Analyzing the operation of the agreement DAO from a legal perspective

Written by: Gabriel Shapiro

Compiled by: RR, Old Yuppie

Abstract

• DAO tokens only control code ------ on-chain, code is law.
• DAO tokens cannot control people (developers, validators, liquidation bot operators, enterprises, etc.), but can be used for emotional signaling ------ off-chain, law is law.
• Developers and others cannot respond to on-chain stakeholders (shareholders, etc.) like off-chain stakeholders (DAO token holders, etc.) because doing so would expose developers, DAO participants, users, and others relying on the protocol to significant legal risks.
• Developers must keep any major work they do on the protocol opaque to avoid legal obligations to token holders and to prevent the entire protocol, DAO, and all participants from being subject to heavy financial regulations.

Main Purpose of Protocol DAOs

The primary purpose of protocol DAOs (and the "governance tokens" that comprise them) is to give users of autonomous digital infrastructure (also known as smart contract systems) a voice in whether and how to change any mutable characteristics of these systems. This is achieved through direct, binding, on-chain control of these systems via a necessary majority vote of DAO token holders. In the MakerDAO community, these are referred to as "executive votes."

In practice, protocol DAOs are simply large multiplayer online games used to adjust parameters of ownerless, decentralized software systems. This is also why DAO tokens are primarily allocated to users of these systems (through liquidity mining, etc.) ------ users need to have a strong voice in the systems they rely on.

For on-chain governance, DAO tokens and DAO voting are the "God mode" ------ they are the first, final, and only authority operating under the principle of "code is law." Any quorum and majority rules written into the code must be strictly adhered to.

Secondary Purpose of Protocol DAOs

The second purpose of protocol DAOs is to participate in off-chain social coordination based on a rough social consensus of loosely related autonomous system issues. This includes chats, "governance" forums, Twitter ------ all social media platforms where the community around the system communicates. In this context, DAO token holders may sometimes vote on various things they believe should happen on the social layer ------ for example, writing new major code upgrades or the community adopting certain social goals. MakerDAO refers to these as "signal votes," which include a consistent expression of social values, such as "green" environmental technology financing plans.

These votes are non-binding ------ they represent sentiment. No individual, group, or enterprise is required to "follow" the results of these votes, and the votes do not need to adhere to strict quorum or specific majority standards. They are simply expressing the community's sentiment on a topic.

Moreover, these votes may not even represent the sentiment of the entire community ------ they only represent the sentiment of those holding governance tokens. Since the complete community around a protocol is usually broader ------ including bot operators, developers, and even validators/miners on L1, governance tokens cannot be the sole authority on these subjects. They are merely an input into this larger process of "rough social consensus," although it is an important input.

Confusing Primary and Secondary Purposes is Catastrophic

Unfortunately, many people either confuse the primary and secondary purposes or wish for the secondary purpose to operate differently. They want governance token holders to have binding authority over certain individuals on the social layer. There are many reasons why this does not work and why it is a dangerous and bad idea. I will focus on the legal reasons, although there are also non-legal reasons.

Assets that grant their owners binding social voting rights are legal contracts ------ in most cases, they are highly regulated "securities." The reason corporate stocks are regulated is largely because they carry specific legal rights, including the right to appoint company directors. Elected fiduciaries have specific legal obligations to shareholders. For example, corporate directors have fiduciary duties, and they have only one goal when making corporate decisions: maximizing shareholder value. If they do not adhere to this goal, they may be sued.

Since DAO tokens are unregulated, treating them similarly to corporate stocks or other securities would violate many financial regulations. Worse, unlike corporate directors, in this case, the so-called fiduciaries would have no insurance, no protections, and unlimited liability ------ which is a very bad outcome for software developers and others involved in the protocol. Therefore, everyone participating in a DAO must be very careful in handling and responding to sentiment votes.

Example: Code Upgrades and Handling Methods

Let’s take an example:

A signaling poll supports a certain software upgrade for the protocol, but no one has coded this upgrade yet; it has only been conceptually described, and it is not even clear if it will work. Coding, testing, and deploying this upgrade requires a significant amount of time, resources, and talent, and even if people attempt to code it, it could completely fail and never be adopted.

In the U.S., the Howey test indicates that if a group relies on the entrepreneurial efforts of another group to obtain asset value, then that asset may be a security. Therefore, under the law, if a team announces that it will implement an upgrade within the next six months, it will essentially be understood as a promise to token holders to complete the work they requested through sentiment voting. Such a team would turn DAO tokens into something more like corporate stock ------ securities. Even if this team is a new team and not the original team that built the protocol, the SEC refers to these new teams as "active participants," and under securities law, they may bear liability. These activities pose risks not only to the development team but also, as we have seen in the recent CFTC case against Ooki DAO, they are detrimental to the DAO itself, as every participant in the DAO could be accused of operating an off-chain business enterprise.

In this example, if the development team wants to build social support for the code upgrade, what should they do? To quote the notorious B.I.G.'s immortal words, "Bad boys move in silence and violence."

In the new normal where DAOs and DeFi face enormous legal risks, development teams must learn to work in secrecy until the work is completed and submitted for binding on-chain voting. From an outsider's perspective, it is impossible to know whether they are doing something unless it is completed. This achieves two important goals:

• Reducing legal risks for the team and others in the community; and
• Avoiding speculative pump-and-dump scenarios, where the value of potential, experimental software upgrades becomes part of the token price, leading to a collapse in price if it is discovered that such upgrades are not or cannot be implemented.

Limiting formal governance to on-chain is not so bad, and it is quite common in practice.

While the dynamics described above may be frustrating, this is why smart contract systems must be open source. This way, anyone can work on the protocol, and if they submit specific actual code to be placed on the blockchain, binding governance votes can be held on it. However, for social proposals, governance votes are merely expressions of sentiment and do not guarantee any specific outcome.

Many successful protocol communities have adopted this attitude ------ for example, Ethereum achieved tremendous success without formal protocol governance, relying on rough social consensus and depending on "core developers," who do not respond to ETH holders' votes but decide for themselves what and how to code. Bitcoin is similar. Admittedly, the DeFi community is somewhat inconsistent in this regard, but the "Yearn Manifesto" clearly states that "Yearn is governed by YFI, but YFI does not govern Yearn contributors." We have seen protocol communities with differing views punished by governments (such as the CFTC lawsuit against Ooki DAO).

Conclusion

We have entered a new normal where anyone involved in free technology faces enormous legal risks ------ similar to the risks faced by cryptographic technology developers during the "crypto wars" of the 1990s. This requires everyone involved in free technology ------ from amateur users to hardcore degens, programmers, bot operators, validators, CEXs, and social media leaders ------ to strengthen their game, becoming more aware of what they are doing, how they are doing it, and the potential legal consequences. In the long run, this is best for everyone, as it forces us to think about what this technology and the associated social forms (DAOs) should truly achieve and how to best realize these goals without falling into old TradFi models like corporate governance.