SwiftDao Standards Remove The Need For Active Participants And Thus Securities Regulation

Summary

SwiftDao is a set of standards for operating for-profit Daos (register at swiftdao.com). These standards are designed to prevent fraud, encouraging the development of honest decentralized organizations. While not a feature per-se, the SwiftDao methodology of developing Dao standards contrasts with most other Dao platforms which focus on experimentation and novelty. This approach allows the standardization of financial statements for easy comparison between various SwiftDao organizations. Standardization also opens up Daos to auditing by third party organizations which can issue certifications to organizations that meet financial, social, or other governance standards. These decentralized fraud-resistant standards remove the need for a trusted “Active Participant” (“AP”), one of the requirements to avoid securities regulation by the SEC. Reduced fraud and lower overhead will cause SwiftDaos to outcompete traditional centralized firms.

Decentralized Organizations Should Adopt Traditional Best Practices.

“I have studied the enemy all my life [...] so when the time comes, I’m going to whip the hell out of him” – George S. Patton, US WWII General.

Truly decentralized governance always stands opposed to the centralized means of control that reinforce traditions of oppression and limit human freedom. But most decentralized platforms have gone too far the other way. Instead of studying the history of capital, they instead have focused on experimentation and creativity, assuming any structures created by centralized organizations are inherently tainted. AragonOS with its focus on governance hacking, DaoStack’s completely novel Holographic consensus, and many others are all examples of the laudable research projects devoted to discovering new forms of governance.

Experimentation has greatly advanced research into decentralized organizations, including SwiftDao, but it has failed to produce the decentralized unicorn the future needs. Most informed individuals will place the blame on one of two sources; securities regulation or fraud. What has been overlooked is that securities regulation itself was developed in response to fraud, including the SEC’s 1934 Act to protect investors from the rampant fraud that was partially responsible for the Great Depression and the Sarbanes-Oxley Act of 2002 increasing financial transparency in response to Enron. It is true that both the Great Depression and the financial scandals of the early 2000’s were caused by the failures of centralized governance. But before Daos can build the future, they need to be designed with the history lessons of capital fraud and capital market failure in mind.

Structuring To Avoid Fraud Wins; Structuring To Avoid Securities Regulation Fails.

Designing against fraud has a secondary positive effect; when done properly, it makes securities regulation unnecessary and inapplicable. Many decentralized governance projects have attempted to avoid securities regulation while not addressing the underlying economics. These projects are all doomed. Even if they did succeed, the public backlash would result in stronger regulatory forms. But none will reach that state because securities regulation in the US is based on “economic reality” irrespective of how an investment contract is structured. From Cornell’s Legal Information Institute:

“The term 'investment contract' is undefined by the Securities Act or by relevant legislative reports. But the term was common in many state 'blue sky' laws in existence prior to the adoption of the federal statute and, although the term was also undefined by the state laws, it had been broadly construed by state courts so as to afford the investing public a full measure of protection. Form was disregarded for substance and emphasis was placed upon economic reality. An investment contract thus came to mean a contract or scheme for 'the placing of capital or laying out of money in a way intended to secure income or profit from its employment.' State v. Gopher Tire & Rubber Co., 146 Minn. 52, 56, 177 N.W. 937, 938. This definition was uniformly applied by state courts to a variety of situations where individuals were led to invest money in a common enterprise with the expectation that they would earn a profit solely through the efforts of the promoter or of some one [sic] other than themselves.”

Structuring to avoid securities regulation will always fail because courts have consistently ruled that substance matters, not form. So not only should projects be structured to avoid fraud; if they don’t, they will find themselves quickly running afoul of the law.

Active Participants Are A Source Of Centralization And Fraud.

One such source structuring to avoid securities regulation without addressing underlying fraud is an Active Participant (AP). Remembering the Howey test, the third portion of the test makes it clear that every member must be actively involved in governance. Many early Daos tried to dodge the requirement with an “Everyone is equal, but some are more equal than others” policy. The first Dao, called “The DAO” was one such organization. In one of the rare successes of centralized governance, the SEC’s report identified the flaws in such a plan, and how it resulted in defrauded investors, with extreme clarity. Slock.it created The DAO, aggressively promoted it, and clearly indicated it planned to continue developing and promoting the platform throughout its lifecycle as an AP. Members had no responsibilities, could freely trade the tokens, and did not have to even sign a contract to purchase tokens. Even worse, members did not have control over proposals The DAO could vote on. Proposals were selected by “Curators” appointed by Slock.it. The DAO was a DINO (Decentralized In Name Only).

The results were horrific. Because investors trusted Slock.it to conduct due diligence, the smart contracts for The Dao were not properly audited. The Dao was hacked, the assets stolen, and a controversial fork of Ethereum still divides the community to this day. In the next blow, the SEC found that Slock.It’s AP activities meant that:

“These facts [AP activities by Slock.it] diminished the ability of DAO Token holders to exercise meaningful control over the enterprise through the voting process, rendering the voting rights of DAO Token holders akin to those of a corporate shareholder.”

And furthermore:

“Whether or not a particular transaction involves the offer and sale of a security—regardless of the terminology used—will depend on the facts and circumstances, including the economic realities of the transaction.”

So not only do AP’s damage the decentralization of a Dao; any Dao with an AP, no matter what claims it makes about how it structures its transactions, is an issuer of securities and must comply with security regulation.

SwiftDao Standardization Removes The Need For An Active Participant.

The needs that pushed The DAO, and many other Daos, to utilize an AP are as follows:

  1. Development of unique smart contracts,
  2. Promotion of unfamiliar organizational structures,
  3. Lack of financial transparency, and
  4. Centralization of proposal selection.

SwiftDao addresses the first three through standardization, and the last through social media integration. Standardization means audited, common smart contracts that don’t rely on a third party for auditing or development. While a new set of SwiftDao standards may be developed, older SwiftDaos stay on the old standard and do not rely on such upgrades. SwiftDaos follow a consistent organizational structure, so a third party promoting a Dao’s specific structure is unnecessary. Finally, standardized ways of creating and displaying financial information create financial transparency and allow anyone to generate, verify, and compare financial statements.

The SwiftDao post on Networked Investing discusses how investor networks bring value to SwiftDaos and how social media integration encourages communication between members.

Fraud Resistant Daos Will Outcompete Centralized Institutions.

Given the complexities of structuring Daos, some might wonder if the effort is worthwhile. Many organizations have decided to just accept centralized securities regulation. Such efforts ignore the huge advantages fraud resistant Daos offer. Better Daos will outcompete traditional organizations, not only because of reduced organizational overhead but also better incentives.

Traditional securities regulation sits on top of poorly aligned economic incentives. Managers in traditional organizations are still incentivized to run the firm for their own benefit at the expense of shareholders. All that securities regulation does is limit the ability of managers to do so by publicly exposing their activities through reporting requirements and penalizing the most atrocious activities, such as insider trading, with jail time. Anyone who has worked inside a large organization has seen how managers still benefit themselves at the expense of the firm. Moral hazard creates huge inefficiencies in corporate governance, as the book Corporate Governance In Japan discusses in great detail. Securities regulation papers over the problem without changing the underlying cause.

Properly design Daos can fix the underlying cause of fraud, eliminating inefficiencies created by moral hazard and removing unnecessary compliance costs. Current centralized organizations are greatly limited in their capabilities because of organizational costs. As Coase noted in his seminal 1934 paper on The Nature Of The Firm:

“[A] firm will tend to expand until the costs of organizing an extra transaction within the firm become equal to the costs of carrying out the same transaction by means of an exchange on the open market or the costs of organizing in another firm. “

Reduce the costs of organization, and the size of the firm will increase. Fraud resistant Daos will grow several orders of magnitudes larger than centralized organizations. Traditional, centralized organizations simply will not be able to compete. Whether or not you support decentralization is irrelevant. Competitive capitalism rewards the best model, all others fall by the wayside as historical relics.

Decentralization Is A Moral Imperative

To read decentralization as merely important for its economic impact would be a massive mistake. Centralized organizations aren’t just economically inefficient; they are morally bankrupt. These organizations, both public and private, have shown themselves incapable of managing the wide range of issues facing humanity today. Rigid, hierarchical structures have built in moral hazard that rewards damaging others to benefit oneself. We must design, build, and operate decentralized organizations that are able to tackle any and all issues flexibly at a scale never seen before. But these organizations must be designed to succeed. Building fraud resistant governance structures will enrich the participants while benefiting the entire globe.