The DAO's Existential Crisis: Bitcoin Still Not Affected

Disclaimer: This is a legal analysis (But Not Legal Advice) regarding the DAO exploit. Nothing herein is intended to be understood as legal advice. Consult a lawyer qualified to provide legal advice in your jurisdiction.

Are smart contract implementations requiring zero human intervention reliable? A thousand years of legal history and the DAO suggest something more than zero is required.

Also read: New FCC Rules Could Block Your E-Wallet

Contract Reformation

The DAO (Distributed Autonomous Organization) resembles a smart contract. It deploys source code on a blockchain distributing virtual currency to parties according to rules set by the code. The DAO’s purpose is to act as an investment vehicle, investing in and voting on ventures according to the collective will of its investors. One DAO member discovered that the code allowed him to create a sub-contract that bypassed the normal rules governing balance of funds. He created a sub-contract allowing him to take for himself ~$50M USD worth of the DAO’s virtual currency. He wrote the DAO a letter justifying his actions on the sole basis that the source code permitted it. Large DAO stakeholders proposed hard-forking the DAO’s code recoup the ~$50M.

The DAO hard-fork dilemma ushers contract reformation into the blockchain era. Is a hard-fork justified? Is the DAO a contract? Was this preventable? Does it hold implications for Bitcoin? Understanding how the legal doctrines of law and equity developed can help with answers.

Law & Equity

It may be said that law is the application of the law according to its letter (code), and equity is application of the law according to its spirit (hard-fork). In a broad sense, equity is the body of principles, which provide and govern exceptions to the law. The function of equity is the correction of the law where the law fails by reason of its universality (e.g. law’s tendency to establish rules without exceptions). Since it is theoretically impossible to create a code with a perfect set of exceptions, equity exists to ensure fair results.

In medieval England, law courts lacking equity jurisdiction were used to resolve disputes. When the law courts reached decisions contrary to the law’s intent, English subjects of wealth and influence could seek relief by petitioning the King, who as sovereign possessed the highest power under England’s law. The King granted relief from the law courts frequently enough to justify establishing a Court of Chancery to render decisions on his behalf. The Court of Chancery developed rules and remedies from its cases that became the common law of equity.

America adopted England’s common law legal system, but many legal scholars at the time were skeptical of equity courts. Having just fought a revolution to escape the control of a distant sovereign, skepticism of an institution representing the King’s sovereignty above the law was natural. Courts of law and equity were thus merged. Today, both in state-run courts and private arbitration a single judge administers remedies in equity and law.

The hard-fork now proposed by the DAO’s most wealthy and influential members is similar to the position of wealthy medieval English subjects prior to the creation of the Court of Chancery. The hard-fork proposal, like special appeals to a King by his friends, risks being applied to benefit special interests. Such a system is inferior to one designed to be applied according to principle. But establishing a system of equity poses identity issues for the DAO.

Libertarians & Technologists

The founders of the DAO, not unlike early American legal scholars, perhaps saw equity as representing the arbitrary interference of a sovereign. This view is misguided. Where Bitcoin is libertarian in its ideals, the DAO/Ethereum is technologist. Bitcoin provides an alternative to government-issued currency, the DAO/Ethereum provides an alternative for enforcing agreements. During the past 100 years, the state has treated currency and dispute resolution differently, aggressively asserting a monopoly over issuing currency while consistently upholding agreements to arbitrate disputes privately. The DAO/Ethereum thus appear technologist compared to Bitcoin, which has more libertarian leanings.

Equity would destroy the DAO’s technological purity. The nature of equity means there is no precise way to control an arbitrator’s discretion when applying equitable remedies. Rogue human elements can presently only be mitigated through traditional systems of checks and balances (e.g. requiring consensus from a panel, electing and impeaching arbitrators, etc.) Perhaps we have to accept that justice is an art, not a science.

The DAO’s crisis poses questions for technologists, but not libertarians. Bitcoin still not affected.

Applying Equity to the DAO

On the surface, the DAO presents an appropriate situation for an equitable remedy. But analyzing the intentions of the DAO’s creators reveals equity may not be appropriate.

Equity requires that parties negotiate agreements in good faith, and it imposes fiduciary duties on partners requiring them to act honestly toward each other. The DAO’s “Attacker” appears not to have acted in good faith. The purpose of the DAO was to be an investment vehicle with investors sharing profits from their investments. The Attacker added zero value while taking roughly a third of the DAO’s total investment for himself.

If the DAO is akin to a partnership, the Attacker acting in his own self-interest at the expense of his DAO partners breaches the fiduciary duty he owed to the DAO. The Attacker even penned a letter to the public, brazenly admitting his bad faith intent to profit at the DAO’s expense. Contract reformation has been justified on less.

The Attacker maintains in his letter his actions were justified. His argument, essentially, is that the “The DAO Creation”, as its terms call it, was not a partnership or a contract: it was source code and nothing more. The Attacker reasons his actions are thus justified because the source code accepted his input. If we take his reasoning one step further, the DAO’s creators are the ones acting in financial self-interest, breaking their own rules to propose a hard fork after they lost money. Since equity requires “clean hands” (meaning the party seeking equity must have done no wrong) even if the Attacker’s act was in bad faith and intended to harm the DAO, a prudent judge exercising discretion may decide the DAO’s creators are not entitled to it.

Trying to pick sides begs a series of increasingly complex questions.

Is the “DAO Creation” a contract or something new? Can one draft a contract term agreeing to exclude equitable remedies? If the DAO is something new, is it possible for a blockchain to exist outside the natural law?

Regardless of the DAO’s fate, these questions will persist for Ethereum and require further introspection. Though the DAO may be having an existential crisis, smart contract implementations seeking a to compete in today’s private arbitration market need not have one if they leave room in their system for equity.

How would you answer these questions? Let us know in the comments below!

Images courtesy of wikipedia.org, dao