DAO investment dispute highlights potential SAFT pitfalls

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In the generally opaque emerging world of “DAOs,” a rare public dispute recently played out between investment group Web3 Yield Guild Games (“YGG”) and Merit Circle DAO, a decentralized autonomous organization, or “DAO,” of which YGG had purchased certain “tokens” related to the governance and purpose of the DAO. The disputing parties have issued a joint statement (available here) that appears to resolve the matter amicably, but the alleged facts underlying the dispute raise important considerations for purchasers of tokens and related instruments issued by CAD.

Context of DAOs

A Decentralized Autonomous Organization, or “DAO”, is an “organization” coded as a transparent computer program, controlled by the members of the organization, not by a central entity. Some legal considerations for structuring DAOs are discussed in a previous BitBlog article available here.

In many cases, DAOs, or support organizations active in the formation of DAOs, are funded through simple agreements for future tokens (or “SAFTs”). In a SAFT, an investor commits to invest capital (often to finance the initial start-up costs of a DAO or the development of a project to which the DAO relates), and in return the investor is promised an allocation of relevant “tokens” that govern the DAO or are to be used in its associated platform.

As the term implies, a SAFT is an agreement to coming tokens. In all SAFT, the tokens would not be released to the investor until the tokens are minted or there is a time when the tokens are formed and made public, often referred to as the token generation event. Additionally, SAFT tokens are typically subject to a hold period where no token is issued until some time after the token generation event. Even after the full lock expires, tokens are usually gradually released, to SAFT buyers, over a vesting schedule.

These locks and vesting schedules are frequently in place both for legal compliance purposes and to prevent the market from being flooded with DAO tokens that could make DAO governance subject to manipulation, misalign DAO participant incentives or negatively affect the price of DAO tokens. Sometimes SAFT investors are destined to receive their tokens before full governance of a project, or its associated tokens, is transferred to a DAO. In others, like this, governance migrated to DAO members before initial investors received their tokens and, therefore, before they could vote for those tokens, even though their initial investments helped to bootstrap the DAO community.

YGG and Merit Circle dispute

In October 2021, YGG announced that it was or had invested $175,000 in Merit Circle, a Decentralized Autonomous Organization (DAO) focused on Web3 games. This would have given YGG 5,468,750 Merit Circle DAO tokens, which were expected to unlock and begin linear vesting in May or June 2022. At some point after this investment, governance of Merit Circle DAO was handed over to Merit token holders Circle DAO. . The particular governance mechanisms of this DAO are described in more detail here.

On May 20, 2022, a community member submitted a proposal (“Proposal 13”) which he summarized as follows: “[t]his proposal aims to demonstrate the lack of value that YGG has provided to the DAO since becoming a seed investor. It also aims to cancel YGG’s SAFT, refund their initial investment, and remove their MC seed tokens. This led to a public community debate (available for review in the proposal link above) on the merits of the proposal. In the end, the community voted to approve the proposal with a clause allowing time “for Merit Circle ltd and YGG to come up with a solution that would be more beneficial to the DAO and all parties involved in the event of a YES vote”.

Proposition 13 set the price at $175,000 to “have their seed investment refunded and MC seed tokens returned to the DAO.” At the time of Proposition 13, the Merit Circle Token ($MC) was trading at around $1.00. After the adoption of Proposition 13, an additional proposal (“Proposition 14”) was submitted and adopted, which proposed “Merit Circle DAO redeems YGG and Nifty Fund allocation, a total of 5,468,750 MC$ tokens at 0 $.32. For a total of $1,750,000 USDC. This was also voted on and adopted. While this amount was significantly higher than the $0.032 per token YGG purchased the tokens for under SAFT, it was also lower than the amount the tokens were trading for on the open market at the time, although discounts due to the illiquidity of the tokens could reasonably be expected.

In their joint statement, YGG and Merit Circle Ltd. (the entity that formed the DAO but would no longer have control after the transfer to community governance) said:

We both recognized the arbitrary nature of the MIP-13 proposal and the danger that a precedent like this could set for the Merit Circle DAO and the industry as a whole if agreements are not honored and investors do not are not respected. The tool chosen was too rudimentary and did not do justice to previous agreements.

The discrepancy between the prior agreement and the DAOs proposal would likely have led to legal action against Merit Circle Ltd. Although the legal issue is one that could probably be debated at length, both parties agreed that it was best to settle. This would save both parties from a long and costly legal process with uncertain results. Neither party had to settle, but both parties chose the constructive path to help Merit Circle move forward.

While this joint statement and associated agreement likely settles the dispute between the parties, it provides a valuable lesson to future investors in DAOs.

Lessons from YGG and Merit Circle Dispute

It is quite common for early investors in DAOs or other similarly decentralized organizations to see their assigned tokens only vest after organizational governance has passed to the community. A buyer of a SAFT may not even know, at the time the SAFT is sold, which entity or organization will ultimately issue the tokens, or what functionality the tokens will eventually have. While this is not always inherently problematic, it does require significant trust and can lead to situations like this where, at the time the tokens are in the hands of the SAFT buyer, there is a discrepancy between the interests of the initial investor and the community that manages the DAO.

SAFT is modeled in many ways on the simple Future Equity Agreement, or “SAFE” commonly used by early stage venture capital investments in more traditional businesses. While, like a SAFT, the traditional form of SAFE is designed to provide no guarantee that equity will eventually be issued to investors, SAFE issuers rarely choose to break the agreement and not issue equity. own funds provided that the conditions for the granting of own funds are met. If the issuer flagrantly violates the agreement, it is likely to suffer serious financial and other repercussions.

Investing in a DAO has some inherent differences in application and governance from traditional investing. Due to the decentralized nature of a DAO and the difficulty of informing DAO members, there is a risk that DAO members will choose to breach a contract or even break the law without fully knowing the consequences. In more traditional seed investing, an abandoned investor is less likely to settle for pennies on the dollar because the investor can sue the issuer for breach of contract. However, when a DAO is involved, it can be difficult to locate the right entity or people to prosecute, as seen in the Sarcuni vs. bZx DAO, 22-cv-00618 (SD Cal. 2022) litigation. This is especially true when many otherwise anonymous DAO members could be untraceable or even possibly insolvent if legal action were taken, and therefore have limited financial incentive not to infringe.

To prevent this type of abuse, DAO investors or sponsors may wish to place a limit in the DAO’s governance smart contract that prevents certain types of actions from being voted on or approved. If this happened, the community would not have full control over the organization, which would limit its ability to take full advantage of “effective breach” when it makes financial sense to break contracts in certain situations. It could also be seen as a reduction in a DAO’s core ethos, which is that the members have full control over its destiny. However, such a limitation could give initial investors peace of mind that they cannot later be deprived of the fruits of their investments just before they are ripe.

This dispute reminds investors to exercise due diligence about the risks they face when investing in DAOs, where enforcement and governance are a work in progress, and in particular to be cautious in situations where token control is intended to be released to the community before the investor receives their agreed tokens. While DAOs are an exciting new form of corporate governance with many potential benefits to transparency and participant ownership, disputes like this can be expected as DAO investors and contributors navigate the web3 between the code is the law and various jurisdictional and contractual laws.

© Polsinelli PC, Polsinelli LLP in CaliforniaNational Law Review, Volume XII, Number 182

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