Who really runs that DAO?
Good morning, and welcome to Protocol Fintech. This Wednesday: the hidden risks of DAOs, Pinterest at the Ready and the Bitcoin Jesus default.
DAO? More like d’oh.
Decentralized autonomous organizations, common in crypto projects, promise a fairer, more democratic governance structure than a traditional public company. They often control substantial assets through treasures they oversee. But a few recent incidents have thrown DAOs’ virtues into question.
Solend, a Solana-based lending protocol, voted to reclaim a whale’s wallet that posed a risk to the rest of the protocol, then overturned that controversial vote. Some members of the Merit Circle DAO sought to refund an investment from Yield Guild Games, potentially in violation of an investment contract. All this has left many in the crypto industry wondering: What rights do DAO participants legally have? And what can parties that transact with a DAO expect?
The answer depends on the DAO. According to K&L Gates partner Andrew Hinkes, whose practice includes work on blockchain projects, it’s hard to make generalizations about what laws or regulations apply to a DAO because the organizations take on so many different forms.
Some are what Hinkes describes as “legal DAOs.” These are rare, incorporated in one of three states that have applicable regulations: Tennessee, Wyoming or Vermont. State laws might regulate how DAOs reach a quorum or impose minimum cybersecurity requirements. The Lummis-Gillibrand crypto bill makes some provisions to recognize DAOs, though it largely leans on state-level registration.
Then there are what Hinkes calls “alegal” DAOs. Participants in these DAOs collectively agree to make decisions on how they control digital assets using technology, without signing legally binding agreements. How all of this interacts with conventional legal contracts is a gray area.
Most of the DAOs that people are familiar with are alegal. These leave participants legally murky as to their rights to governance tokens and the digital assets controlled by the DAO. However, disappointed token holders may have recourse through the rules of the DAO, Hinkes explained.
Yield Guild Games and the Merit Circle DAO ended up settling, buying out the investor’s stake for a tidy profit — and leaving the legal issues untested.
In the case of Solend, participants considered a proposal to take over a whale’s wallet and liquidate its assets in an effort to keep the price of solana from sinking dangerously. The initial proposal passed with 97.5% of the vote.
Because alegal DAOs write their own rules, they open themselves up to loopholes and vulnerabilities. In the case of Solend, one entity held 1 million of the 1.1 million votes which voted “yes” to overtake the whale. This is not a bug, but a feature — DAO rules didn’t prohibit a single user from owning most of the governance tokens.
DAOs can devise rules to diversify their governance. Dream DAO, for example, reserves a new governance token for a future Gen Z participant every time an NFT is purchased, so that voting power and financial opportunity is reserved for future participants.
DAOs promise democratization, but they should carry a warning: Voter beware. Those who join a DAO — or do business with one — should “spend time to research the DAO, understand how it operates” and realize many DAOs are “experimental,” Hinkes said.
In 2019, FinCEN issued guidance on crypto business models, offering some clarity on who can be sued, but not much. It suggests that developers who profit off the code they have written for a decentralized app could be held liable for negative consequences of their software. The guidance does not directly mention DAOs.
The SEC is investigating DAOs that allow users to lend assets for others to trade. Under the Howey Test, investments in a “common enterprise” for which there is “reasonable expectation of profits” are subject to disclosure and registration requirements with the SEC.
In short, the only guaranteed rights in a DAO are the ones written in code. In one sense, this is liberatory: One of the underlying philosophies of Web3 is that people can create fairer and more efficient systems with technology than centralized governments can. On the other hand, it’s risky and sometimes opaque. In the worst cases, rules are created by a small handful of powerful people. According to Chainalysis, less than 1% of governance token holders have 90% of voting power. That doesn’t seem particularly decentralized, or autonomous.
Protocol link: https://www.protocol.com/newsletters/protocol-fintech/dao-solend-merit-circle