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The Legality of The DAO

The DAO (a for-profit Distributed or Decentralized Autonomous Organization) raised more than $100 million to support the sharing economy, making it the largest crowdfunded project in human history. ((Giulio Prisco, The DAO Raises More than $117 Million in World’s Largest Crowdfunding to Date, BITCOIN MAGAZINE (May 16, 2016, 6:09 PM), https://bitcoinmagazine.com/articles /the-dao-raises-more-than-million-in-world-s-largest-crowdfunding-to-date-1463422191.)) However, a careful look at the constitution of The DAO reveals that its legal ambiguities contributed to the resolution of its infamous hack in June of 2016.

The DAO was a vehicle by which Ethereum-related projects were supported; The DAO primarily accepted ETH (the Ethereum cryptocurrency) in exchange for DAO tokens – enabling investors a right to vote on potential projects and future investments. ((See Michael del Castillo, The DAO: Or How A Leaderless Ethereum Project Raise $50 Milliion, COINDESK (May 12, 2016, 9:19 PM), http://www.coindesk.com/the-dao-just-raised-50-million-but-what-is-it/.)) As such, the nature of these transactions qualified The DAO as engaging in crowdsourcing behavior. ((See Danny Bradbury, What is a Cryptocurrency Crowdsale?, THE BALANCE, https:// www.thebalance.com/what-is-a-cryptocurrency-crowdsale-391277 (last visited Aug. 11, 2016).)) The DAO was comprised of smart contacts written on the Ethereum application platform using blockchain, and these smart contracts were subject to the audit of any investor. ((See Gideon Greenspan, Smart Contracts and the DAO implosion, MULTICHAIN (June 22, 2016), http://www.multichain.com/blog/2016/06/smart-contracts-the-dao-implosion/.)) All the smart contracts amounted to a series of by-laws – and anyone who had purchased DAO tokens with ethers voted on investment decisions, allocated resources, and in theory, created a wide-range of possible returns. ((Castillo, supra note 2.))

Some believed that The DAO qualified as a venture capital firm while its token holders represented investors. ((Id.)) However the of terms of The DAO specifically stated that “DAO tokens do not represent or constitute an equity ownership stake, share, or equivalent in ANY public or private company, corporation, or other entity in any jurisdiction.” ((Reuben Bramanathan, Blockchains, Smart Contracts and the Law, MEDIUM (June 24, 2016), https://medium.com/the-coinbase-blog/blockchains-smart-contracts-and-the-law-709c5b4a9895#.gpl72vjzp.)) Returns to the investors were in ETH but the tokens themselves did not represent equity since token holders did not explicitly own a part of a company like common stock or preferred stock holders would in a public corporation. ((Castillo, supra note 2.))

Furthermore, SEC v. W.J. Howey Co. (1946) set the precedent that an investment contract entails the giving of money to others who manage and control the funds with the expectation of profit – and that the expectation of profits will depend on the efforts of someone other than the investors. ((Justin O’Connell, The Securities Law Implications of the DAO Hack and Proposed Ethereum Hard Fork, BITCOIN MAGAZINE (June 29, 2016, 3:50 PM), https://bitcoinmagazine.com/articles/the-securities-law-implications-of-the-dao-hack-and-proposed-ethereum-hard-fork-1467215402.))

With respect to The DAO, no legal entity possessed control of the funds raised, and no legal entity managed The DAO’s activities. ((Bramanathan, supra note 7.)) As such, the profits of the enterprise were likely not ‘solely dependent on the efforts of the promoter or a third party’ — because the profitability of The DAO would have depended on the decisions cast by the token holders voting for profitable projects. ((Id.)) However, a court could have applied the Howey test to cover transactions undertaken by The DAO. ((Id.))

Nevertheless, The DAO faced a host of pressing issues in addition to these open-ended legal questions. In June 17, 2016, a hack occurred in which a “child DAO” was created and drained The DAO of 3.6 million Ethers. ((See Morgen Peck, “Hard Fork” Coming to Restore Ethereum Funds to Investors of Hacked DAO, IEEE SPECTRUM (Jul. 19, 2016, 1:52 PM), http://spectrum.ieee.org/tech-talk/computing/networks/hacked-blockchain-fund-the-dao-chooses-a-hard-fork-to-redistribute-funds.)) Existentialist questions arose as to the right solution in compensating investors. ((Id.)) Many feared that failure to implement a hard fork of the blockchain (a backwards incompatible software upgrade) would lead to law suits by investors within The DAO and even by federal regulators, but implementing a hard fork led to concerns that the hacker could file suit against the Ethereum Foundation for taking away assets obtained through the permitted use of The DAO. ((See Drew Hinkes, A Legal Analysis of the DAO Exploit and Possible Investor Rights, BITCOIN MAGAZINE (June 21, 2016, 3:57 PM), https://bitcoinmagazine.com/articl es/a-legal-analysis-of-the-dao-exploit-and-possible-investor-rights-1466524659.)) Nevertheless, the Ethereum community decided that the ETH was wrongly stolen and a hard fork was implemented. ((Peck, supra note 13.)) Original investors were refunded but this effectively led to the dissolution of The DAO because the Ethereum blockchain, which was supposed to be an unchangeable record of all transactions, was no longer seen as immutable. ((See Michael del Castillo, The Hard Fork: What’s About to Happen to Ethereum and The DAO, COINDESK (July 18, 2106, 8:03 PM), http://www.coindesk.com/hard-fork-ethereum-dao/.))

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Lucy Liu

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