How Can We Fix the Broken DAO Model?

Decentralized Autonomous Organizations (DAOs), the cutting-edge organizational structure that has taken over the Decentralized Financial (DeFi) space, have an issue. A number of key DeFi projects governed by DAOs are facing regulatory action or stalled due to internal disputes. These issues threaten to kill off a number of exciting projects well before their time.

What Is A DAO?

DAOs are self-governing entities that operate on blockchain networks. They function as a set of hardcoded smart contracts to govern the behavior of the entity and its members. Incentives within a DAO are powered by cryptocurrency-based rewards. The rules and reasons for decision-making are meant to be transparent, open, and democratic.

DAOs power a variety of business cases including exchanges, NFT marketplaces, investment funds, exchanges, borrowing and lending platforms, and many other types of decentralized applications. A key factor in the popularity of DAOs is their decentralized, headless nature. Investor protections can be embedded into the code of smart contracts, which can greatly reduce the amount of trust that investors need to put into the operators of the protocols.

Major DAOs include Uniswap, the Curve DAO, MakerDAO, DeveloperDAO, PleasrDAO, Meta Cartel, ConstitutionDAO, and BanklessDAO.

How To Build A DAO

There are 4 basic steps to setting up a DAO:

• Determining the foundations of the DAO – At this stage, the key humans that are involved in the community come together and set up the purpose of the DAO. It is important to clarify the key goals of the DAO so that disagreements in the future won’t break the organization. Major potential pain points like Multisig arrangements, how community funds are managed, how the DAO makes money, and how revenues are distributed need to be determined thoroughly.
• Determining ownership structure – This is a complicated question because DAOs are decentralized. So what is ‘ownership’ within a DAO? It is essentially how tokens and key assets are initially distributed and how they will be disseminated in the future. Key questions to answer here include — how will any airdrops work? Will there be an airdrop or will tokens be earnt by rewards?
• Establishing governance structure – This is the means by which voting on decisions works within the DAO. Most voting structures within DAOs are based on a token-weighted structure but there are variations and nuanced versions of token-based voting like vote-escrow token models.
• Rewards and incentives also need to be set up within the organization so that tasks are completed efficiently and the DAO can move forward. It needs to be determined who will be rewarded with tokens for what role within the DAO (I.e. bigger rewards for stakers versus application users).

DAOs have incredible value and potential. They allow everyone within an entity to have a voice in decision-making. Within traditional organizations, decision-making power is only in the hands of a few but when DAOs work as intended far more stakeholders have a say. This creates a more inclusive governance structure which leads to more equitable results and often better results. Additionally, DAOs are highly investable because of the barrier-less nature permitted by smart contracts.

DAOs have clear recurring challenges, however. They are prone to internal disputes and go toe-to-toe with regulators constantly. Brave New Coin recently spoke to Alex O’Donnell, the CEO of Umami Labs, which is currently in the middle of a messy DAO dispute.

The Umami DAO incident

Umami is an Arbitrum-based DeFi protocol that targets the institutional adoption of DeFi through an array of strategic investment vaults that generate sustainable risk-hedged yield on core crypto assets including USDC, BTC, and ETH. Umami Labs LLC is a U.S.-based C-corp that is formally incorporated in the state of Delaware.

The Umami DAO Foundation serves as the legal representation of Umami and stands as an ownerless, leaderless DAO. Umami’s governance, and custody of its treasury assets, are designed to remain in the hands of its multisig and DAO community.

A few weeks ago the Umami Labs leadership team left en masse and O’Donnell is now involved in a legal battle with his former executives. The Umami protocol battle stems from disagreements over whether the project should focus on institutional products or maintain a more decentralized, accessible ethos. Both sides are accusing the other of trying to take control of the Umami Labs treasury.

Issues appear to have begun for the Umami protocol after an announcement on January 31st stating that staking rewards would be paused. Following this the Total Value Locked (TVL) of Umami immediately fell significantly. It went from hovering near US$20 million to under US$5 million. The project decided to suspend the flow of funds pending the completion of a compliance review by its legal team.

Source: DeFiLlama

In a quote sent to Brave New Coin, O’Donnell explains the lawsuit. He said the lawsuit began on February 17th 2023 when Umami Labs sent a ‘Notice of Breach and Demand to Cure’ notice to the Umami DAO. Umami Labs then requested a multi-sig comprised of O’Donnell and the two current multi-sig holders among the former employees who are also members of the legal entity, Umami Holdings. The treasury is worth ~US$4 million and the DAO has 2000 members.

According to O’Donnell, on March 2nd, the former employees agreed to enter into negotiations with Umami Labs, and a meeting was set up but had to be revised. He said that the group of former employees stalled and obstructed the arbitration process. On March 20th, 2023, Umami Labs took the nuclear option and filed a court Summons and Complaint with the Supreme Court of the State of New York. Umami Labs further filed an Emergency Injunction on March 22nd, 2023.

Some DAO contributors have hired lawyers and the individuals cited in the lawsuit have hired their own legal counsel. Within the community, things have gotten messy. The community is upset and disappointed and it appears to have taken sides with the former employees. The Umami DAO voted in favor of letting the nine former Umami Labs employees continue the project.

While the tokens in the Umami DAO treasury have not been touched, an Umami developer has accused O’Donnell of selling his personal token stake which sent the price of the token downwards. The pseudonymous nature of blockchain wallets means it cannot be confirmed if the wallet belongs to O’Donnell.

O’Donnell said the Umami governance breakdown and other DAO-based protocol collapses like the DeFi Llama situation boil down to similar circumstances. “A group of employees who disagreed with the project’s direction decide to leave and effectively start their own project, making a replica and taking brand name, assets, and intellectual property.”

O’Donnell maintains a view that there needs to be a structure for robust legal protections for protocols, token-holders, and founders. “If anyone can copy a protocol’s intellectual property, even its brand name, at any time, innovators are never going to feel safe investing in DeFi in the long term,” he says.

The DeFiLlama incident

A management/developer dispute at DeFi analytics platform DeFiLlama began after the launch of a DAO token and another ended with a hostile DeFi protocol takeover.

On Twitter last week, a key DeFiLlama developer ‘0xngmi’ claimed that the person who controls both the DeFiLlama Twitter and domain had decided to launch a token despite not everybody in the team wanting the shift. The developer pointed to a new URL and Twitter handle (llama.fi and @llamadotfi) and suggested this would be the alternative tokenless version of DeFiLlama.

The split in DeFiLlama began because of a disagreement between the cofounders of the project 0xngmi and 0xLlam4 over whether to launch a token to streamline its revenue despite opposition. 0xLlam4 led the ‘launch token’ camp, while 0xngmi was in favour of continuing without one.

Tendeeno, a contributor to the DeFiLlama ecosystem, said although 0xLlam4 was the original founder of DeFi Llama, 0xngmi led the team and was a larger contributor to the project’s success. He continued on Twitter describing a hostile takeover by llam4 because of frustration over the project’s inability to generate revenue.

In the same thread, Tendeeno explained that the DeFiLlama team, apart from 0xLlama4, has always been against launching a token. The developer continued that a token would not have value as DeFiLlama is not a protocol, and tokens cannot legally be a form of equity. Tendeeno continued “also tokens distract people via "y number go down" messages”.

A day after the Twitter drama unfolded, the official DL Twitter apologized for the incident and said the token launch was canceled.

The platform and its operators have said that it would ensure all ‘Llama Corp divisions’ would keep working together to create transparent solutions. 0xngmi confirmed that the internal resolution arrived, explaining “Everything has been solved, fork has been canceled, all work will continue on defillama.com.”

The Sushi incident

SushiDAO and its Head Chef (internal term for CEO) Jared Gray, announced last week that they had received a subpoena from the SEC. The SushiDAO is the entity that manages and operates the popular decentralized exchange Sushiswap.

There is currently a proposal in the Sushi Community DAO to establish a DAO legal defense fund. The fund seeks to establish a fund to cover potential legal costs. The proposal in the community forum, written by Jared Gray, said Sushi and himself are cooperating with the SEC. The SEC has issued a number of crypto-related subpoenas and filings recently charging the likes of Justin Sun from Tron, Do Kwon from Terra, stablecoin issuer Paxos, and more.

This proposal follows a Sushi legal structure proposal posted in the Sushi community forum about three weeks ago. The proposal was approved by the majority. The proposal sought to set up an entity in a more open jurisdiction, with Swiss Association law being the most likely avenue.

The updated legal defense fund aims to provide coverage for reasonable attorney’s fees and costs for core contributors and multi-sig partners of Sushi.

The proposal suggests that US$3 million should be made available in the form of Tether (USDT) for the legal fund. It also adds that an extra US$1 million contingency should also be created in case the initial US$3 million is depleted.

What remains unclear is the exact nature of the subpoena. Members of the Sushi community have suggested that it was served directly at Grey, in order to shut down the DAO, which in itself is not a legal entity.

In September 2022, the CFTC charged the successor of the bZx decentralized exchange, the OokiDAO. The CFTC alleged that the founders of bZx Tom Bean and Kyle Kistner created the OokiDAO to decentralize their operation but nevertheless broke the same laws. This raised major questions about the legality of DAOs and how they may be enforced. In December, a California court ruled that the CFTC needed to serve specific individuals within the DAO and not the DAO itself. Other members have said that it would be easiest for executives of Sushi to not live in the United States.

Alex O’Donnell is pessimistic about the legal future of DAOs. He told BNC “DeFi protocols’ emphasis on ‘DAO governance’ comes at the expense of investing in robust legal structures to provide token-holders with real and enforceable protections and rights.”

Conclusion

The Umami DAO incident highlights the recurring challenges that Decentralized Autonomous Organizations (DAOs) face, including internal disputes and regulatory hurdles. As a self-governing entity, Umami’s legal and governance structure was designed to remain at the hands of its multisig and DAO community, but disagreements over the project’s direction and control of the treasury led to a messy internal legal battle.

This highlights the importance of establishing clear foundations, ownership structure, governance, and incentives within a DAO to avoid future conflicts. While DAOs offer incredible potential for inclusive and equitable decision-making, it’s essential to address these challenges to ensure their longevity and success.

The other challenges for DAOs include regulatory challenges and enforcement action from agencies like the SEC. What are the options for DAOs going forward? There appears to be a fork in the road — either continue to be structureless, rule-less entities that are open, and accessible but prone to chaos, or adopt elements of more traditional, non-blockchain-based organizations to create structure and systems that can come in handy in the case of governance breakdowns or regulatory enforcement.

According to O’Donnell the second option is the solution to mitigate DAO breakdowns going forward. “The solution isn’t pitting ‘DeFi’ and ‘TradFi’ against one another as adversaries. It’s integrating the best elements of traditional legal and regulatory structures with the transformative potential of trustless smart contracts.”