The Arbitrum Saga, How much can DAOs really do?

Recently, the Arbitrum Foundation proposed (AIP-1) to allocate 750M ARB tokens to themselves to cover administrative and operational costs, but ARB holders voted against it. Notwithstanding, the Foundation allocated the tokens to themselves, saying that the vote was just a formality. At that time, they had already spent 50.5M ARB tokens (6.7% of the allocation). Now everyone is scratching their heads, wondering what power the Arbitrum DAO and DAOs generally have, especially when they disagree with their founding structures.

This absolute dismissal of decentralized governance led to several DAO participants taking to Twitter and venting their understandable disappointment in the Arbitrum management. That prompted the Foundation to publish a clarification saying that this melee was caused by some confusion around the notion of the AIP-1 proposal being a ratification and not a request. “For those that didn’t realize that this was a ratification,” they said, “they may have been surprised to see that the Foundation’s tokens have already been separated and begun to be utilized.” Before we look at the details of AIP-1, let us walk through DAOs generally and the Arbitrum DAO specifically. 

Now What Are DAOs, and How Far Have They Come

Well, to state its meaning, the term DAO stands for “decentralized autonomous organization” and can be described as an open-source blockchain protocol with members whose assets are governed by a set of rules created by its elected members or by proposals that have been voted in a decentralized fashion into “law,” and these rules can automatically execute certain actions without the need for any intermediaries. 

For transparency and effective democracy, both the program rules and subsequent actions are recorded on a secure blockchain ledger, which cannot be tampered with due to the inherent characteristics of timestamp immutability and the decentralized distribution of the information to network participants. Two important attributes of DAOs are usually;

  • An organization with a group of participants with a common goal 
  • An organization that is governed by code that is decentralized, open, and transparent.

Usually, the steps to building a successful DAO go with this framework;

  • Build a strong foundation – Define goals and find interested participants.
  • Determine ownership – Most DAOs establish ownership by issuing tokens, sometimes through Initial Coin Offerings and other times through Airdrops.
  • Establish a governance structure – Institute guidance on how they will make decisions in the future.
  • Set up rewards and incentives – Enact a reward system for both existing members and new members with the desire to cultivate a resilient and efficient network.

If the system is well designed, It can organically evolve toward achieving the common goal. The first attempt at a DAO was called the DAO and was a slightly confusing idea at the time. To define it, it was a decentralized venture capital fund. A group of investors with the goal of maximizing returns on their funds had come together and established a decentralized governance by code to choose their investment strategies. The smart contracts (which are built on top of the Ethereum blockchain) will take votes from shareholders (that is, people who hold DAO tokens) on which startups to invest in and how much to invest. The more tokens a shareholder locks up, the more weight he has in the vote. Once the votes have been recorded, the smart contracts will automatically allocate the funds based on the vote results. Here, participants can be sure that the vote results are fair because every line of code is transparent and immutable on the blockchain. Different modes of voting, which are usually pre-determined, have been used to facilitate this democracy. They include; token-based quorum voting, quadratic voting, conviction voting, holographic consensus, and multi-sig voting. Most DAOs run on a token-based quorum voting system.

“The DAO” set a precedent for every other DAO to come, and since then, DAOs have gone on to undertake every human venture you could think of – bidding for the US Constitution, engaging in philanthropy, issuing grants, running protocols, etc. Arbitrum DAO falls under DAOs that run protocols, but as with every human endeavor, there are downsides.

Arbitrum DAO

On March 16, 2023, the Arbitrum networks (Arbitrum One and Arbitrum Nova) were decentralized and given to the newly formed Arbitrum DAO. Included in this transition were:

  • Control of the upgradeability and technical future of the chains
  • Control over the DAO treasury
  • Control over net fee revenue, that is, the net difference between fees collected by on-chain operations and L1 fees paid by the Sequencer
  • All Arbitrum social media platforms and accounts
  • The task of fostering and developing the Arbitrum ecosystem, where the DAO may seek to partner with companies or organizations that either cannot or will not publicly negotiate collaborations or partnerships due to confidentiality and other operational requirements
  • Ability to elect and, if deemed appropriate, remove the Security Council and Directors

The full responsibility for the chain’s technology, future, and fee revenue was given to the DAO directly. With the DAO assuming those rights and controls, the DAO also assumed the responsibility to fund the ongoing operations of the chains and the costs of running critical chain infrastructure, including RPCs, the Sequencer, and third-party vendors and service contracts.

AIP-1 and Crisis

After a bumpy start to the airdrop that distributed governance tokens to Arbitrum users, the first use of those governance tokens arguably went even worse. Arbitrum submitted a proposal for DAO members to vote on various governance processes, as well as the distribution of 750 million ARB tokens to an “Administrative Budget Wallet” — tokens that were priced at around $1 billion. This was the AIP-1 proposal that had been drafted by the Arbitrum Foundation and put up to the Arbitrum DAO for equity-based democracy to do its thing. Basic voting started on March 27, 2023, at 11:13 PM, and ended on April 3, 2023, at 11:13 PM, exactly a week later. 

On April 2 with a day left before vote completion, and with the majority going against the proposal at 75% while the other 25% were in support, it was discovered that the Arbitrum Foundation had already begun spending those 750 million tokens, including via the movement of a substantial amount of tokens to a market maker, and the “conversion of some funds into stablecoins for operational purposes”. This caused Arbirtrum Foundation to subsequently publish a post in which they claimed that the proposal was not really a vote but rather a “ratification” of decisions that had already been made by the Arbitrum team, leading many to question what the DAO was even for in the first place. Others questioned the fact that Arbitrum was receiving so much money to use however they liked, not subject to DAO approval.

Things got even messier when the Arbitrum Twitter account “clarified” that “40M $ARB tokens have been allocated as a loan to a sophisticated actor in the financial markets space”, and the rest had been converted to fiat to cover for “operational costs”. The loan of $52 million worth of ARB to an unnamed actor and the conversion of another $13 million to stablecoins led some to accuse the Arbitrum team of “selling off”, cashing in far more than would likely be required for foundation costs in a brief period of time.

Aftermath of AIP-1

With the ongoing saga showing no signs of slowing down, a new proposal tagged AIP 1.05, has recently surfaced to attend to rising tensions. According to recent information from Snapshot, at press time, voting was underway for a proposal introduced on April 8. The proposal sought to address the issue of the 700 million ARB tokens that have been at the center of the ongoing dispute. 

Specifically, the proposal called for returning these tokens from the Arbitrum Foundation to the DAO as a symbolic gesture of the governance token holders’ ultimate power and authority over the resources granted to the DAO. Additionally, the proposal requested a buyback of the ARB tokens from Wintermute, using any remaining fiat funds from the $10 million OTC sale. This proposal which was created by “clurbcapital.eth”, is still live on Snapshot but looks very likely to fail as 84% of votes are currently against it. Nonetheless, controversy still abounds. Blockworks Research has two running proposals – AIP 1.1 and AIP 1.2. AIP 1.1 proposes a 4-year lockup with an annual unlock schedule, a budget of $36 million for the Foundation, and a transparency report regarding the 7.5% of the $ARB tokens distributed to the Foundation’s “Administrative Budget Wallet”. AIP 1.2 on the other hand proposes a redesign of the protocol’s constitution to adjust the cap on votable tokens from 5 to 1 million, to rename “special grants” to “Arbitrum ecosystem growth”, and to allow the DAO to change the Foundation members. Both proposals have been live for 4 days and will end in 3. They currently have 98 and 99% votes respectively in their favor but there are fears that the Foundation would not honor this and that begs another question, “Can the DAO go to court?”

Legal Issues Related to DAOs

The first question would be, “Are DAOs even legal?” and the answer is Yes. However, this ultimately depends on the DAO. The legal status of decentralized autonomous organizations is complex and can vary depending on the jurisdiction. In general, DAOs do not fit neatly into existing legal categories, as they operate outside the traditional legal framework and are governed by code and smart contracts rather than by traditional legal entities. In some jurisdictions, they may be considered legal entities, such as a partnership or a trust, while in others they may be considered a form of contract or agreement. However, in many cases, the legal status of DAOs is still uncertain, as governments and regulators are still grappling with how to classify and regulate this new technology. This in turn presents a number of issues which include;

Jurisdiction: DAOs operate on a decentralized, global network and may not have a clear physical location. This can make it difficult to determine which jurisdiction has authority over a DAO and its activities.

Regulation and Securities Laws: The regulatory landscape is still evolving, and there is currently no clear guidance on how they should be regulated. This can create uncertainty for DAO creators and operators, as well as for regulators trying to oversee their activities.

Liability: DAOs operate on a decentralized network and may not have a clear legal entity or individuals that can be held liable for their actions. This can make it difficult for victims of fraud or other illegal activities to seek redress.

Contract Enforcement: Smart contracts, which are used to govern and operate DAOs, may not be legally binding in all jurisdictions. This could make it difficult for parties to enforce the terms of a contract in the event of a dispute.

This means that while DAOs are not illegal in all jurisdictions, the legal landscape is complex and uncertain. The legal status of DAOs may continue to evolve as governments and regulators gain a better understanding of the technology and its implications.

What Now for DAOs?

It is expected that the resolution of the Arbitrum saga will set the tone for DAOs going forward. In an industry built on anonymity, participants who identify with protocol goals but are denied their voices will grow less interested over time. Therefore, it is in the best interests of every DAO that Arbitrum moves past this without rocking the waters of decentralized governance.

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