Legal Implications of the Ethereum Merge and Potential Ethereum Proof-of-Work Fork

Ethereum’s transition to proof of stake presents opportunities and pitfalls for certain digital assets and tokens built on the network.

After years of development, the Ethereum blockchain appears poised to make its much-anticipated transition from a proof-of-work (PoW) consensus mechanism to a proof-of-stake (PoS) model. This change has been described as one of the most significant upgrades in the history of blockchain. Barring unexpected technical hurdles, the Ethereum Mainnet, upon which transactions are executed and recorded, is expected to merge in September 2022 with the PoS Beacon Chain consensus layer that has been under development for several years (the Merge).

Consensus mechanisms are the backbone of blockchain. They are the means by which a decentralized network such as a blockchain achieves agreement on the state of the data in the network (basically, to prevent double spending and other fraudulent transactions). The Merge is intended to maintain continuity in Ethereum’s transaction history while replacing its consensus mechanism with one that drastically reduces Ethereum’s energy consumption, sets a foundation for future scalability upgrades, and provides other security and technical benefits.

The Ethereum Foundation and the majority of participants in the Ethereum ecosystem seem to support the Merge. However, some critics have raised concerns with the Merge, and point to a less-decentralized PoS model and potential security vulnerabilities and execution risk with the challenging technical upgrade. These critics also seek to protect the interests of Ethereum PoW miners who have been accustomed to being rewarded in ETH for supporting the PoW consensus model. As a result, groups are attempting to formally fork the Ethereum network, or create a duplicate of the Ethereum blockchain that maintains a PoW consensus mechanism, and to recruit miners and exchanges to participate in this new, parallel network (ETHW).

While proponents of a PoW chain face practical challenges such as attracting adoption and navigating a “difficulty bomb” in the Ethereum codebase that would make mining prohibitively expensive, the prospect of two Ethereum blockchains emerging post-Merge nonetheless remains a real possibility. This ETHW fork would contain the same transaction data as the current Ethereum network at the time of the fork, meaning that end users would have duplicate tokens, one on the main version of the Ethereum network and another on the ETHW fork.

Challenges That Hard Forks Pose for Certain Tokens

If ETHW succeeds as a stand-alone blockchain after the Merge, it will hardly be the first, as the open source nature of blockchain technology ensures that most public blockchains always face the possibility of a hard fork. Indeed, some of the most widely adopted and active blockchains in existence today began as contentious forks of existing networks, including Ethereum itself after it famously forked in 2017 as a result of a widespread hack affecting “The DAO” (the original Ethereum blockchain continues as “Ethereum Classic”).

For many fungible “store of value” tokens, hard forks have a relatively straightforward impact. Each chain ends up with a different version of the token, but each set of tokens is still used in a similar fashion on its respective, newly forked chain. For example, when Bitcoin Cash forked from Bitcoin, the respective rights of Bitcoin holders and Bitcoin Cash holders were relatively clear. Each could be used as a store of value or means of payment on its respective network, and the market determined the value of each based on factors such as supply, speed, cost, adoption, and general sentiment.

Hard forks, however, present unique legal issues for tokens tied to rights that exist outside the context of a particular network. These include:

• tokens that can be redeemed for other items of value, such as the USDC stablecoin that can be redeemed for real US dollars, or non-fungible tokens (NFTs) that can be redeemed for real-world assets;
• content-based NFTs that grant holders certain licensed rights to use and exploit the underlying artwork; and
• governance tokens that permit holders to vote on proposed changes to a protocol or decentralized autonomous organization (DAO).

For these types of tokens, a hard fork may present challenges because it takes a single record commonly presumed to be unique and splits it in two, creating potential confusion as to how rights might be administered post-fork across the two sets of tokens. For example, if the terms of sale of a particular NFT state that owning such a token “on the Ethereum blockchain” allows a holder to exercise certain rights in the NFT-related artwork, what happens post-fork when there are two copies of that token, one recorded on Ethereum post-Merge and the other on ETHW? Should two separate holders of the Ethereum and ETHW versions of the same NFT each be able to sell merchandise using the same underlying NFT artwork?

In addition, hard forks can represent challenges for those who rely on third-party service providers to store and monetize their cryptocurrency. For example, often custodial agreements provide the custodian with the right to choose whether to provide services with respect to assets resulting from a fork. While it is unlikely that any major custodian will refuse to provide services with respect to ETH following the Merge, it may take time to sort out how such services will be provided, and there may be an interim period in which ETH cannot be accessed. In addition, new versions of ETH on a PoW chain may not be accessible through custodial services. Market participants who rely on custodial service providers should review their agreements with custodians and determine how they will access ETH and ETH clones following the Merge.

Cryptocurrency loan and derivatives arrangements may also give market participants challenges following the Merge. Cryptocurrency loan arrangements often dictate when and how each of the lender of a cryptocurrency or the borrower pledging a certain cryptocurrency get the benefit of forked coins in the event of a hard fork of the respective cryptocurrency. However, a hard fork may not be defined with precision. An unscrupulous borrower or lender could opportunistically argue, if in their favor, that the post-Merge ETH results from the hard fork and thus should be retained by the respective borrower or lender rather than be repaid. As a result, loan agreements should be carefully reviewed.

Similarly, counterparties to derivatives transactions referencing an ETH or ETH-related underlier should carefully review their documentation for any sources of legal uncertainty or potential opportunistic counterparty action as a result of the Merge. Derivatives counterparties using ISDA-based contractual documentation should give particular attention to hard fork-related additional termination events and disruption events, including any bilateral modifications that may have been made to the “Material Change in Content” and other ISDA disruption events to encompass hard fork events. Understanding which party is entitled to call any such additional termination event or disruption event and the potential consequences will be key to assessing the impact.

Market participants should also evaluate smart contracts to which ETH has been contributed to ensure that unintended results do not occur.

Clarifying What Rights Apply Upon a Contentious Fork

Most projects, regardless of what chain they are on, can provide additional certainty by clarifying in their terms of service, NFT license agreements, or via other public announcements exactly how rights accompanying their tokens would apply upon a hard fork. Doing so could prove valuable to not just existing holders, but also other stakeholders such as prospective holders and potential commercial partners.

Many projects may only seek to grant rights to holders of tokens on the most widely adopted, “mainstream” version of the chain post-fork. Granting rights to all versions of the tokens across forked chains could reduce the uniqueness and corresponding value of such rights, or simply make it untenable for the project to allow redemptions of a single off-chain asset for duplicate tokens. For example, Circle has clarified that post-Merge, “USDC as an Ethereum asset can only exist as a single valid ‘version’, and … our sole plan is to fully support the upgraded Ethereum PoS chain.” This presumably means that holders of USDC on ETHW could not redeem those tokens for US dollars.

NFTs that grant intellectual property (IP) rights would benefit from making similar clarifications. If any holder of an NFT on “an Ethereum chain” could sell merchandise using the underlying NFT art, the value of such a commercial right could be significantly diminished if two sets of tokens now hold the same rights to the same artwork. Limiting rights to the most widely adopted chain would preserve such uniqueness, and could also provide assurance to partners that might be sensitive to the degree of influence they can exert over tokens featuring their IP. To implement this, projects could state that rights associated with a particular token will only be granted to owners as recorded on the Mainnet recognized as the legitimate successor of the original chain.

Determination of the successor could be made in the project’s discretion. Alternatively, to add a degree of decentralization, some projects may choose to offload this determination to a DAO, or to an external indicator of adoption such as market capitalization. If a project aligns philosophically or economically with the minority chain, it could also clarify that token rights will only be granted to the less popular chain.

However, projects with particular business goals and community vision might seek to deviate from this default and grant rights to all holders across all chains. For example, the Rarible Standard Collectibles Sale and License Agreement states that upon an “Ethereum Persistent Fork,” all IP licenses granted to owners of the applicable Ethereum-based NFT governed by such license agreement “shall be deemed expanded to include each person who lawfully holds exclusive title to and ownership of the copies of such NFTs that are included on the Ethereum Persistent Fork.” This would mean that the applicable licensed rights are granted to NFT holders on both the post-Merge Ethereum Mainnet and any ETHW fork. This approach may be beneficial to reduce consumer confusion, promote an open and inclusive ethos, and avoid forcing the project to take a stance on a contentious issue regarding what is the “true” blockchain upon a fork.

Not every project will arrive at the same outcome. Each project should carefully consider what arrangement best fits its unique set of needs and, once the project has settled on its treatment of rights in its legal provisions, communicate that position early and consistently across channels to help clarify expectations for stakeholders.