Andrew "Drew" Hinkes is Counsel at Berger Singerman LLP, a
business law firm in Florida. Hinkes represents companies and
entrepreneurs in state and federal commercial litigation matters,
representation of court-appointed fiduciaries, and electronic discovery
issues.
In this opinion piece, Drew takes a deep dive into the legal
structures that surround distributed autonomous organizations, or DAOs.
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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.
Disclaimer: The views expressed in this
article are those of the author and do not necessarily represent the
views of, and should not be attributed to, CoinDesk.
Ernst & Young revealed today that multiple bidders claimed 24,518
BTC (worth roughly $16m at press time) as part of a scheduled bitcoin
auction that began on 20th June and ended on 21st June.
