Companies Face Risk and Opportunity with Distributed Governance Structures

In 2016, enterprising software developers sought to create a business entity with a unique governance structure: a leaderless, decentralized venture capital firm that would allow investors to vote on and collectively fund proposals. The Distributed Autonomous Organization (DAO) attracted more capital than its backers had anticipated, becoming the largest crowdfunded project ever with $168 million raised. To participate, investors poured funds into ether, a digital currency designed to facilitate decentralized applications on Ethereum, which is an open source, blockchain-based computing platform. After acquiring ether, investors exchanged it for the DAO’s tokens, entitling them to participate in its governance, profits, and losses.

The DAO gathered capital by offering a seductive solution to traditional agency cost problems. Unlike entities with more traditional, hierarchical governance structures, the DAO would not face the risk that officers and directors would grant themselves generous perquisites, because the DAO replaced these human agents with computer code. Its offering materials made clear that participants received one assurance: that the DAO would simply execute its publicly available source code. Of course, this code allowed participants significant influence. Token-holders could even vote on governance proposals to shape the DAO’s own rules.

When it launched, the fanfare and enormous amount of capital raised fed high hopes for the entity. Some believed that the DAO might allow ordinary persons to participate in early-stage investments traditionally reserved for well-connected venture capital firms. Developers hoped that the DAO would allow them to access capital on better terms than transactions with traditional venture capital firms. Some believed that by bringing in more stakeholders, the DAO could benefit from their collective wisdom.

These early hopes soon collapsed, along with the DAO. On June 17, 2016, one of the DAO’s own token-holders withdrew ether worth approximately $55 million—an exploit made possible by the DAO’s code. Other token-holders cried foul and characterized the withdrawal as an illegitimate attack. A person purporting to be the “attacker” issued a statement, arguing that the appropriation was rightful under the DAO’s peculiar terms, which had specified that “all explanatory terms or descriptions [were] merely offered for education purposes,” because the governing terms were “set forth in the smart contract code.”[1]

While the DAO collapsed, its failure holds lessons for others considering whether and how to adopt distributed governance structures. We argue that for future iterations, investors and developers should be aware of potential challenges, analyze those carefully, and opt for distributed governance only when the benefits outweigh the risks.

To be sure, a distributed governance structure made possible through distributed ledger technology might unlock significant benefits for many stakeholders. Some entities may benefit from radical transparency and non-hierarchical structures. Backfeed, for example, offers a decentralized protocol based in distributed ledger technology that allows people to govern, collaborate, and cooperate — all without a centralized authority or agency. It functions by allowing community members to evaluate each other and recognize superior performance, rather than relying on management to allocate resources and compensation.

Still, as illustrated by the DAO’s demise, tremendous risks remain. Crafting the governing code for distributed entities remains incredibly difficult. Undiscovered vulnerabilities may expose these entities to tremendous cybersecurity risks. These entities may also struggle to mitigate free-rider problems if stakeholders lack adequate incentives to participate in governance matters. Completely decentralized entities, such as the DAO, may also face significant regulatory risks. Currently, their offerings may not comply with requirements imposed by the federal securities laws.

Ultimately, future entities should learn from the DAO and from the governance structures that have allowed more traditional entities to flourish in a competitive marketplace. Participants should proceed cautiously and only adopt these structures when the benefits offset the dangers.

ENDNOTE

[1] Letter Posted June 18, 2016, http://pastebin.com/CcGUBgDG (purporting to be from “The Attacker”).

This post comes to us from Visiting Professor Carla L. Reyes at Stetson University College of Law, Professor Nizan Geslevich Packin at the City University of New York’s Baruch College – Zicklin School of Business and Professor Benjamin P. Edwards at Barry University’s Dwayne O. Andreas School of Law. It is based on their recent paper, “Distributed Governance,” which is available here.