Slow Rug: The "tactical" collapse of the DAO is dividing investors

Author: Xiao Za lawyer

The Sa Jie team has always believed that DAO, as a phenomenon born from the close integration of traditional legal systems and emerging technologies, possesses flexibility, transparency, and autonomy in various aspects such as initiation, operation, decision-making, liquidation, shareholder contributions and withdrawals, and profit distribution, which traditional corporate entities find hard to match. Meanwhile, the technology trust mechanism generated by blockchain significantly reduces the regulatory and compliance costs for companies. Overall, DAO is a new type of "legal entity" that is likely to be widely accepted in future business activities and even has the potential to reshape the forms of future business entities.

However, a recent form of fraud has emerged where a DAO is established with the intent of illegal possession, followed by artificially inflating expenses and fabricating false debts to slowly "extract" operational funds from the DAO, ultimately shutting down and liquidating the DAO under the pretext of "poor management." This type of fraud is referred to as "Slow Rug." Compared to the traditional Pull Rug, this method of fraud is more covert and has a longer duration, often leading investors to suffer significant losses without realizing it, resulting in severe losses in a "boiling frog" style of fraud.

Today, the Sa Jie team will discuss some characteristics of Slow Rug and how to protect one's rights through legal means.

1. Is DAO bankruptcy a true "liquidation" or a real fraud?

The development of emerging phenomena is unlikely to be smooth sailing. No matter how good an idea or project is, if poorly managed, it may lead to shutdown and liquidation in a short period. In fact, bankruptcy liquidation is not uncommon; the bankruptcy system plays an important role in adjusting the market economy and is a key component of the legal system of market economy. A mature economy allows commercial entities to go through legitimate bankruptcy procedures and liquidation methods, forcing the liquidation and distribution of all assets when the debtor loses the ability to repay, ensuring fair compensation for creditors. Ultimately, the bankruptcy system resolves the dilemma of the bankrupt being trapped in continuous losses while providing the maximum fair compensation to creditors.

In 2022, affected by the global economic downturn and various factors related to the immature development of DAOs, several once-prominent DAO projects faced shutdown and liquidation, including Tride DAO and Panda DAO, which were particularly lamentable.

However, since DAO is a new organizational form that has not yet been accepted by the vast majority of countries and regions, only a few places like Wyoming and Utah in the United States, and the Marshall Islands have enacted relatively experimental legislation. There is basically a legislative vacuum regarding how DAOs should undergo bankruptcy, restructuring, and liquidation.

In practice, the bankruptcy liquidation of projects like Tride DAO and Panda DAO generally follows a set of procedures:

1. Founders or influential community members announce relevant information about the shutdown and liquidation on social media;
2. Negotiate with investors and other community members to publish a liquidation plan and compensation scheme;
3. Initiate a formal shutdown and liquidation proposal within the community;
4. Community voting;
5. After the vote passes, investors apply for liquidation;
6. Investors receive the assets after liquidation.

This relatively simple and direct bankruptcy liquidation procedure, while largely adhering to the principle of code is law, can complete the liquidation of the DAO in a short time but does not guarantee the fairness and justice of the liquidation, often leading to community skepticism. Additionally, due to the lack of legal norms supporting DAOs, if problems arise after liquidation, such as omitted assets or abuse of power by the liquidator, investors often cannot seek legal remedies, let alone if the DAO itself is a Slow Rug scam.

For example, during the Tribe DAO shutdown and liquidation event in August 2022, there was a dispute over whether "creditors" or "shareholders" should be prioritized for repayment, and the entire DAO project's liquidation even triggered a serious crisis of trust within the community. At that time, the founder of Fei Protocol announced the closure of the protocol and the repayment proposal on social media, planning to calculate 57 million TRIBE (worth about $9 million at the time) based on a weighted price over seven days, releasing corresponding FEI or DAI, and distributing it evenly to victims of the hacking incident (which involved about 28,380 ETH), proportionally distributing the assets controlled by the DAO, such as stETH and ETH, to TRIBE token holders.

This compensation mechanism was widely criticized; since the funds were distributed equally to each address, this meant that users with lower losses would receive full compensation, while users with higher losses could only receive the same amount of compensation, resulting in a serious unfair phenomenon. Additionally, Tribe DAO prioritized repayment to "investors" (also referred to as "shareholders") over creditors, leading to a disproportionately low repayment level and ratio for creditors, sparking significant controversy.

2. Slow Rug may commit fraud under the guise of DAO

As mentioned earlier, a very novel and highly covert form of DAO fraud has emerged, where funds are raised through deception, and then the DAO is liquidated under the pretext of poor management leading to severe losses, insolvency, or even false hacking attacks causing asset losses (which are actually due to collusion between management and hackers to steal and transfer DAO assets). This method is relatively rare compared to traditional Pull Rug, has high fraud costs, long cycles, but is extremely covert and difficult to retain evidence.

In fact, this behavior is not unique to the crypto world; similar actions have been taken in traditional commercial economic activities. Article 162-2 of China's Criminal Law [Crime of False Bankruptcy] stipulates that companies or enterprises conceal assets, incur fictitious debts, or transfer or dispose of assets by other means, causing a false impression that the company or enterprise does not meet the legal conditions for bankruptcy or cannot repay due debts, thus applying to the people's court for bankruptcy declaration or being declared bankrupt by creditors, resulting in serious harm to the interests of creditors or others.

However, it is important to note that the crime of false bankruptcy is not entirely the same as Slow Rug. The object of infringement in the crime of false bankruptcy is complex; on one hand, it infringes on the legitimate rights and interests of creditors or other stakeholders, and on the other hand, it infringes on the state's management order of corporate bankruptcies. Among them, the former is the main object, so traditionally we believe that the crime of false bankruptcy primarily infringes on the legal interests of creditors. In contrast, Slow Rug primarily infringes on the interests of investors, or "shareholders," whether in the form of fabricating expenses to steal DAO assets during the DAO's operation or in the distribution of assets after the DAO enters liquidation, severely harming the interests of investors.

The Sa Jie team believes that Slow Rug may constitute multiple crimes, which we will analyze one by one.

(1) Embezzlement

According to Article 271 of China's Criminal Law [Embezzlement], this crime refers to the act of staff members of companies, enterprises, or other units illegally taking for themselves property of their unit by utilizing their position for convenience, in a relatively large amount.

In Slow Rug, a common method is for key community members or other influential personnel to collude with members outside the DAO to embezzle DAO assets through fake transactions; some DAO members also obtain large amounts of "salaries" or other benefits from the DAO by fabricating non-existent work or exaggerating their workload.

(2) Theft & Crime of Damaging Computer Information Systems

According to Article 264 of China's Criminal Law [Theft], this crime refers to the act of illegally taking public or private property with a relatively large amount or committing theft multiple times, breaking and entering, using a weapon to commit theft, or pickpocketing public or private property. Additionally, according to Article 286 of China's Criminal Law [Crime of Damaging Computer Information Systems], this crime refers to actions that violate national regulations to delete, modify, add, or interfere with the functions of computer information systems, causing the systems to fail to operate normally, with serious consequences; violating national regulations to delete, modify, or add data and applications stored, processed, or transmitted in computer information systems, with serious consequences; or intentionally creating and spreading computer viruses and other destructive programs that affect the normal operation of computer systems, with serious consequences.

(3) Crime of False Bankruptcy

As mentioned earlier, the crime of false bankruptcy is stipulated in Article 162-2 of China's Criminal Law, and the purpose of this crime is to prevent enterprises from evading debts or infringing on others' rights through false bankruptcy.

It is important to note that "concealing assets" in this crime refers to transferring or hiding the property of companies or enterprises so that it cannot be effectively disposed of under bankruptcy procedures, or failing to disclose financial information, making false records in the property list and balance sheet of the company or enterprise, and using methods such as underreporting or low reporting to conceal the actual amount of the company's or enterprise's assets.

At the same time, this crime is a result crime, and to constitute this crime, it must also result in "serious harm to the interests of creditors." Specifically, due to the false bankruptcy behavior of the company or enterprise, the huge debts that should have been repaid to creditors cannot be repaid; causing unpaid wages, labor insurance fees, and state taxes owed by the company or enterprise to remain unpaid; harming the legitimate rights and interests of other shareholders of the company or enterprise, and other similar situations.

3. How to determine if a DAO is undergoing Slow Rug?

Slow Rug is a behavior with strong concealment, but we can check for some clues to prevent ourselves from falling into fraud traps or to timely extricate ourselves from such traps.

In the opinion of the Sa Jie team, current Slow Rugs generally exhibit the following characteristics:

1. Some active community members of the DAO have unclear or false backgrounds;
2. The DAO increasingly shows a trend of "centralization" (of course, centralization is a common problem in DAOs currently and cannot solely be used to determine if a DAO is undergoing Slow Rug);
3. There are unreasonable or suspicious circumstances regarding the DAO's main expenditures;
4. The income of some DAO members is severely disproportionate to their output;
5. The speed at which the DAO's "treasury" resources are depleting is significantly abnormal;
6. The DAO has been running poorly for a long time, has not achieved its expected goals, and there is no possibility of achieving those goals in the future;

In summary, Slow Rug has various characteristics that are difficult to generalize, and it requires a comprehensive judgment based on the operational situation of different DAO cases. If investors in our country believe that a DAO project may be undergoing Slow Rug, they should consider keeping records of all actions, voting resolutions, and statements from key active members of the DAO, so that they can later use this as evidence to protect their rights through legal means.