1 November 2022

Arthaud Mesnard

INC Governance & the Principal-Agent Problem

For organisations to compete, they need to be fast. The moment you decentralise them, you make them less competitive.

But then —

The Principal-Agent Problem 🕵️

When we grant power to individuals in organisations, we get a principal agent problem. The managers can act against the interests of the “stakeholders”.

So, to move business on-chain, we need to inherit some of the great protections of corporate governance, and then add some new tools from DeFi.

We need to achieve:

1. Constraints to limit abuse
2. Fraud detection to find abuse
3. Punishments to disincentivise abuse

In Companies, we have the Law 👩‍⚖️

Companies solve their Principal-Agent problem via corporate governance and encoding them in legally binding contracts:

1. Constraints include contractual restrictions, information flows, separation of decision making from execution
2. Fraud detection includes whistleblowing policies and public audits to find abuse (typically discoveries in companies, who report 90 days after quarter end, are found too late)
3. Punishments can include the loss of a director’s personal assets, and even imprisonment (loss of freedom)

So how effectively can we do this on-chain?

On-Chain, we have Code 🛠️

INCs can use the tools of DeFi and smart contracts to achieve some of these things:

1. Constraints: DeFi to Constrain Bad Actors
2. Fraud detection: Fraud Proofs to Find Bad Actors
3. Punishments: Slashing to Punish Bad Actors

Let’s address each of these in turn:

1. DeFi to Constrain Bad Actors

In companies, money can be dispatched from accounts by single actors — e.g. a financial controller can instruct payments directly out of the company account.

In DeFi, we can apply programmatic controls to money to reduce an INC’s risks:

• Atomic Swaps: Uniswap for treasury management — money never leaves the account
• Streaming: Sablier swaps enable payroll operators to switch streams on and off, but a quickly-caught fraud has minimal costs
• Multisig Safe: n of m signers required for one-way / bullet payments (i.e. where lump sums of cash need to leave the organisation)

On-chain mechanisms such as vaults, outcome-based rewards (c.f. Carrot ) and back-loaded vesting can be used to incentivise participants to behave in the interest of the INC.

Just like rails make trains 10x faster than buses by constraining movement, so too will DeFi keep the companies on (fast) track.

2. Fraud Proofs to Find Bad Actors

Here’s an illustrative example of how we could have safe fraud proof systems

To submit a formal complaint about a governor’s suspected misbehaviour, the whistleblowing governor will have to stake tokens and provide evidence. The governors will discuss and vote on the issue at hand.

The discussion and result will be made public and be validated or challenged using optimistic governance.

Whoever is proven wrong will see their tokens burnt (partially or totally), whoever is right will mint tokens for free. The cost of an inconclusive compliant should be lower than that of misbehaving.

3. Slashing to Punish Bad Actors

Tokens are the carrot, slashing is the stick.

Slashing is the simplest form of on-chain penalty to reprimand malfeasance.

Much like PoS functions with a weaker trust assumption than PoW because the PoS “mining equipment” can be slashed, so too will INCs require less consensus-seeking governance than DAOs as the members’ stake can be slashed. This enables INCs to move fast and incentivises members to behave in the INCs best interests.

The limits of on-chain penalties make it harder for INCs to coerce behaviour compared to their incorporated counterparts. The absence of legal system on which to rely is detrimental to INCs but certain solutions exist (Kleros, arbitration). INCs may need to form legal entities to limit the liability of token holders but, in the long term, their limited liability will be recognised and they will graduate towards smart contracts.

Code is Law

A final observation — creating on-chain organisations potentially has significant consequences for its participants.

In the light of Ooki/CFDT case, INCs may need to incorporate as LLCs to limit the liability of their token holders, especially where those token holders cast votes and are engaged in the governance of the organisation. The abiding risk appears to be that these organisations could be held to be general partnerships. LexDAO has gone to great lengths to simplify the creation of series LLCs that can be governed by smart contracts in Delaware and Wyoming.

However, we think the long term direction is clear. The INC represents a completely new universal business cartridge which will gradually reduce its reliance on any one ‘home’ jurisdiction. As system governors find they are increasingly accumulating on-chain capital, they may even be asked to stake some or all of that capital as a deposit against their future behaviour.

The powers of smart contracts to enforce against bad governance practices, recklessness or other malicious or bad behaviour will increasingly be shown to be the most efficient way to run competitive business.