Practice Note: Foundations
Commonly used, rarely understood.
All views are my own. Notes are for informational purposes only and not legal advice.
Foundation companies occupy a curious space in US crypto law. They are everywhere, having gone from being a novel option in the “decentralization wrapper” toolkit a few years ago to practically de rigueur today (in particular, the now ubiquitous Cayman ownerless foundation company/BVI sub TokenCo meta stucture). Despite this they remain an enigma to many founders, investors, and even lawyers.
Like most industry participants, I am hopeful the new US administration results in federal legislation that positions the US as the go-to jurisdiction for development and capitalization of crypto innovation. When this happens, the US segment of the industry may begin to ween itself off of the arcane and oft-times overwrought nature of foundation meta structures (with apologies to my offshore counsel partners).
Having said the above, I do not think the foundation practice will slacken in the next year or two. Replacing offshore foundations with Wyoming DUNAs, for example, cannot happen at scale until we have resolution on the applicability of the federal securities acts. Even then, if legislation is anything like FIT21, it may take months, or even years, to resolve fundamental ambiguities. In the interim, projects with tokens that are more securities-like may continue to operate offshore. Additionally, it is unknown how non-US exchanges will react to new US legislation. If material ambiguities remain, they may continue to refuse listing/onboarding issuers with US UBOs.
Practice observation 1: Engage reputable counsel that understands foundation law and the regulatory treatment various DLT activities.
No-brainer. But the reality is that foundation work is considerably more expensive than entity set up engagements in the US . Given that structuring is sometimes (incorrectly) viewed as a commodity, and in light of the relatively high cost, there is often a tendency to want to cut corners on budget. Don’t cut corners here. Hire an expert in foundations/trust law who also understands crypto.
Practice observation 1a: Ensure foundation counsel closely coordinates with US counsel, especially with respect to: (i) determining which activities/assets are wrapped and (ii) governance.
Perhaps the second biggest mistake, next to hiring the wrong foundation counsel to begin with, is isolating the US and foundation meta structure work streams and legal teams. I have observed this is usually driven by cost consciousness (specifically, avoiding multiple firms addressing the same issue) or the misguided notion that since foundation counsel are the relevant subject matter experts in the room, they should not require US legal input.
While the last part of the foregoing sentence is usually true (offshore counsel should be the experts in the room on foundation meta structure formation, organization and regulatory treatment), the reality is that a material, if not the singular overarching, rationale for many protocols in setting up foundations is US regulatory risk mitigation. Cayman, Swiss, Emirate, etc. counsel should not be expected, or relied upon, to ensure that offshore structuring efforts dovetail with US regulatory mitigation strategy.
Practice observation 2: Understanding what does (and does not) need to be wrapped.
In the “typical” scenario, I encourage founders to think of wrappers in modular terms. For most projects, the fundamental considerations are:
Treasury management: this generally requires wrapping in every circumstance to avoid unintended tax and civil liability issues. Usually, the foundation, itself, will wrap treasury management. But in certain situations, it may make sense to limit foundation involvement to procurement and processing of treasury grants while the treasury wallets are custodied by a separate trust or another foundation.
Token issuance: this also generally requires mandatory wrapping for regulatory mitigation purposes. This wrapping most commonly takes the form of a BVI tokenco wholly owned by the foundation.
IP management. Here we start to see more divergent options, driven by the particular facts and circumstances. Open source ownership may lie with the foundation, proprietary IP may sit with the devco, and/or a foundation may own a separate IP holdco dedicated to managing IP acquired from 3rd parties to run independently-managed ecosystem front-ends.
Governance. This is perhaps the most misunderstood activity with respect to offshore wrapping. We know, from the Ooki DAO enforcement, that unwrapped DAOs are at risk of being deemed general partnerships. The general consensus since then (at least from the cryptobar) is that “DAOs should be wrapped” to protect token holders. Notwithstanding this, the vast majority of protocol foundations are ownerless. Governance token holders in an ownerless foundation are unwrapped. This fact does not always present a concern, but where an ownerless foundation’s charter permits token holders to vote on treasury dividends, a future fee switch, or even dissolution of the foundation, there is risk of token holders being deemed general partners. If any of the foregoing voting rights are contemplated, projects should consult with both US and offshore counsel re: wrapping governance. This may take the form of changing the ownerless foundation to a member-based one or setting up a separate association or foundation to independently wrap governance (one foundation/association can be structured to govern another).
Practice observation 3: Understand when to utilize binding, non-binding, and conditionally-binding director instructions to achieve governance goals.
Generally speaking, governance decisions must be actioned by a foundation board (or if actioned by a council, then ratified by the board). Governance decisions, however, need not be binding. In scenarios involving a core token holder right, or an existential threat to the protocol, for example, you most likely will want binding instructions. In other words, a binding governance decision must be actioned by the foundation (or ratified if already actioned by a council in an exigent situation) if so decided by the appropriate proportion of eligible voters.
But there are times when non-binding instructions are not only appropriate, but also a necessary mitigant to US regulatory risk. As discussed below, projects should generally avoid any US Person being deemed a UBO of the protocol (for many reasons). Clearly, US Persons should not control a foundation board, but on some occasions a US UBO is unavoidable in an ancillary entity within the protocol meta structure (e.g. an affiliated front-end foundation, or subsidiary trust). If US Persons control or may be deemed to influence governance having any impact on protocol economics, it is usually advised that any such governance be subject to non-binding instruction. In other words, such governance participants may give instructions to a foundation board and, while the board is bound to consider the instructions, it is not bound to adopt or action them.
Additionally, board instructions may be conditionally-binding where a board is bound to adopt and/or action instructions upon the happening of certain conditions. Conditionally-binding instructions may be used to design a check and balance governance frame work whereby instructions may only be adopted and/or action after multiple governance checks are passed. Such checks may take the form of voting processes (a vote passing multiple stages within the same body) and/or multiple voting bodies (e.g. votes requiring token holders + one of the councils or multiple councils).
Practice Tip 4: US Person UBOs should almost always be avoided.
A US Person being deemed a UBO of a foundation (or any affiliate within the meta structure) likely results in:
The unavailability of Reg S as a TGE safe harbor (unless the protocol is prepared to comply with Category 3 of Reg S - but see my earlier posts on the challenges with that proposition). This leads to potential SEC and (more recently) US plaintiffs class action exposure.
Potential challenges in listing or onboard with non-US exchanges.
Practice Tip 5: Fashioning an appropriate foundation board ejection-button
When working with crypto founders grappling with the foundation issue for the first time, it is normal to need to address the fear about a board going rogue. There are mitigants, some extremely effective, to allay this fear. Fundamentally, well-drafted charters should function to keep boards in check. But there are more comprehensive (and proprietary) methods that require additions and tweaks to the meta structure’s design. All to say that experienced practitioners will have tools to address and minimize the potential for, and impact of, rogue activity.