/>iIn the generally opaque emerging world of “DAOs”, a rare public dispute recently played out between the Web3 investment group Yield Guild Games (“YGG”) and Merit Circle DAO, a decentralized autonomous organization, or “DAO”, from which YGG had purchased certain “tokens” relating to the governance and purpose of the DAO. The parties to the dispute released a joint statement (available here) which seems to resolve the issue amicably, but the alleged facts underlying the dispute bring up important considerations for purchasers of tokens and related instruments issued by DAOs.
Background on DAOs
A decentralized autonomous organization, or a “DAO,” is an “organization” encoded as a transparent computer program, controlled by the organization members, and not by a central corporate entity. Certain legal considerations regarding the structuring of DAOs are discussed in a prior BitBlog post available here.
In many cases DAOs, or supporting organizations active in the formation of DAOs, are funded through simple agreements for future tokens (or “SAFTs”). In a SAFT, an investor agrees to invest capital (often to fund initial costs for start-up of a DAO or the development of a project to which the DAO relates), and in return the investor is promised an allocation of the relevant “tokens” that govern the DAO or are to be used in its related platform.
As the term implies, a SAFT is an agreement for future tokens. In any SAFT, the tokens would not be released to the investor until such time as the tokens are minted or there is otherwise a time that the tokens are formed and publicly released, often called a token generation event. Additionally, SAFT tokens are typically subject to a lock-up period where no tokens are issued until sometime after the token generation event. Even after the full lock-up expires, the tokens are usually gradually released, to the SAFT buyers, over the course of a vesting schedule.
These lockups and vesting schedules frequently are in place both for legal compliance purposes and to prevent the market from being flooded with DAO tokens that could make DAO governance prone to manipulation, misalign the incentives of DAO participants, or adversely affect the price of DAO tokens. Sometimes, SAFT investors are intended to receive their tokens before complete governance of a project, or its associated tokens, are shifted to a DAO. In others, such as this instance, governance migrated to DAO members before the initial investors received their tokens and, accordingly, before they were able to vote those tokens, even though their initial investments helped seed the DAO community.
YGG and Merit Circle Dispute
In October 2021, YGG announced it was investing or had invested $175,000 in Merit Circle, a decentralized autonomous organization (DAO) focused on Web3 gaming. This reportedly entitled YGG to 5,468,750 Merit Circle DAO tokens, which were to unlock and begin linear vesting in May or June of 2022. At some point after that investment, the governance of Merit Circle DAO was turned over to the holders of Merit Circle DAO tokens. That DAO’s particular governance mechanisms are described in further detail here.
On May 20, 2022, a community member submitted a proposal (“Proposal 13”) which it summarized as “[t]his proposal aims to demonstrate the lack of value YGG has provided 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 above proposal link) on the merits of the proposal. In the end, the community voted to approve the proposal with a clause allowing for time “for Merit Circle ltd and YGG to propose a solution that would be more beneficial for the DAO and all parties involved in case of a YES vote.”
Proposal 13 set the price at $175,000 to “have their seed investment refunded, and their MC seed tokens returned to the DAO.” At the time of Proposal 13, Merit Circle’s token ($MC) was trading at around $1.00. After Proposal 13 passed, an additional proposal (“Proposal 14”) was submitted and passed, which proposed “Merit Circle DAO buys out the 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 passed. While this amount was significantly greater than the $0.032 per token for which YGG purchased the tokens under the SAFT, it was also less than the amount for which the tokens were trading on the open market at the time, though discounts due to illiquidity of the tokens could be reasonably expected.
In their joint statement, YGG and Merit Circle Ltd. (the entity which formed the DAO but allegedly was no longer in control after hand-off to community governance) stated:
We both recognized the arbitrary nature of the MIP-13 proposal and the danger a precedent like this could set for the Merit Circle DAO and the industry as a whole if agreements are not upheld and investors are not respected. The chosen tool was too crude and did not do justice to prior agreements.
The divergence between the prior agreement and the DAOs proposal would have likely led to legal action against Merit Circle Ltd. While the legal question is one that could probably be argued at length, both parties agreed it was better to settle. This would spare both parties from a costly, time-consuming legal process with uncertain outcomes. None of the parties 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 brings up a valuable lesson for future investors into DAOs.
Lessons from YGG and Merit Circle Dispute
It is fairly common for early investors to DAOs or other similarly decentralized organizations to have their allocated tokens vest only after organizational governance has been handed over to the community. A purchaser of a SAFT may not even know, at the time the SAFT is sold, what entity or organization ultimately will issue the tokens, or what functionality the tokens will eventually have. While this is not always inherently problematic, it requires significant trust and can lead to situations like this where by the time the tokens are in the hands of the SAFT buyer, there is a divergence between the interests of the early investor and the community running the DAO.
The SAFT is in many ways inspired by the simple agreement for future equity, or the “SAFE” commonly used by early-stage venture capital investment in more traditional businesses. While, similar to a SAFT, the traditional form of SAFE is designed to provide no guarantees that equity eventually will be issued to investors, SAFE issuers rarely choose to breach the agreement and not issue the equity provided that the conditions to the grant of the equity are met. If the issuer were to blatantly breach the agreement, it is likely that the issuer would suffer severe financial and other repercussions.
An investment in a DAO has some inherent differences regarding enforcement and governance from traditional investing. Because of a DAO’s decentralized nature and the difficulty of getting DAO members informed, there is a risk that members of a DAO could choose to breach a contract or even break the law without fully knowing the consequences. In more traditional early-stage investments a jilted 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, locating the correct entity or individuals to sue can be difficult, as seen in the Sarcuni v. bZx DAO, 22-cv-00618 (S.D. Cal. 2022) litigation. This is especially true when many otherwise anonymous DAO members could be unlocatable or even possibly insolvent if a lawsuit was brought, and thus have limited financial incentive not to breach.
To prevent this type of abuse, investors or DAO sponsors may wish to place a limit in the DAO’s governance smart contract which prevents certain types of actions from being voted on or approved. If that happened, the community would not have complete control over the organization, limiting their ability to take full advantage of “efficient breach” where it makes financial sense to breach contracts in certain situations. It also could be seen as curtailing a core ethos of a DAO, which is that that members have full control over its destiny. However, such a limitation could give initial investors the peace of mind that they cannot be later cut out of the fruits of their investments right before they become ripe.
This dispute is a reminder to investors to perform their due diligence into the risks they face when investing in DAOs, where enforcement and governance is a work in progress, and in particular to be cautious in situations where token control is intended to be handed over to the community prior to the investor receiving its agreed-upon tokens. While DAOs are an exciting new form of corporate governance with many potential upsides regarding transparency and ownership by participants, disputes like this can be expected as DAO investors and contributors navigate the Web3 intersect between code-is-law and various jurisdictional and contractual laws.
