The DAO leapt into the headlines earlier this month after it captured nearly $150m in funding, constituting almost 12% of the total amount of ether tokens in the Ethereum network.
The DAO’s structure attempts to emulate the behavior of a crowdfunding business entity, and allows its investors to choose how The DAO will invest the collective ether (ETH) contributions among specific target projects.
The idea and structure of The DAO presents significant legal challenges. Specifically, courts will be forced to grapple with the implications of a web of contracts imitating an entity, instead of a legally incorporated entity.
The law is simply unprepared for DAOs. However, based upon the structure of The DAO, it is foreseeable that the US Securities and Exchange Commission (SEC) would view its tokens purchased by investors as a security or investment contract, subject to its jurisdiction.
The voting system implemented for The DAO is likewise problematic due to its mixed incentives and propensity to depress the value of ETH and its own tokens. Because investment in The DAO is laden with risk and seems to implicate SEC jurisdiction, The DAO may attract regulatory attention.
What is a DAO? What is The DAO?
The DAO is an example of a decentralized or distributed autonomous organization (“DAO”). Generally speaking, DAOs are structures that use smart contracts to provide additional features and functionality to blockchains.
Implementations of DAOs, like The DAO, can include sophisticated arrangements of rights and powers encoded through smart contracts that emulate the attributes and activities of business entities or regulated financial contracts, including insurance, futures, options, etc. The DAO is attempting to emulate a crowdfunding entity where its backers vote to choose on which project The DAO’s aggregate investment should be spent.
DAOs are said to offer advantages to conventional business entities because (a) their activities are limited to that of the code used to operate them, (b) all terms, conditions, and governance are expressly disclosed to the investors, and (c) DAOs are based on blockchains, which generally provide increased transparency.
The DAO is intended to three primary functions. First, it is expressly intended to aggregate investor assets by taking ETH in exchange for DAO tokens. Second, it enters into contracts to use the ETH invested for projects selected by investor vote. Third, it pays returns on those investments back to DAO token holders.
As stated in the organization’s manifesto:
“The goal of The DAO is to diligently use the ETH it controls to support projects that will: …[p]rovide a return on investment or benefit to the DAO and its members.”
Traditional business entities exist as a result of legislation permitting groups of actors to shift risk and obtain legal protection by incorporating. In exchange for these privileges, groups of individuals operating as entities must comply with financial and operational restraints imposed by the State. Unlike conventional business entities, DAOs exist only within their own blockchains, and are generally unable to interact with the outside financial and/or regulatory actors. As a result, DAOs are reliant upon outside information in order to act.
The DAO is structured to include four types of actors: the creators of the platform, the curators, the contractors, and the DAO token holders (i.e. investors). The creators of the platform wrote open-source code that allows The DAO to function and that anyone can freely use. Investors (also called DAO token holders) in The DAO obtain stakes in The DAO by exchanging ETH for DAO tokens. Along with these tokens investors are granted voting rights.
Contractors then offer proposals which are potential investments for The DAO’s accumulated ETH assets, along with clear payment terms in the form of a return on The DAO’s investment. Curators in-turn verify and “whitelist” proposals without providing opinions as to the merits of any proposal. The DAO thus requires external inputs in the form of investor capital, investor voting participation, the supply of project information from contractors, and the approval of projects by curators.
Will the law recognize The DAO?
DAOs are not currently recognized legal actors in the US. This creates uncertainty for legal actions brought against a DAO, and the legal rights of a DAO. It is unclear whether the actions of a DAO would be attributed to the creators of that DAO, those who maintain that DAO, those who suggest projects, or those who have invested in a DAO. Although it may be helpful for a DAO to designate a human representative, DAO token holders may choose not to disclose an owner or primary actor.
If a lawsuit were filed against a DAO, it would stall immediately because of the difficulty of identifying a party who represents the DAO to serve with process. A plaintiff would need to verify that the person is appropriate to represent the DAO, and prove that the person falls within the jurisdiction of the court. Any party served with legal process on behalf of a DAO would likely seek to quash service on the basis that they are not an authorized representative of the DAO. The court would then need to determine what is a DAO in a legal context.
As litigation lawyer Steven Palley suggests, DAOs would likely be considered general partnership or joint ventures, resulting in any participant being a representative of the DAO’s interests. Palley’s article earlier this year suggests that DAOs would be considered general partnerships, which would allow a plaintiff to reach individual participants for service and or liability.
Under Palley’s theory, anyone suing The DAO could attempt to obtain jurisdiction over the organization by serving any human participant in The DAO. If considered a general partnership, each partner would then be held jointly and severally responsible for all liabilities of the business, and all personal assets of each partner are subject to seizure or lien by creditors. Thus, the parties to a DAO may have unlimited potential liability for the entity’s actions. The lack of regulatory recognition will thus limit the utility of DAOs for risk-mitigation.
Palley’s conclusion is problematic. It suggests that a lawsuit against bitcoin itself might be viable, provided that the digital currency’s creator, a bitcoin core developer, node operator, and/or miner may be served with process, be deemed a representative of the network, and potentially have liability.
If considered a general partnership, a plaintiff could thus serve any participant who benefits from the DAO who is within the geographic scope of the Court’s power. Using pseudo-anonymous blockchains to obtain funding makes identifying and locating investors extremely difficult. Contractors who suggest projects may be easier to identify than any other actors because disclosure of the nature of the project is necessary. If the DAO’s creators, or those who benefit from the DAO, are not located in United States, obtaining judicial redress may be functionally impossible.
Why voting might be The DAO’s Achilles Heel?
Investors in The DAO have voting rights that permit them to collectively determine whether projects are funded. Each investor has a voting share that is proportional to the amount of tokens the investor DAO held. The voting investor has the ability to irrevocably vote once per proposal, and a vote freezes that investor’s DAO tokens. However, for The DAO to engage in any investment activity, at least 20% of its DaoToken holders must vote for the project. This may be a critical vulnerability in The DAO.
“Accepting a Proposal requires a majority decision after a debating period of two weeks minimum, and a participation rate of 20% or higher calculated proportionally to the value of ETH requested in the Proposal.” As noted by chief technical officer of SteemitDan Larimer, once a party has voted, their ETH is committed to that project until the project is accepted or rejected, which seems to dis-incentivize voting.
Agreeing to fund projects may actually cause a drop in the value of ETH and DaoTokens because a project will require The DAO to transfer ETH to a contractor, who would then likely convert it to fiat currency, which may depress the value of the ETH on open trade markets, which would then reduce the value of The DAO’s ETH holdings. As Larimer suggests “Every time a project is funded, the amount of ETH backing the DAO tokens falls and is replaced with speculative IOU from a contractor.” Thus, The DAO funding a project may actually cause a reduction in the value of ETH and reduce the value of its own investment base.
Finally, the voting system may be subject to manipulation by disproportionate actors. If a small group of investors hold an aggregate 20.1% share of existing DaoTokens, they could collaborate to force the acceptance of the proposal, irrespective of any other investors’ votes. If less than 20% of the investment value of The DAO actually votes, The DAO will never fund a project.
Why the investment in The DAO is probably a security?
The SEC regulates securities or investment contracts, which are defined as an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. In this case, it is likely that investors who purchase or “create” DAO tokens with ETH are purchasing securities or investment contracts.
Investors in The DAO pay ETH to “create” DAO tokens. Although ETH is not “money,” the law suggests that money equivalents qualify as “money” for this analysis as long as the investor is subject to financial loss. A court will also examine what was represented to the investor. Thus, if the representations suggest that the investor was promised a return on the investment, and has a risk of loss, then it is likely considered a payment to an investment contract or security.
The DAO clearly promotes the expectation of investors of ETH obtaining returns. “The goal of The DAO is to diligently use the ETH it controls to support projects that will: …[p]rovide a return on investment or benefit to the DAO and its members;” “The DAO then has the option to accumulate this ETH to support its growth, or redistribute it to the [DAO token] Holders as a reward.” The DAO discloses the risk of loss of invested ETH: “The use of The DAO’s smart contract code and the Creation of [DAO tokens] carries significant financial risk.” But The DAO also clearly represents that investors should expect a return on investment or to receive benefit through the increase of value of the [DAO tokens].
The next prong is commonality of enterprise. Although different courts apply different tests to determine commonality of enterprise, under the tests applied by most courts, the structure of The DAO would be deemed sufficiently common to satisfy this prong of the test.
Finally, The DAO appears to satisfy the requirement that profits derive solely from the efforts of others. The DAO functions to fund projects approved by the investors. Without projects, The DAO does nothing but hold invested ETH pending approval of a project. To determine whether the profits derive from the efforts of others, the court will determine whether the significant, managerial efforts that affect the failure or success of the enterprise are made by those other than the investor. Because The DAO relies upon contractors and their projects to present investment opportunities from which returns or profits may be obtained, this prong is likely also satisfied.
The sale of DAO tokens by The DAO in exchange for ETH carries all of the hallmarks of an investment contract or security, and under this analysis, the SEC could assume jurisdiction over The DAO. The DAO presents novel legal issues, both with respect to its ability to interact with the legal system, and as to the potential regulatory ramifications of investing in a new novel structure.