Decentralized Autonomous Organizations: When Code Mirrors Law

In this piece¹, members of Mayer Brown’s Digital Assets Initiative break down a digital-native form of business—the Decentralized Autonomous Organization, or DAO—and examine one of the first DAO mergers. We also take a look ahead at ways that DAOs may become increasingly relevant to established technology and financial services businesses.

Decentralized Autonomous Organizations – A Primer

DAOs are a form of digital-native business that can be organized to do just about anything: management of a crypto protocol (MakerDAO), investment (MetaCartel Ventures), art collection (PleasrDAO), or even completion of a single purpose (ConstitutionDAO). The key distinguishing feature of a DAO—beyond its digital roots—is its decentralized and autonomous governance structure.

Hyper-democratic by nature, DAOs are not historically creatures of state law, unlike the predominant forms that most businesses take—corporations and limited liability companies. Unlike corporations and limited liability companies, DAOs do not have boards of directors, managers or executive management; instead, in a DAO’s purest form, decisions made by tokenholders are implemented with self-executing smart contracts. While shareholders and bylaws are the backbones of a corporation, the foundations of a DAO are its tokenholders and smart contracts.

• DAO membership is derived from ownership of the DAO’s token and is often permission-less. As with most crypto-tokens, these are typically freely-tradeable on decentralized exchanges or earned by performing actions the DAO seeks to encourage, such as providing liquidity.
• Smart contracts, a type of program stored on a blockchain, allow DAOs to forego many of the management and other authority structures of a typical organization by automatically executing actions when certain conditions are met, without need for intermediaries. Rules of the organization are made by members and encoded in smart contracts. Among other things, these rules control the DAO’s treasury and spending. Rules can be changed by vote of the membership.

This decentralized milieu has also impacted the way in which discussions, advocacy and battles among DAO stakeholders are conducted. For example, instead of lawsuits, proxy battles and traditional media campaigns—the norm for corporate stakeholders—these issues have played out among DAO communities in online discussion forums and Discord channels.

DAOs and M&A: Evolve, Combine, Grow

While some states (such as Wyoming) are exploring or have recently passed laws formally granting legal status to DAOs through legislation that mirrors existing laws applicable to limited liability companies and corporations, DAOs are otherwise not subject to state law-based governance rules that would typically provide the boundaries of a company’s powers and obligations. Among other things, these laws regulate a corporation’s conduct and shareholders’ rights in the context of a merger or acquisition.

As DAOs evolve and expand, they are beginning to face some of the very same issues that these laws, rules and customs have been designed over decades to address, particularly as they begin to use “merger”-like transactions that seek to combine elements of two protocols and even DAOs themselves.

In one recent example, one of the largest DAO mergers to date² was approved by members of two distinct DAOs: Rari Capital and Fei Protocol. Rari Capital is a DAO that manages a decentralized lending and borrowing platform and Fei Protocol is a DAO that manages the issuance of a decentralized dollar-pegged stablecoin called FEI. In concept, this combination has some similarities to a typical merger among two corporations:

• One protocol (and corresponding token) —Rari Capital and its token, RGT—will be merged into another (Fei Protocol), with Fei Protocol (and its governance token, TRIBE) as the merged survivor over a two-part “governance transition.”
• Just like in a merger of two corporations, the surviving DAO obtains control of all the merging DAO’s treasury positions and assumes all of the merging DAO’s liabilities (in this case, Fei Protocol will assume legacy liabilities from Rari Capital’s May 2021 hack).
• The members of the protocol merged out of existence will exchange tokens for the surviving protocol tokens at a fixed rate of exchange.

Because this merger was structured and executed as a purely commercial arrangement—albeit one that changed the nature of the business and its ownership—it took place entirely outside of the state laws that would ordinarily govern the merger of two businesses. That said, the arrangement itself had several elements commonly seen in state law that serve to provide owners of the business with value certainty, ongoing rights and possible alternatives if they do not agree with or approve the arrangement/merger.

• For example, the merger will result in a token swap with the exchange of Rari’s RGT for Fei’s TRIBE at a fixed rate of exchange—1 RGT will be exchanged for 26.7 TRIBE. RGT tokenholders have until August 1, 2022, to exchange their RGT for TRIBE.
• An effect of this exchange is that Rari Capital protocol governance will become fully integrated with the Fei Protocol DAO.

The token swap mirrors equity consideration in typical mergers—RGT holders are receiving governance tokens (as opposed to being offered cash for the value of an existing ownership stake).

In addition, TRIBE holders—i.e., current owners of the surviving Fei Protocol—that are unhappy with the terms of the merger have the right to exchange their TRIBE tokens for a proportional share of Fei Protocol’s (i.e., the surviving protocol’s) treasury, claimed as a payout of newly minted FEI. This right to be cashed-out of an existing stake is called a ragequit option, similar to a put right and a mirror image of dissenters’ rights in a merger under Delaware (and most state) law (dissenters’ rights allow owners of the entity to-be merged out of existence—not the surviving entity—to challenge the value they are receiving in the merger). The ragequit allows TRIBE tokenholders to exchange their tokens for FEI during a three-day window, after the voting schedules outlined in the merger proposals have passed. This option allows those TRIBE holders to avoid the merged entity all-together by exchanging TRIBE for newly minted FEI at value that is measured through a formula executed on the protocol.

This is a “mirror image” of dissenters’ rights because it is opposite of the way these rights are applied in a typical merger, where they protect the minority shareholders of the entity to-be merged who can be dragged along into the deal if a majority of shareholders approve the merger. In a typical merger, these rights to challenge the value being paid for the to-be merged company are exercised through a legal process in court. Unlike dissenters’ rights, this ragequit option is already built into the terms of the merger at a fixed redemption price; a token holder would not have to invoke a statutory right for their tokens to be appraised or for an alternate value to be ascribed.

Interestingly, while the merger proposal provides a protection for the disgruntled holders of TRIBE, there is no corresponding provision protecting RGT holders—i.e., the minority owners in the “target” entity—if they do not exchange in the eight-month long window. RGT holders’ dissatisfaction over this fact—voiced publicly in discussion forums—have not yet been fully addressed. The founder of FEI has said in the Fei Protocol voting forum that further amendments and correction to the proposal will have to be made to work out other details that are not addressed in the proposal as it passed in December 2021. This highlights another difference between this DAO merger and a typical corporate one: the idea that the deal itself may evolve over time, even after it has been publicly announced and approved by a majority of DAO membership.

Relevance and Key Takeaways

By all accounts, we are still in the early stages of the emerging (and still very small) world of DAOs and decentralized finance in general. That said, there are several contexts in which DAOs and these issues may become relevant to established businesses—especially in technology and financial services—in the not-too-distant future.

• DAOs and JV partners or acquisition targets: Consider a technology or financial services company that wants to partner with or purchase a DAO. Understanding the differences between corporations and DAOs—the way they are structured, the way they function and the way their membership thinks about their role in the DAO—may inform how these companies approach and structure the deal. This may include commercial arrangements cloaked in code, such as the ragequit option.
• DAOs as investment opportunities and activist targets: In addition, as DAOs become more mainstream—and especially as traditional pools of investment capital such as hedge funds and other institutional investors turn their attention towards digital assets—the influence that these pools of capital have in DAOs may grow. For example, pooled investment vehicles may be able to use their purchasing power to accumulate control stakes in DAOs and influence their activities. The analogy here is to activist investors and publicly traded corporations—though at this time, DAOs don’t appear to have in place the types of activist investor restrictions and protections that corporations have been using for decades (such as poison pill shareholder rights plans). It remains to be seen whether DAOs and their members would look to incorporate protections like poison pills into their code protocols to limit the accumulation of control by members.

Given the explosion of growth in capital and other resources devoted to DAOs, it will be difficult to ignore this new form of business organization in the coming years, especially as it continues to evolve. Many of the legal and commercial issues they encounter, while novel in the decentralized finance ecosystem, will be familiar to lawyers and other advisors who have dealt with them in “meatspace.” Successfully navigating these issues in new and emerging contexts will require, among others things, an ability to identify and solve for these similarities and differences.

¹ Danielle Marino also contributed as a co-author.

² The combination of these two DAOs will result in an entity with a total value locked—i.e., the sum of all assets deposited in a protocol—of approximately $2 billion.