#THEDAO: Broken, but worth fixing

tl;dr – there’s a thing called THEDAO, and it’s almost irredeemably broken. In many, many ways. 

This blog post doesn’t discuss the economic or game-theoretic aspects of its brokenness – this piece by Bitshares’ Dan Larimer over at Steemit.com does so very capably, so there’s no need to duplicate that work.

My expertise in this field relates to how people use blockchains to automate organisational governance, and in particular, legal aspects surrounding their use. So the rest of this blog post focuses on that. 

Suffice it to say, none of the below is intended to be, nor should it be construed as, legal advice. 

So. I hear you ask:

 1) WTF…

a) is a D.A.O.?

Paul Vigna at the Wall Street Journal called it a “chiefless company”; Fortune called it a “blockchain Venture Capital Fund.” Neither of these explanations is correct. 

“D.A.O.” means “Decentralised Autonomous Organisation.” This is a term of art in the blockchain community  that has been used to describe a wide range of applications that 

  1. automate organisational governance; and
  2. run on a peer-to-peer network. 

“#THEDAO” is by no means the first Ethereum D.A.O. prototype; people have been hammering away at the “D.A.O.” concept, one way or another, since at least 2013.  Not to toot my own horn or anything, but Casey Kuhlman, Tyler Jackson and I were responsible for that back in the summer of 2014 (see introductory paper and code). Andreas Olofsson’s People’s Republic of Doug, another “DAO,” came out at about the same time. 

One thing we knew going into this is that just because software runs an organisation doesn’t mean software is an organisation. Legally-recognised organisational forms (various flavours of corporates, trusts, partnerships, and unincorporated associations) are distinct and separate from the tech stacks they use. We don’t call a LLC a “Mecha-Corp” because its IT department runs SQL Server. We shouldn’t call a partnership a “DAO” because it uses a blockchain. 

Additionally, it turns out that permissioned distributed systems, i.e. permissioned blockchains, can do all the same things THEDAO can do. In that case, however, these are just software applications that run at the network level, where the game-theoretic component (e.g. Bitcoin mining) is removed and replaced with legal-technical frameworks (i.e., permissions and identity). 

Meaning a developer can obtain the same (if not greater) process efficiency gains as one would get from running the “D.A.O.” on a public network like Ethereum, only with less hassle, more functionality, better performance, and full legal compliance.

Once you start thinking like that,

Decentralised Autonomous Organisation (DAO)

turns out to be nothing more than a really clunky neologism for 

Software that runs on a blockchain.

In June of 2014, Casey, Tyler, and I went into business together. Andreas was our first hire.

Because of our approach to the tech, the first thing we did was fork and modify Jeff Wilcke’s golang implementation of the Ethereum client so it worked more like a distributed database (i.e., free to use) and less like a cryptocurrency (i.e., pay-to-play). It was thus that the “permissioned blockchain” was born.

The second thing we did was to stop calling these blockchain things “D.A.O.s” and start calling them “applications.”

Because that’s what they are. 

b) So WTF is #THEDAO?

“#THEDAO” is a software application that runs on the Ethereum blockchain.

It follows in the “DAO” tradition in that some of its programmatic functions are (ostensibly) related to organisational governance.

In the early experiments we conducted in 2014, no money whatsoever was involved, or even needed – the tools were designed to enhance governance and make processes more transparent, while also being more or less free to use.  

#THEDAO is different. It has rekindled interest in the original “DAO” concept because this DAO been entrusted with $147m equivalent in Ether (the cryptocurrency of the Ethereum blockchain) in funds from the public and cryptocurrency speculators.

#THEDAO has been programmed:

  • to allow a bunch of people (“DAO Members”) to pool cryptocurrency together to spend on some common purpose
  • to allow third parties (“DAO subcontractors”) to propose that disbursements of these cryptocurrency funds be made to them
  • to allow DAO Members to review requests for work done by DAO subcontractors and vote on these requests; and
  • ostensibly, to allow DAO Members to get some economic upside from the work that they support. 

But does it really do all of that?

2) How a company works in real life

  • A company, SquirrelCorp Limited, has shareholders: Alice, Bob, and Carol.
  • The company is a “legal person,” i.e., it has its own agency, can own property, and can perform legally meaningful actions.
  • A legally binding contract exists between A, B and C, known as the company’s Articles of Association, which governs their relationship.
  • Alice, Bob and Carol authorise SquirrelCorp to hire Dave to be SquirrelCorp’s CEO.
  • Dave, acting for and on behalf of SquirrelCorp, hires Emory, Emily, and Ethan to be SquirrelCorp’s employees. 
  • A series of legally binding contracts exist that assign the intellectual property in E’s work to SquirrelCorp. This allows, A, B and C to be certain that their ownership stake in the company is worth a damn. 
  • One day, Marmot Heavy Industries, Inc. offers to buy SquirrelCorp from Alice, Bob and Carol. In diligence, MHI can see that all of the work has been assigned to (and is legally owned by) SquirrelCorp and can be certain that if MHI buys the company, it will own the work product and be entitled to exploit and benefit from the property it just bought.  

Nice and neat. Step by step. Everything proceeds from something else.

3) How a company works, “#THEDAO” Style

  • A DAO is created on a blockchain. Being a bit of software, it has no legal personality or existence.
  • No agreement, in a traditional sense, exists between its members. It is possible that a contractual relationship may exist if the “DAO Code” is sufficiently certain to create one. I doubt that EVM bytecode is going to be readable by most of the DAO’s users; if it were (and possibly even if it were not) it is possible that a partnership (less likely) or unincorporated association (more likely) will be deemed to exist between its members. 
  • For these reasons the DAO is not, prima facie, a “legal person,” i.e., it has no agency, cannot own property, and cannot perform legally meaningful actions.
  • People submit funds to the DAO in exchange for “DAO Tokens.” “DAO Tokens” are not ownership stakes, as there is no entity to be owned. Rather these are contemporaneous records of who contributed how much to the DAO, in cryptocurrency funds, and when.
  • As compared to an investment contract in a private company, onerous terms (likely so onerous as to be unenforceable) have been ‘agreed’ where all warranties and representations of any kind are disclaimed. Because “experimental software.”
  • These “DAO Tokens” are tradable and have exchange-value, as they are (a) cash collateralised in Ether and (b) are also listed on exchanges. They entitle their holders to proportional voting rights over what the DAO chooses to fund. These “rights” are expressed as contingent write permissions to be executed automatically by smart contract code on the Ethereum blockchain, not as legal rights enforceable in a court.
  • The DAO funds projects which are proposed to it “in plain English.” These projects

Provide a return on investment or benefit to the DAO and its members.

 

Benefit the decentralized ecosystem as a whole.

Not neat. Leaps in logic. Non sequiturs. Missing legal nexuses all over the place.

And yet:

4) Cargo cult corporate law

“But wait,” I hear you cry, “I thought returns on investment – i.e. exit events – were dependent on things like acquirers obtaining legally enforceable rights over certain assets which were set out in elaborate detail, like 

  • “50 pages of a company’s articles; plus
  • “several hundred pages of diligence showing a chain of custody over things like intellectual property which pertain to the company’s business.”

If you thought that, you’d be right. 

My very strong suspicion is that the plain-English covenants made on funding proposals, the absence of legal certainty as to what THEDAO actually is and the nebulous and ever-shifting nature of THEDAO’s “membership,” will make it very difficult to properly assign ownership in these projects’ work product.

#THEDAO might look and feel like a company, but on cursory examination, too many gaps, too few formalities, not enough structure and legally incorrect methods reveal themselves as fatal to the exercise.

Richard Feynmann criticised a similar lack of discipline, in his field, as “cargo cult science:”

In the South Seas there is a cargo cult of people. During the war they saw airplanes land with lots of good materials, and they want the same thing to happen now. So they’ve arranged to imitate things like runways, to put fires along the sides of the runways, to make a wooden hut for a man to sit in, with two wooden pieces on his head like headphones and bars of bamboo sticking out like antennas—he’s the controller—and they wait for the airplanes to land.

They’re doing everything right. The form is perfect. It looks exactly the way it looked before. But it doesn’t work. No airplanes land. So I call these things cargo cult science, because they follow all the apparent precepts and forms of scientific investigation, but they’re missing something essential, because the planes don’t land.

We might therefore call the instant case an example of “cargo cult law.” 

I do not therefore think that profit-shares as described there will be feasible under the framework the creators of the THEDAO have put forward.

That leaves one other option for any of this to make sense, which is that #TheDAO goes and makes grants to “benefit the decentralised ecosystem as a whole” – i.e., grants to particular projects that build products on Ethereum, which then increases demand for (and use of) the underlying “Ether” cryptocurrency. 

As DAO tokens happen to be part-collateralised in Ether (the currency of the Ethereum platform), and DAO tokenholders are very likely also holders of Ether, it would therefore make some economic sense for DAO tokenholders to try to promote projects that use Ether as a means to jack up Ether’s value. 

I could see this being done by a product such as slock.it, a reasonably interesting reimagining of John Gerryts’ outstanding Airlock work from 2014. Slock.it, which both wrote THEDAO’s source code and is one of only two projects currently pitching the DAO for funding, could possibly provide the Ethereum ecosystem with some practical IoT utility.

However, for reasons given above, speculation in Ether would be all the return that DAO Members should reasonably expect to benefit from under such an arrangement. In the absence of clear and unambiguous legal documentation relating to and governing (a) the DAO’s membership and formation and (b) heavily negotiated terms and conditions for each funding proposal, it would seem to me that DAO Subcontractors are, under the current state of affairs, likely to retain 100% of their intellectual property and that the benefit of that work product would not accrue to the members of the DAO. 

Screen Shot 2016-05-17 at 15.18.15.png
Q.E.D.

5) It’s not too late to fix this

There is much that is broken about the DAO. But it doesn’t require rocket science to fix. It requires formally constituting the relationships of the DAO’s members. 

In other words, it needs lawyering. No surprises there. As Team Marmot put it in 2014:

(A DAO is) more effective as a representative and educational tool if it is paired with a real-world incorporated non-profit entity which operates within legally permissible parameters (the exact form of business organisation is somewhat flexible based on the desires of the implementing group or organization).

By way of example, in our 2014 DAO prototype – version 0.1 of what would later become Eris – we selected a 501(c)(6) non-profit as our DAO’s corporate vehicle of choice.

Two things need to happen – quickly – to put this right (and these are just starting points). The first is to get a formal structure involved. The second is to abandon the token sale and utilise legally compliant funding structures.

Why address funding? Because the practice of selling blockchain tokens as an investment over the internet – as THEDAO is doing – while not new, is a big problem. Hundreds of cryptocurrencies (e.g. Bitshares, Swarm, and Omni/Mastercoin, to name a few) have come and gone since 2013 which have used “token sales,” “software licence sales,” “crypto-equity,” “cryptofuel,” or other artifices to raise funds from unaccredited investors.

Unfortunately, this practice is against the law.** Not maybe against the law, not possibly against the law, but straight-up, 100%, beyond-a-shadow-of-a-doubt against the law. This was my opinion in 2014 and it remains my opinion today. 

Even if that issue were fixed, #THEDAO’s legal problems are only just beginning.

Summing up, I sympathise with THEDAO’s intentions, in that I believe that the financial markets are currently rigged against the “little guy” and that there is no reason why the kinds of investment opportunities (and returns) available to the super-wealthy should not be available to small investors whose traditional means of accumulating wealth (savings) are all but useless given current, zero interest-rate monetary policy. 

I also believe that blockchain tech will one day play a role in facilitating more democratic access to the capital markets. However, the current body of laws governing this sphere of conduct exists to ensure that people to whom investments are marketed can be absolutely certain about what they’re getting in exchange for their money.

In this respect THEDAO clearly falls very short of the mark.

More charitably, THEDAO can also be viewed as one flavour of what’s going on all across the ecosystem: using distributed systems to automate relationships and processes in ways that existing systems, on account of existing technical or political constraints, cannot.

Most interestingly, THEDAO shows the Ethereum community has some clout in terms of capital and is eager to deploy it.

With the above in mind, there is absolutely no reason why “the DAO” or something like it could not be used as the automatic backbone to a bona fide, properly structured, equity crowdfunding business (a practice which, done correctly, is legal in the UK).

Blockchain technology can be used in a legally-compliant manner. People and businesses are currently using it in a legally-compliant manner, all over the world, every single day.

It’s perhaps more boring when we do it that way. It takes more work. It takes much more time. It means not cutting corners.

But at the end of the day, not cutting corners is very much its own reward. 

 

** The Securities and Exchange Commission has confirmed, in a 2017 report, that this practice is in fact against the law. 

15 Comments

  1. Bogdan

    I’m not sure if I agree with your statement that DAO in its current form is illegal. Was Bitcoin legal when it started. Is it legal now after 6 years of its existence? Would creators of Bitcoin ever started if they waited for regulatory approval. New inventions are not illegal becaous nobody had to deal with it before. If DAO went the way you are suggesting, it would be not much different than current corporations. This is not the goal. In my view the goal is to create higher level of interaction between governed, where governed are the government and what is legal is what governed want.

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    1. It’s a different question. There is a lot of human agency with the DAO – from voting power (who holds how many tokens?) to authentication (curators) to authorship (the Slock.it team who designed the framework, and whoever is running the website and promoting the sale).

      Just because something hasn’t been seen before doesn’t mean it isn’t contravening legal rules – it means you have to anticipate how legal rules will interact with a novel invention (since, in the common-law jurisdictions, law operates by analogy) and plan accordingly. When my teammates and I looked at the legality questions around cryptocurrency (before we founded Eris), we tried to resolve the apparently different, apparently competing requirements for distributed trust and legal compliance in blockchain tech. Our solution was the permissioned blockchain.
      I sympathise for people wanting to self-govern. However, at the end of the day what they’re also doing is they’re promoting a scheme to get hold of other people’s money with the promise of high returns from passive investment.

      That is an activity society regulates for very good reasons.

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      1. Bogdan

        The promise of the DAO is to go one step ahead of where Bitcoin got. Whoever came up with Bitcoins,(meaning we probably never know for sure), wanted to demonstrate existence of the money in its own stream independent from governments or simply money in only digital form safe from any influences.

        Even though governments will try to regulate it, they will always be several steps behind the inventions and progress of it. Ethereum and its application DAO is such a next step and there will be others. The money market is rigged and everyone who ever traded knows it. The only way to demonstrate fair mechanism for future money handling is to create a system which governments and big corporations have no unfair advantage of and can’t corrupt it easily.

        But the gaol shouldn’t be to get of other’s people money but to create new value through collected money. Starting money is needed to have relevance in the current economical and financial markets. I’m sure that DAO will have to go through several bumps, but the chance to be relevant only exists if it will continue through a path which has never been travelled to date.

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      2. Maybe. But tbf this would be a lot easier, in the long run, if the organisers would just do things properly and start a fund.

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  2. Didn’t Ethereum itself accept investments from unaccredited investors in its own crowdsale?

    Liked by 1 person

    1. If you ask them, they were selling “cryptofuel.”

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  3. What about his recent change in the rules? Does it affect your argument? If not, why not?

    Thanks for the illuminating discussion.

    http://mobile.nytimes.com/2016/05/15/business/dealbook/new-crowdfunding-rules-let-the-small-fry-swim-with-sharks.html

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    1. No, because this crowdfund does not appear to comply with those rules.

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  4. There’s a fine line between “going one step ahead” and one step too far – just ask Icarus. Not to diminish the vision and accomplishment that has literally been capitalized upon with this project’s apparent success, Gavin Wood’s response is a reflection of Preston’s assessment. Maybe some recognizable legal structure can be reverse engineered before the money is touched. In regard to the principled desire for lawfulness in the financial markets. The inherent lack of any lawful basis in our current system from Citizens United to Goldman’s latest Tesla dealings is the catalyst behind the overall movement into this new way of doing things which provides some positive interpretation.

    I would also issue a warning similar to Gav of York in that if this works the problems with the U$D as a global reserve currency will create much bigger problems than these novel approaches to financial organization are providing. A one world system of governance appears increasingly inevitable because anything that is tech-based in the end is arguably centralized, or centralizing, or “centralizeable.” Be careful what you wish for. Not to diminish Bitcoin or Tor, or TheDAO, but understanding where you end and the Platonic Form begins is increasingly difficult in a tech solutions world of rapidly declining friction.

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  5. David Harrison you mention “a one world system of governance” as if that would be a bad thing. I respectfully suggest that, if we set it up as a democracy, perhaps a liquid democracy, based on the blockchain, it could save us all (whether from war, or climate change, or escalating inequality). See: https://medium.com/@pschurman/how-the-blockchain-could-prevent-world-war-iii-734397d52880

    Also, where is “Gavin Wood’s response”?

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  6. Lars Pensjö

    “Why address funding? Because the practice of selling blockchain tokens as an investment over the internet – as THEDAO is doing – while not new, is a big problem.”

    “Unfortunately, this practice is against the law.”

    What law, the US law? For a law to be effective, there has to be a legal entity to bring to account. But there isn’t any. To make it even more complicated, some of they buyers may not be legal entities. They can be other forms of DAO. The legal side of this is going to be very interesting.

    You can’t prosecute the person that launched the DAO contact. I am not sure if it is known who it is, but that person is not the one doing the sale. He has no control over the operation, and makes no profits from it. To make matters even more complicated, future DAOs will be launched by the DAO itself (in the form of splits), which is also out of control of any legal entity.

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    1. US, UK, and Swiss (in my opinion). And you definitely don’t need an entity – only promoters, of which there are clearly identifiable ones.

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  7. […] quote Eris COO (and attorney) Preston […]

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  8. Peter: Your liquid democracy might not save some of us, but it most certainly would improve my and Preston’s standing after we impose our 2/3 majority rule and then divide all of your holdings between the two of us… and in the Sunstein spirit that’ll include your default opt-in organ donations. Thank you! And thank the UN Commission on Blockchain Identity for Global Democracy.

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  9. […] For example, Eris Industries co-founder and COO Preston Byrne believes that blockchain technology will eventually “play a role in facilitating more democratic access to the capital markets” but he notes that the DAO will not be able to avoid current regulatory realities. […]

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