Code is Law: The Importance of Legal Engineering in DAOs

By: Stephen Cromwell

Decentralized Autonomous Organizations (“DAOs”) are a revolutionary new way of conducting business, earning an income, and distributing profits to participants and investors. DAOs are, in essence, companies or organizations built on decentralized and permissionless blockchains using smart contracts. Smart contracts are simply programs stored on a blockchain that run when predetermined conditions are met, and can be customized to execute different business functions. Just as a company maintains one or more bank accounts in the real world, DAOs maintain one or more cryptocurrency wallets governed by smart contracts. 

The governance of the company is typically commanded by documents and legal precedents dictating standard procedures for the formation, fundraising, employment, and operations of the company. Company governance may take many forms depending on how the company is structured, and there are a multitude of legal considerations for differing corporate structures, such as tax implications, fiduciary agreements of officers and board members, and profit distribution mechanisms. Each of these considerations are affected by the conduct of individuals and are dictated by corporate charters and contracts, which typically assign power in a hierarchical way. Although some forms of partnerships may mandate a democratic process for business purposes, typically they still maintain a board to simplify control and gain efficiency in decision making. 

DAOs, however, are entirely governed by the terms of the smart contract and money cannot move without the terms being met. This concept is commonly referred to as “code is law.” This means the charter can be automatically executed, and dividends and wages can be paid without necessary authorizations coming from officers or employees. Additionally, the issuance of governance tokens, much like traditional shares of equity, are issued in a predetermined way in accordance with the code of smart contracts. This enables much greater flexibility with respect to compensation schemes, ways to earn shares, or how DAO voting is conducted. For example, a DAO may issue governance tokens to its employees or contributors, much like an employee stock option. This issuance may be done in a more traditional, scheduled manner by issuing tokens in a specific quantity for a given period of time. However, the DAO could choose to issue governance tokens in a less traditional way, such as automatically awarding tokens for work performed, almost distributing equity through micro contract arrangements. Therefore, after a X amount of work is done, a contributor may receive Y amount of shares. This incentive structure may produce greater work efficiency as the contributor is incentivized to work as hard as possible and maximize both the wage and dividend they might receive. Since smart contracts monitor work products automatically, efficiently, and without bias, this form of compensation may prove to be more fair and allow for changes in productivity given a dynamic workforce. 

However, DAOs are not exempt from the law, and it is critically important that DAO founders think about building compliance into their smart contracts. For example, Merit Circle is a DAO that develops play-to-earn video games in which assets within the game can be bought and sold on open markets. To get off the ground, Merit Circle raised $4.5 million dollars in a seed round of funding composed of 10 investors in October of 2021, including another DAO named YieldGuild and YieldGuild’s founder. Merit Circle and YieldGuild entered a Simple Agreement for Future Tokens (SAFT), constituting a $175,000 investment at a price of $0.032 for 5,468,750 Merit Circle governance tokens. Then on May 5, 2022, a member of the Merit Circle DAO named “HoneyBarrel” posted a governance proposal titled “MIP-13” on the DAO’s forums requesting that YieldGuild’s ownership in seed tokens be refunded prior to the public unlocking of the tokens, effectively canceling their investment. Many of the members of the DAO expressed support for the action while a few members criticized the action. Given the public nature of decision making that is inherent in DAOs, the proposal was set for voting on the DAO’s governance protocol and passed with 86% of the vote. This vote forced the DAO to refund the investment and remove the governance tokens. In response, the Merit Circle administration issued a counter proposal to buy back the tokens at a price of $0.32 for a total purchase of $1,750,000 under a settlement agreement. This vote passed with 100% support of the DAO’s voting members. Both parties decided it was in their best interest to settle the matter and avoid litigation, and YieldGuild accepted Merit Circle’s settlement offer. However, if YieldGuild had decided to litigate instead, it is likely the DAO founders would have been liable for the resulting roughly $3 million dollar loss. 

Harm, such as the case above, is avoidable so long as DAO founders consider the agreements or laws they might be held to during development. However, doing so is extremely difficult given the need to diagnose complex legal agreements, determine what law applies, and build statutory interpretation into code. Therefore, a new class of lawyering has arisen. A lawyer that can practice and code is referred to as a Legal Engineer. As the importance of smart contracts grows and Web3 expands, the demand for competent legal engineers will grow as well. Some lawyers are actively embracing this new class and are beginning to set certifications and standards for this new kind of work. Additionally, there is opportunity for the development of legal applications that can add ease, certainty, and dispute resolution to Web3 transactions, something that has been missing in the world of immutable crypto transactions. So whether you’re a lawyer, law school administrator, or law student, adding Legal Engineering skills to your skillset is a must-do as the nature of transactions and contracts begins to evolve around the world of Web3. 

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s