Ethereum and Smart Contracts

Attorney for smart contracts advises on blockchain contracts

Next to Bitcoin, Ethereum is probably the most famous cryptocurrency. Contrary to Bitcoin, however, Ethereum's main focus is not on its use as a means of payment. Rather, Ethereum considers itself to be a platform for "smart contracts." In particular, the idea of the autonomous company respectively the "Decentralized Autonomous Organization" (DAO) plays a key role.

How do Smart Contracts work?

Smart contracts are Internet-based contracts whose contract terms are determined by means of a programming language. After the contract has been concluded, it checks continuously and independently. Once this is the case, the other part automatically fulfills. This promises fast and cost-efficient contracts that mean significant added value.

DAO as simple partnership under civil law

A DAO is an collection of smart contracts that are executed independently and autonomously. There is no general manager or supervisory board that manages a DAO. It only has investors, who receive digital tokens from the DAO against payment of a contribution. These tokens carry voting rights, so that investors can vote on the organization's future actions.

What legal nature does such a DAO imply under civil law? A DAO is not a natural person and not a legal entity, either, since it is not recognized as such by any legislator. Under German law, they could best be described as a partnership under civil law, assuming German law would be applicable. This type of company arises when several persons pursue a common purpose.

Promoting a DAO should represent such a common purpose. As a consequence, all investors of a DAO would be its shareholders. Since a partnership under civil law has legal capacity, it could effectively enter into contracts and even sue and be sued. Would DAO investors then be personally liable? The classification of the DAO as a partnership under civil law would mean that all investors would be directly and unlimited liable for the company's liabilities, irrespective of the investors personal investment in the DAO.

Regulatory classification of DAO unclear

Also in terms of regulatory issues, the operation of a DAO and the procurement of its funds are raising new legal questions. First, the legal nature of digital tokens is to be clarified. Tokens are mostly acquired by investors in return for their investment capital, being Ether mostly. These tokens do not only provide voting rights, they also entitle investors to receive dividends, if decided by the DAO. Therefore, tokens could be considered "shares granting participation in a company's earnings" within the meaning of Section 1(2)(1) Capital Investment Code of Germany. Basically, this could in turn have the consequence that the provisions of the German Capital Investment Code need to be observed when acquiring funds for a DAO.

We consider it legally difficult to justify, however, that a prospectus would have to be drafted and approved by German supervisory authority BaFin for the sale of shares in a DAO. This would require that a "vendor" would be "publicly offering" shares "in Germany." Due to the decentralized structure of Ethereum and DAO, it is unlikely that it would be possible to identify a vendor in the required sense without resorting to legal trickery. Even the domestic connection to Germany would be rather difficult to derive in our opinion. The case would obviously have to be assessed differently if a holder of DAO shares were actually looking for potential buyers in Germany. Ultimately, each individual case must be examined separately.

Numerous risks require legal advice

While the legal framework of cryptocurrencies is slowly emerging, smart contracts are still new legal ground. Autonomous companies based on virtual currencies and smart contracts are even multiplying the legal question surrounding them. Anyone wanting to program a DAO by means of smart contracts or intending to participate in a DAO should obtain information about this uncertainty and the possible requirements and risks. In particular, the provisions concerning penalties and fines under finance law and the potential unlimited personal liability of (Ethereum) investors should not be accepted lightly.

Before you venture out into this unknown territory, we recommend a consultation with our lawyers, who have been supporting and helping shape the legal development of block chain-based innovations in Germany since the earliest days of Bitcoin.