Fractionally Yours: Jesse's Legal Newsletter v3

Hi, and welcome to my third newsletter. This is becoming a bi-weekly habit for me to write and, hopefully, for you to read.

In this edition of Fractionally Yours, I'm delving into some of the intriguing "defamation" laws that we're creating in these early days of AI and analyzing the implications of where that is heading. I'm also examining why the SEC did not do more to stop the new Bitcoin ETF, and commenting on the phenomenon of "Zombie Companies."

First, a word about my work. A few weeks ago, I wrote a piece in Brad Hargreaves's Thesis Driven about structuring Operating Company, Property Company partnerships ("OpCo/PropCo"). OpCo/PropCo partnerships are a novel way to fund "proptech" operating companies and innovative real estate development projects. Since the built environment is fascinating (we literally spend most of our time occupying it), and the housing crisis is probably the most solvable yet frustrating economic and public policy challenge the US faces today, I'm deeply interested in real estate. Since writing the article, several groups with innovative models have reached out to me to explore if an OpCo/ProCo model is suitable for them. I'm happy to talk to you, too, if you're working on proptech and/or development projects.

AI Made Me Do It: Robot Defamers

Artificial intelligence “Doomers” envision our super-intelligent robot overlords shooting us into space “Mitchells vs. the Machines” style (with free wifi!) or turning us into batteries, Matrix style. While there is certainly a chance of that, AI is already altering human existence by, for the first time, being able to mass-produce nonsense on a scale we’ve never seen before. We’ve come to know these as “deep fakes.” Just ask Taylor Swift, George Carlin, and of course, Joe Biden.

Most people won’t be fooled (some will be), and in time I think we will have some measure of regulation and counter-measures, all of which I’ll happily write about when there is something to write about. But what I find interesting is how people are using current law to fight back against AI-generated nonsense. And that's beginning to happen more and more.

Case in point: OpenAI is currently defending a defamation case in Georgia where ChatGPT “Generated an entire complaint with an erroneous case number” and claimed that the case said that the plaintiff “had been accused of defrauding and embezzling funds.” Needless to say, the plaintiff was never sued. The plaintiff, however, sued OpenAI for defamation. Defamation and its spoken equivalent, libel, is actually one of the oldest torts we have in the American common law tradition. Turns out that people have been fighting against nonsense for generations.

In this new case, OpenAI made a motion to dismiss and lost, which just means that the complaint states a claim, not that OpenAI is guilty of anything. But OpenAI’s arguments raise some interesting issues in how defamation works in the AI era. OpenAI argues that there was no publication since it was just a “chat” between a user and a super-smart computer and that chat is actually owned by the user and not OpenAI. So if there was a defamer, it was the user who got OpenAI to create the phony lawsuit. OpenAI also claims that the plaintiff is a public figure and you need actual malice to defame a public figure and that this was just negligence. We’re not at the stage of the case where the plaintiff needs to show he is not a public figure (or where OpenAI can show that he was) but assuming that he is a public figure (he is a well-known right-wing talk radio host so there is a good chance), the plaintiff will certainly assert that ChatGPT acted with actual malice. My human brain hurts just thinking about how a computer can act with actual malice and what that would mean for the future of humanity.

One interesting thing about the case is the defense that OpenAI is NOT raising, namely that there is some type of liability shield for content created by a chatbot, the same way that the infamous Section 230 of the Digital Millennium Copyright Act shields social media companies from being liable for user-generated content (that is generally how internet companies avoid liability for deep fakes, blaming the creator). It makes sense that Section 230 is not a defense: this content was clearly generated by OpenAI and not the user since content creation is the whole point of ChatGPT. So at least our robot overlords (and the people who own them) can be sued for the ancient tort of defamation by the humans they hurt.

No, Most Crypto Currencies Should Not be ETFs

As I wrote about in the last Fractionally Yours, there is a new Bitcoin ETF which essentially allows investors to get exposure to Bitcoin without actually owning it. Apparently, setting up a wallet and buying a Bitcoin, or part of one, was way too hard for most people. The SEC fought the ETF for years, but eventually gave in.

The SEC dislikes Bitcoin because they view it as a speculative asset with no underlying value. However, since everyone agrees that it's not a security (it's classified as a commodity), their objections were more philosophical than practical. If people want to invest in something, and it's free from price manipulation, let them. If you want exposure to natural gas, corn, or gold, there are ETFs for that. Most are a bit more diversified than just one asset, but whatever.

The red line for the SEC is whether the asset is subject to price manipulation. Bitcoin is “sufficiently decentralized” that no one entity can control it - i.e., release materially non-public information that moves the price up or down, or really do anything to affect the price other than promote it, buy it, sell it, and criticize it. But since those individuals don’t actually control Bitcoin, they can’t manipulate the market.

That's not true of almost any other cryptocurrency. Those “projects” are actually run and promoted by a few people, even though they pretend to be decentralized (ostensibly owned by Cayman Island-based “foundations” and run by Decentralized Autonomous Organizations - remember those?) And because crypto is still basically unregulated, there is nothing to stop the “team” from just making stuff up to jack up the price - exposing ETF investors to losses as the air comes out of the asset. That is exactly what the SEC wants to avoid.

The only interesting case here is Ethereum, which was very decentralized until it decided to switch from “proof of work” to “proof of stake.” For somewhat complicated reasons, a “proof of stake” blockchain relies on a few validators, and that is where there could be some concern about whether or not the asset is sufficiently decentralized to avoid the market manipulation issues. I’m actually interested in whether the SEC will approve an ETH ETF. My money (crypto?) says no.

Zombie Companies: The Travails of the Undead

One of the legacies of the pandemic is the proliferation of zombie companies. This is because, to keep the economy from completely falling off a cliff, in 2020, 2021, and into 2022, policymakers reduced interest rates to near zero in an effort to get companies and people to invest. This policy move set the housing market on fire, led to record inflation (although the inflation also had a lot to do with supply chain issues too), and, as was apparent to all in the tech world, a boom in venture funding. Lots of that funding went to companies with unproven products (particularly in crypto) and questionable business plans. Basically, with nowhere to get solid, steady financial returns (like buying bonds) or lending, money needed to go to riskier places seeking a high return.

Entrepreneurs were more than willing to take that easy money. Now, 2 to 4 years later, some of those companies still have no real product or business plan but, if they were smart, also remain well funded, for now. If they want to keep going in the hope that maybe, one day, they will succeed, they need more money and to appear functional. They wander the earth seeking a working product, more money, and employees – brains! Essentially, they are zombies.

If you’re running a zombie company, chances are you know it (even if no one admits it). What is your legal obligation, however? That's a more complicated question.

Typically, officers and directors owe the shareholders a fiduciary duty. So it's tempting to think that going out of business is the worst thing you can do to your shareholders because their investment goes to zero. But it turns out that once a company hits the “zone of insolvency” (which awaits any zombie company that can’t raise more money), a director or officer can owe a duty to creditors (lenders, suppliers, employees). Creditors can sue directors and officers under the “deepening insolvency” theory, which goes like this: directors and officers know there is no path forward (other than a restructuring) but take on more debt, or make other decisions, to artificially prolong the life of the company and avoid insolvency. This then has the effect of further diminishing the corporate assets, leaving nothing left for the creditors when the moment of truth arrives. It's a risk to the officers and directors, personally. The company, after all, has no money. Hopefully, there is good directors and officers insurance in place.

I don’t think that lawsuits by creditors (or employees) are a big threat legally, but they do happen in egregious situations. In my legal opinion, if you’re a zombie that can’t raise money, the best thing to do is to restructure. But the more important question is one I can’t advise on - why not find something more productive to do with your time than be a zombie?

Keep thinking, keep building,

Jesse

I'm Jesse Strauss, Your Fractional General Counsel. I'm a lawyer with a private practice based in New York City, assisting clients both in the United States and globally with their U.S. legal needs. My expertise covers various areas, including raising funding rounds, addressing employment issues, negotiating master service agreements, managing intellectual property, ensuring compliance, overseeing legal process management, and facilitating dispute resolution. My focus is on founding and nurturing great companies from seed to exit. Discover more at www.yourfractionalgc.com and book a complimentary 30-minute consultation at https://www.yourfractionalgc.com/contact-yourfractionalgc.