet and Society at Harvard University; Affiliated Faculty, Indiana University Bloomington Ostrom Workshop Program on Cybersecurity and Internet Governance. J.D., L.L.M. in International & Comparative Law, Duke University School of Law; M.P.P., Duke University Terry Sanford School of Public Policy.

** Assistant Professor of Law, Baruch College, Zicklin School of Business, City University of New York; Affiliated Faculty, Indiana University Bloomington Ostrom Workshop Program on Cybersecurity and Internet Governance. S.J.D., University of Pennsylvania, L.L.M. Columbia Law School, B.A. & L.L.B. Haifa University.

*** Associate Professor of Law, University of Las Vegas William S. Boyd School of Law. J.D., Columbia Law School; B.A., University of South Carolina.