May 2, 2019

Due Diligence: All About Permissioned Blockchains

Most businesses seeking to capitalize on blockchain technology involve, to a greater or lesser extent, “permissioned blockchains” – i.e., those that restrict access so that only certain kinds of users can participate in the network. If you’re representing a company that’s thinking about buying or investing in a business involving a permissioned blockchain, you should check out this Davis Polk memo.

The memo lays out the differences between permissioned & permissionless blockchains and addresses a variety of legal issues associated with acquisitions & investments in permissioned blockchain businesses. Here’s an excerpt discussing potential governance issues:

One important consideration relates to governance. As a blockchain becomes more centralized, it looks less like a blockchain and more like a traditional database. Elements of centralization will certainly be useful to the acquirer, but too much centralization will give the acquirer control to manipulate or unmask on-chain data. If the acquirer comes to dominate the acquired blockchain’s technical or economic environment, that blockchain can no longer offer a shared landscape that facilitates the decentralization of trust from one central party—in other words, that blockchain will replicate the centralized dynamic of traditional databases, in which a core administrator controls the other users.

Importantly, even the perception that these outcomes could occur would drive some participants elsewhere, because an acquirer that retains some latent right to unilaterally control or censor the blockchain is still an extremely centralized presence. To mitigate these risks, an acquirer could enter into agreements with other participants that contractually limit its own ability to make certain kinds of governance decisions, such as unmasking on-chain data.

An acquirer could also offer participants equity in a limited joint venture formed for the purposes of governing the blockchain, or transfer governance rights to an independent nonprofit, to signal that the acquirer views decentralization as an important factor in the overall health and value of the blockchain. Finally, the acquirer could give participants the right to influence dispute resolution processes, such as the right to choose an arbitrator.

Other topics addressed include intellectual property issues, risks associated with the potential use of blockchains to avoid sanctions & for other illegal transactions, and cybersecurity issues. The memo also addresses how some of the risks associated with an acquisition of a permissioned blockchain business might be mitigated by an investment instead of an outright purchase of the business.

John Jenkins