Blockchain-Based Corporate Governance

Corporate governance is characterized by agency constructs. The agency relationship in modern finance and corporate governance is characterized by attempts to optimize incentives between principals and agents, control costs, minimize information asymmetries, control adverse selection and moral hazard, optimize risk preferences between principals and agents, and engage in monitoring.  The corporate form remains the most popular form of a governance mechanism, despite the unresolved substantive agency problems associated with the division of ownership (shareholders) and control (agent) and the incomplete and suboptimal rules that govern such conflicts.

Shareholder value maximization has emerged as the dominant corporate governance solution for the agency problems. To reduce the risk of managerial misbehavior and the associated agency problems, alignment of the interests of investor-shareholders with those of other stakeholders has become the dominant implementation of the shareholder primacy doctrine.  The doctrine suggests that, by aligning the interests and incentives of non-shareholders with those of investor-shareholders, all stakeholders in a firm and the public will benefit. Following this logic, increasing shareholder control over other actors within the firm has become the primary goal of corporate governance rules. The correct corporate governance is seen as naturally resulting in shareholder value.

The existing attempts to solve agency problems fall short of accomplishing the needed corporate governance quality and stability.  Such attempts include substantively increased disclosure requirements, shareholder activism, and reforms to the U.S. proxy system executive compensation. Government-sponsored organizational experimentation that enables new business models and new organizational structures is desirable and valuable and may be one of the few ways to facilitate corporate governance reform.

Blockchain-based technology has started to offer alternatives to the existing corporate governance solutions. Blockchain technology can facilitate the removal of agents as intermediaries in corporate governance through code, peer-to-peer connectivity, crowds, and collaboration. Blockchain-based guarantees embedded in blockchain code can help ensure that no participant in business transactions and agency relationships can circumvent the set of governance rules. Blockchain guarantees include contract execution between principal and agent only if and when all contract parameters are fulfilled by both parties and verified in a consensus algorithm.  Hence, in the blockchain infrastructure, a lower level of oversight and monitoring of agents changes the cost structure of the principal agent relationship.

Smart contracts enabled by blockchain technology allow for the comprehensive, near error free, and zero transaction/agency cost coordination of agency relationships.  Smart contracts and smart property are blockchain enabled computer protocols that facilitate, verify, monitor, and enforce the negotiation and performance of a contract between principal and agent. Agency relationships in smart contracts run exactly as coded without any possibility of opportunistic behavior of the agent. All contractual terms are public and fully transparent.  Accordingly, a company’s finances, for instance, are visible on the blockchain to anyone, not just to the company’s accounting department. Smart agency contracts run on a custom built blockchain that enables principals and agents to store registries of debts or promises and create entire markets, among many other things.

Blockchain-based legal constructs, known as decentralized autonomous organizations (DAOs), have started to challenge the core belief that governance necessitates agency. The first DAO, launched in May 2016 as a corporate-type organization without a conventional corporate structure, had a governance structure that was entirely built on software, code, and smart contracts that ran on the public decentralized blockchain platform Ethereum.  Because it was pure computer code, the organization had no physical address, no jurisdiction that could claim control over it, and no corporate hierarchy. What’s more, the DAO did not use a traditional corporate structure that necessitated formal authority and empowerment flowing from shareholders through a board of directors to management and eventually staff. Indeed, it had no directors, managers, or employees. In essence, all the core control mechanisms typically employed by principals in agency relationships were entirely absent.

The DAO is a group of anonymous individuals who decide to follow a certain protocol. For instance, a hypothetical Uber DAO could be seen as Uber the company with all its constituents except without the company, e.g., the entity, itself and its hierarchical governance structures. If Uber were a DAO, the Uber drivers as a group with their respective non-fungible token holdings would become Uber, e.g., a fully decentralized company without hierarchies. The control and power over the Uber DAO would be in the hands of the DAO Uber token holders.  As such, Uber would be subject to the collective decision making of its members, e.g. the token holders. Yet, the staking mechanisms for non-fungible tokens in emerging DAO protocols make the voting structure different than any previous attempts at creating liquid democracies.

DAOs are still in the development stage and so are unlikely to disrupt existing corporate structures and the associated governance solutions in the foreseeable future. However, DAOs have the potential to create significant decentralized equivalents of corporations. Such development is contingent on workable governance solutions for DAOs. Without DAO governance, their evolution is even less certain. The blockchain industry has started to recognize the need for DAO infrastructure and governance solutions. Yet, such governance solutions are still largely lacking, even in the developmental phases.

Blockchain-based corporate governance solutions in DAOs require evolutionary blockchain governance protocols. Existing blockchain governance still mainly consists of forking, e.g. creating a new chain based on the same code and previous blocks under the old protocol except the new chain operates with a foundational new element in the protocol. Blockchain-based coded guarantees will evolve and require protocol upgrades for that changing environment.  Without evolutionary governance upgrades the cost reduction for the agency relationship cannot be maintained.

This post comes to us from Professor Wulf Kaal at the University of St. Thomas School of Law. It is based on his recent article,Blockchain-Based Corporate Governance,” available here.