Anatomy of a DAO Rugpull
How many times have you heard someone say, “but wait, these are not securities!” or “but this is absolutely not financial advice!”??? At your next Web3 feel free to lead the Q&A with “are these securities and are you giving me financial advice?” I promise it’ll kill. Some might think you’re from the SEC, but you’re not right? Who am I kidding — I’d still talk to you.
DAOs have a problem. Ok, DAOs have a lot of problems, it’s why I founded Mode3DAO to solve them. These problems, largely aren’t technical though — we can’t code our way to all of the solutions. The other day I saw a tweet that said something along the lines of the success of Web3 won’t come from devs but compliance officers, risk managers, accountants, lawyers, marketers, government relations experts, and policy writers. It’s true. And the one that’s desperately needed right now the most? REGULATION.
I know, I know, perhaps you got into the Web3 space to get away from regulation. I’m not judging. I have some friends whose businesses are polarizing and straddle legal boundaries across the globe. The funny thing is, they actually WANT to run LEGITIMATE business, but ill-fitting regulations and politics gives them few options. And then there are those that have absolutely no intention of “going legit”. Welcome to the rugpull.
Why do people make the statements “these are not securities and this is not financial advice”? Because securities are heavily regulated by the SEC. What’s a security? In short, it’s an investment device that a company can issue to raise money to operate the business. For a publicly traded company, the most common securities are public stock that anyone can buy and trade freely. For private companies, the rules are more strict — legally registered companies can issue securities but selling those securities on the secondary market is bound by many rules. Private securities can NOT be traded freely.
But what does that have to do with DAOs? With a few exceptions like Wyoming and a few foreign countries (you can probably guess which), DAOs have no legal recognization. There is no way to legally register a DAO and issue securities tokens — which again ARE NOT SECURITIES (keep moving SEC, go worry about Elon). So what ARE people doing? The DAO has to have some funding. People have bills — they have to eat occasionally. When DAO founders take grants, seeds, or more traditional funding — which of course is in fiat, good ole’ dead presidents (and Ben Franklin) — those funds are distributed to a LLC or maybe even a C corp where the DAO founders are legal officers of THAT company.
But that company is NOT the DAO. That company is simply a vehicle for raising money. The DAO creates governance tokens and perhaps even NFTs. These digital assets are distributed to DAO members based on criteria set by the DAO. Now here is where it’s about to get really murky. Again, the SEC has very strict guidelines on how a company issues securities. The DAO has to structure the digital assets so that they are — LEGITIMATELY— not classified as securities. If they were securities, the company would have to track and record who holds the securities and the security owners would have very few options to resell those securities.
Then how does the DAO compensate people? People can work for free for only so long. The governance token is typically the incentive mechanism. The governance token gives voting rights but NOT ownership of the DAO or most importantly the legal LLC or corporation. If the DAO is successful, the governance token will appreciate in value as people will want a vote in the DAO proposals. Voting is the only utility of the governance token as it gives NO ownership rights. How many times have you heard DAOs complain about a lack of voting? Yes, a lack of voting might indicate a lack of engagement but it also reduces the voting utility of the token. Since the only thing the token can do is allow you to vote, and no one’s voting, well, that token will have less value. No voting means the price of the token will go down.
Since that token is the only way to compensate people — how much longer will the DAO last? But what about all that fiat currently the underlying legal company holds? There is NO connection between the legal company and the DAO. The legal company answers only to the listed officers when it was registered — which might be a single person. There is absolutely NOTHING stopping that individual from taking the money and walking away. Rug. Pulled. It’s not illegal — it’s their company, their money. The DAO is totally disconnected from the company legally.
We like to vilify the SEC, from Elon’s current trolling of Twitter to films like The Wolf of Wall Street or even the OG Wall Street, but securities regulations were introduced to PREVENT fraud, scams, and most importantly money laundering. Wash trading and rugpulls might be new to Web3, but those are corporate scams that have existed as long as people have been structuring businesses and investments. This DAO problem can’t be solved with code — it’s a BUSINESS problem. And to solve this problem we need business PEOPLE. The answer isn’t on Github or StackOverflow. Close your laptop and have a conversation with someone that might not know the first thing about Web3, but founded a successful startup that IPO’d or even started a coffee shop where you host your hackathons or even — perish the thought — a lawyer. These are the PEOPLE that are going to get Web3 to mass adoption.
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