A decentralized autonomous organization, or a “DAO,” is a Blockchain based “organization” encoded as a transparent computer program, controlled by the organization members rather than by any outside entity or authority.
Distributed-ledger technology is probably the most discussed innovation in the digital transformation of the economy and society. With features such as decentralization, reliability, and anti-counterfeiting, it opens up a broad field of innovative applications and completely new forms of cooperation.
Although developments often focus on payment systems and other financial instruments, large blockchain-based ecosystems and projects point to a development in which online groups coordinate at eye level and possibly pseudonymously, relying exclusively or entirely on software. These digitally resident/created decentralized organizations – that operate autonomously without traditional leadership and hierarchy – have come to be known as Decentralized Autonomous Organizations (DAOs).
Prelim
A DAO is a Blockchain structure (like a secure database), that any member can leverage to self-govern through participation; A DAO sets rules – baked into code – and permits voting through digital tokens (a form of cryptocurrency) — all while leveraging smart contracts. Only that DAO’s Token holders have the power to vote.
In essence, a DAO allows groups of participants to create organizational forms beyond the hierarchical, top-down corporate firm (which must be responsive to the needs of a board and shareholders). DAOs essentially eliminate or minimize the roles of executives and managers in the organization, relying instead on transparent rules that apply to all members and participants
How does a DAO work?
The primary aim behind the creation of a DAO is to create a virtual entity to replace the central management of previous forms of organization. A decentralized autonomous organization (DAO), is an organization, particularized by rules encoded as a computer program, that is transparent, and controlled by the organization members. In terms of decision making a DAO is, in effect, unable to be influenced by any outside party including any central government.
DAOs are particularly prevalent in the Ethereum blockchain ecosystem, combining ideas about organizational forms, coordination, network effects, blockchain, and smart contract technology. A DAO allows a group to organize around a mission or goal and to coordinate the mission via smart contracts, enforced immutably and autonomously on the blockchain. DAOs represent an evolution in how people coordinate with one another, as the organization itself is autonomous from any third party intermediary’s influence and goals.
The main reason a DAO is formed is to decentralize and automate the governance of an organization. The rules by which a DAO operates are encoded as a computer program that is accessible via the blockchain, and controlled by all of the organizing members, rather than by a central governing board. Since the blockchain is essentially a public record, the DAO seeks to provide total transparency, requiring that all of its financial transaction records be recorded by a public facing blockchain. There is no top-down hierarchal structure to a DAO; A DAO depends almost entirely on the operation of autonomous smart contracts to enliven the rules and carry out the decisions made by/within the organization.
Tokens
Typically, tokens (a random cryptocurrency) are used to govern a DAO, and provide voting and decision-making power to participants, with greater power being given to those with more tokens.
A DAO is in effect a cooperative association which has a stated purpose and a plan to execute decisions via code. (For example the intended purpose of a DAO could be to win a Sotheby’s auction and retain an original copy of the US Constitution). Also stipulated in the DAO is its governance — for example (if it wins the auction) where does the community want the document to be stored or displayed?
In effect a DAO is a new form of scalable, open, self-organized network that is coordinated by crypto-economic incentives as well as by self-executing code on the blockchain that enables the participants to achieve common goals.3
Forming a DAO as your core business structure provides for a number of advantages including:
- making it easier to attract investors
- limits short-termed speculation
- allows for a democratic approach to asset management;
Business Structure
The precise legal status of this type of business organization (ia a/the DAO) is unclear.
Traditional business structures (eg Companies Limited by shares) are focussed on limiting liability in the event of commercial failure or law suits, perpetual succession and/or on providing tax benefits. The uncertainty surrounding the legal status of a typical DAO creates potential legal exposure, leaving open questions, such as, whether or not DAO owners are unlimitedly, directly and personally liable for all financial obligations, debts, and taxes incurred by the DAO, and/or in respect of legal action taken against the DAO.
Furthermore, it is not clear as to whether or not a DAO would even be legally recognized by a court of law. As such, if a court determines that a DAO is not a legally recognized business structure, then that DAO would simply be considered a general partnership, and all members of the DAO would share unlimited, direct personal liability to all debt and legal actions taken against the partnership.
Legal Status?
DAOs represent a unique opportunity and challenge today as they are rapidly evolving into a new class of organization. DAOs are reminiscent of cooperatives (co-ops) in many ways, albeit with an expanded set of abilities enabled by the decentralized and transparent nature of the blockchain combined with automatically executing smart contract logic. The transparency of DAOs is one of their main benefits, since all of the actions and funding in DAOs are viewable by anyone. This significantly reduces the risk of corruption and censorship. The transactions undergone by a DAO are individually visible at any time, whilst also protecting the anonymity of their members through cryptography.
DAOs also have low barriers of entry and exist in contrast to traditional hierarchical firms. While this can be a definite plus for fluidity and flexibility of DAO organization, it can also represent a unique challenge as successful DAOs need to have attractive incentivization structures and keep rent-seeking activities low to retain membership.
Flexibility
DAOs have a key differential in their structure from the hierarchical firm in that they are decentralized, consisting of many autonomous individuals and small teams that take responsibility for their own goals and determine their own forms of governance. Static job descriptions are replaced by a fluidity of roles, where members are allowed to opt in or out as they see fit. The fluidity of roles and ease of entering and exiting DAOs can be a large boon as well as a challenge.
Without the same structure as a firm locking people into certain roles, the game theoretic incentives that keep members participating become increasingly important. A DAO that does not end up structuring its smart contracts and coordination mechanisms in a way that incentivizes and benefits the members faces challenges from a DAO that has a more positive benefit structure for all of its members.
A crucial part of the structure within DAOs that helps with this issue are the autonomous groups that often form within it, to pursue objectives tangential and related to the overarching mission of the DAO. In many current DAOs, these small teams are often called “guilds,” reminiscent not only of medieval crafting associations, but from the squad-like entities born of modern massively multiplayer online games (MMOGs).
The gamification of interaction in DAOs is an important part of how DAOs function, as game theoretic incentives allow DAOs to build inner structures that reward members and encourage positive participation. These incentives also foster a sense of individual and cooperative ownership in the efforts that fulfill the objectives of the DAO. These incentives are not only in the positive feeling members get for participating and furthering the goals of an organization they participate and believe in, but there can also be direct financial incentives through ERC-20 tokens, or non-fungible tokens (NFTs). The renumeration isn’t always financial though, as the NFTs that a DAO generates for its activities or to reward members are often a key piece in establishing a communal identity within the overarching DAO itself.
The ability of members to decentralize and formulate rapidly executing autonomous groups within DAOs, while also adhering to the central mission of the DAO, allow powerful network effects to begin to accumulate, as a DAO itself becomes an organization of organizations. This is where DAOs begin to separate from traditional co-ops in definition (although not entirely), and the organization itself begins to become an aggregate entity that members not only participate ii, but actively vote on and govern to create maximally beneficial rules for the participants.
Smart Contracts
Crucial to how DAOs function are smart contracts, which, (for the purposes of this article), we will be focusing on within the context of the Ethereum Ecosystem.
A smart contract is a directly executing computer program on a blockchain that can represent many different things, from agreements between two persons, to guaranteed execution of funding proposals, to even complex governing structures that cannot be censored. In the context of DAOs, smart contracts enable the rules of how a DAO functions to be executed without interference, and without the necessity of including a trusted third party to make sure that agreements are carried out.
DAOs take advantage of this in many ways, including how members are automatically paid for their efforts, how proposals are voted on and enacted, and even how the agreements of the DAO are audited. All smart contracts will execute and are all available openly to be viewed on the blockchain. This powerful transparency takes us to a point where you simply cannot structure a DAO that has perverse incentives going against the best interests of the members, as they can simply view it in real time, and due to low switching costs, leave the DAO for more appealing opportunities.
It should also be noted that while many DAO’s are for-profit organizations, they also can be set up as non-profit organizations to aggregate capital and fund specific projects (environmental, charitable, housing, social, etc.) based on the votes of the members.
Bankless DAO
A prime example of a rapidly evolving DAO is Bankless DAO, formed as a decentralized community to “help the world go bankless.” This DAO aims to accomplish its mission by forming a decentralized community to coordinate together and “propagate bankless media, culture and education. Its goal is to drive adoption and awareness of truly bankless money systems like Ethereum, DeFi, and Bitcoin”.
The Bankless DAO works towards its key aim/s through the collective participation of its community; A native governance token allows members voting rights in proposals for the DAO and funds a community treasury for the pursuance of the goals of the Bankless DAO. Members are free to organize into guilds and pursue whatever sub-goals they see fit in accomplishing the main mission of the DAO. These autonomous groups within the overarching group are a key aspect of the organizational strength and evolving coordination abilities of how DAOs seek the accomplishment of their objectives.
Autonomy
DAOs are autonomous in the sense that they are unable to be corrupted by an outside groups objective, as the coordination and incentivization layer is the Blockchain that the DAO uses for coordinating its objectives. This is a critically important piece in the evolution of coordination, as third-party influences do not end up co-opting the goals of the DAO, and it remains “autonomous” in the sense that the DAO fulfills the accomplishment of whatever goals the members select without third party input or influence.
While DAOs at a high level represent an evolution in how human beings organize and coordinate, at a lower level they are simply an extension of many related web3 and blockchain technologies. Digital assets allow ownership of fungible and non-fungible goods to be tokenized. Besides the many cryptocurrencies we have seen rise over the past decade, lately there has been an explosion in NFTs ie Non-Fungible Tokens, (where each token is not a 1 to 1 exchange for another).
Importantly, participation in a DAO can be tokenized, and members granted voting rights and incentives based on what tokens they hold. As tokens are all smart contracts, the way DAOs are governed can be programmed and voted on by their participants. Smart contracts run immutably on the blockchain and are censorship resistant. This means that 3rd parties can’t arbitrarily change the rules to their benefit, and members can know that voting proposals within a DAO will execute autonomously of human intervention.
The Coordination Evolution
As an extension of the many different technologies humanity has been building for many decades, DAOs represent an evolution in coordination, and not a revolution. They represent simply an interesting and powerful new way for human beings to coordinate, and with that, a way to help solve many formerly intractable problems.
Many of the large-scale problems affecting humanity today are rooted in an inability for people interested in solving these problems to develop a proper way to coordinate effectively:-By the time interested people and parties are at a scale to effect change, many third parties have established themselves along the coordination layer and inserted their own needs (openly or not) that may come at the expense of the overall mission. DAOs offer an opportunity to change that dynamic and offer a chance at re-imagining how we group together with one another to solve problems.
This isn’t to say there aren’t problems facing DAOs, as in any emergent technology. Issues with long term member retention, gamified participation (that can itself be gamed by bots), benefits for members, governance structures, legal compliance, recruiting, talent retainment, income volatility, and voting are all open issues many DAOs and their members are actively experiencing and attempting to solve.
DAOs are rapidly expanding in the Ethereum blockchain ecosystem, and are being experimented with, used, built, and iterated on in real time. Regardless of the current problems, DAOs have the potential to empower groups to solve problems, coordinate, and execute ideas in a way that may be increasingly necessary to solve entrenched 21st century problems. Moreover, the creation of DAOs as a coordination structure represent an important evolution in how people can democratically coordinate on their own terms to achieve objectives they choose. This of itself represents an important piece of humanity’s own evolution and may indeed play a part in resolving many of the current challenges we face today.
Organizational Structure
DAOs have no leaders, board members or operations beyond what is mutually agreed upon by members in the smart contracts which govern the operation of a DAO. These software enforced rules can cover any aspect of operations, but usually relate to a treasury of digital assets held by the DAO and deployed in grants. No one person can control, profit or endanger the organisation as the model seeks to create a genuine distribution of power among members.
With lessons learned from the COVID-19 pandemic, businesses have been forced to adapt, realising the potential for at home work, and greater digital based collaboration. Global manufacturing, loans and peer-to-peer goods/services could make find improvements to their business models using DAO elements.
The Way Forward?
Being an emergent technology, DAOs are rapidly expanding in the Ethereum blockchain ecosystem, and are being experimented with, used, built, and iterated on in real time. There are many unsolved problems with DAOs, particularly around issues involving legal compliance, benefits, recruiting, talent retainment, income volatility, and governance. Regardless of the current problems, DAOs have the potential to empower groups to solve problems, coordinate, and execute ideas in a way that may be increasingly necessary to solve entrenched 21st century problems.
DAOs represent a unique opportunity and challenge today as they are rapidly evolving into a new class of organization. DAOs are reminiscent of cooperatives (co-ops) in many ways, albeit with an expanded set of abilities enabled by the decentralized and transparent nature of the blockchain combined with automatically executing smart contract logic. The transparency of DAOs is one of their main benefits, “since all of the actions and funding in DAOs are viewable by anyone. This significantly reduces the risk of corruption and censorship.The transactions undergone by a DAO are individually visible at any time, while also protecting the anonymity of their members through cryptography.
DAOs also have low barriers of entry and exist in contrast to traditional hierarchical firms. While this can be a definite plus for fluidity and flexibility of DAO organization, it can also represent a unique challenge as successful DAOs need to have attractive incentivization structures and keep rent-seeking activities low to retain membership.
More Examples
What are some current examples of DAOs? DAOs currently active include MakerDAO, MolochDAO, BanklessDAO, Raid Guild, and MetaFactory. These DAOs all have different purposes, from governing the issuance of funds against crypto collateral, funding grant proposals for different projects (MolochDAO), being a collective of guilds that members vote on to decide different objectives (BanklessDAO), undergoing collective development projects (RaidGuild), and organizing around fashion and culture that creator members produce (MetaFactory). This is only a small snapshot of DAOs, and many more are being created by the day. Another important point is that while many DAO’s are for-profit organizations, they also can be set up as non-profit organizations to aggregate capital and fund specific projects (environmental, charitable, housing, social, etc.) based on the votes of the members.
An example of a very successful DAO is action is MakerDAO. MakerDAO is the governance structure of the Maker protocol. The Maker protocol “allows anyone, anywhere to generate the Dai stable going against crypto collateral assets.” The Maker DAO employs a two-token system, one being the Dai stablecoin, and MKR, the governance token used by stakeholders to vote on proposals and manage the Dai stablecoin and how it is implemented. MKR token holders are the decision makers of the Maker protocol. Token holders vote to decide on different policies governing the DAI stablecoin, including the “stability, transparency, and efficiency” of the stablecoin. The DAO governs the protocol, and the incentives of the token holders ensure that policies benefit all who use MakerDAO, as there is an incentive to coordinate the best policies for all token holders.
The Constitution DAO
As alluded to above, a collective formed a little while back to bid at auction for one of the last remaining original copies of the American Constitution. Had the ConstitutionDAO won the auction, questions of governance would have been proposed, and the individuals who own the requisite digital tokens in their wallets, could have then voted. Indeed, individuals now can create wallets to store tokens or cryptocurrency that not only allows them to own digital assets like cryptocurrency, digital art (NFTs), or land in the Metaverse, but also sign or vote on a topic that a DAO has offered. (They must own those specific DAO tokens in their wallet in order to vote.) These wallets are the future of identity, asset ownership, and your ability to prove something, vote, or sign agreements.
ConstitutionDAO started with the idea that the general population could own a copy of the Constitution. They gave themselves six days to raise the high end of the projected winning auction, $20 million; and at the time of this writing, 7,500 people had contributed to this DAO, at a sum of well over $40 million, blowing past the original goal. (Since ConstitutionDAO did not win the auction, all funds will be returned to those who donated them.)
If anyone wishes to participate in a DAO, you first must purchase tokens, which typically gives voting rights that will allow the owner to guide what that organization does in conjunction with the rest of the community that also owns the tokens. We may also see DAOs using factional ownership of an asset — for example, a Picasso painting, London Bridge, or the Empire State Building. In this instance you have the ability to influence decisions, but you also have a partial ownership of the underlining asset as it appreciates or depreciates.
Kinship groups, tribes, armies, churches, and modern firms (profit and non-profit) are all types of organizations that have evolved legally and in business to coordinate increasingly complex human interactions, goals, and projects. DAOs are what is referred to in the book “Reinventing Organizations” as a “Teal Organization,” or an “organization as an independent force with its own purpose, and not merely as a vehicle for achieving management’s objectives. Teal organizations are characterized by self-organization and self-management.” DAOs are autonomous in the sense that they are autonomous from an outside groups objective, as the coordination and incentivization layer is the blockchain the DAO uses for coordinating its objectives. This is a critically important piece in the evolution of coordination, as third-party influences do not end up co-opting the goals of the DAO, and it remains “autonomous” in the sense that the DAO fulfills the accomplishment of whatever goals the members select without third party input or influence.
While DAOs at a high level represent an evolution in how human beings organize and coordinate, at a lower level they are simply an extension of many related web3 and blockchain technologies. Digital assets allow ownership of fungible and non-fungible goods to be tokenized. Besides the many cryptocurrencies we have seen rise over the past decade, lately there has been an explosion in Non-Fungible Tokens (NFT)s, simply meaning that each token is not a 1 to 1 exchange for another. Importantly, participation in a DAO can be tokenized, and members granted voting rights and incentives based on what tokens they hold. As tokens are all smart contracts, the way DAOs are governed can be programmed and voted on by their participants. Smart contracts run immutably on the blockchain and are censorship resistant. This means that 3rd parties can’t arbitrarily change the rules to their benefit, and members can know that voting proposals within a DAO will execute autonomously of human intervention.
Improved Inter-Communications
Many of the large-scale problems affecting humanity today are rooted in an inability for people interested in solving these problems to develop a proper way to coordinate effectively. By the time interested people and parties are at a scale to effect change, many third parties have established themselves along the coordination layer and inserted their own needs (openly or not) that may come at the expense of the overall mission. DAOs offer an opportunity to change that dynamic and offer a chance at re-imagining how we group together with one another to solve problems.
Legal Framework
Without legal protection, those operating within a DAO may be considered to be in a general partnership or some form of unincorporated association.
This means that where one member to the DAO commits a wrong, the other members, while perhaps being entirely innocent, could be liable at law. Pinpointing which individual is responsible for a wrongdoing could be a potential issue particularly given the lack of legal regulation and the way in which blockchain systems operate.
Since the DAO model first emerged, the series of benefits that an organisation without a centralised controller could provide has been recognised. But the unique features of a DAO also means that hitherto DAOs have operated without a specific legal framework and, as a result, do not have any legal personality at law.
Without such a framework the legal ownership of assets controlled by a DAO remains unclear; A DAO can look a lot like a general partnership or unincorporated association, exposing its stakeholders to personal liability for any debts or legal actions against a member of the DAO. These are core issues which need to be resolved by law so that emerging types of blockchain-based organisations can operate effectively in the countries wherein the members are based or intend to pursue objectives.
The Beginnings of Legal Recognition
In April of 2021, the progressive American State of Wyoming (the birthplace of the LLC ie a Company/Partnership hybrid that can enable tax to be avoided at a/the Corporate level) made headlines when its legislature approved a first-of-its-kind bill that determined individuals and organisations in the blockchain industry can create a legally recognised Decentralized Autonomous Organisation (DAO) in Wyoming. If countries are spurred to play catch-up and enact their own DAO related laws, the new type of organisation may no longer need to be viewed as a risky experiment but a possible corporate option.
Since the DAO model first emerged, the series of benefits that an organisation without a centralised controller could provide has been recognised. But the unique features of a DAO has also meant that they operate without a specific legal framework and, as a result, are not given any legal personality at law.
Without these protections the legal ownership of assets controlled by a DAO has been unclear, and a DAO can look a lot like a general partnership or unincorporated association, exposing its stakeholders to personal liability for any debts or legal actions against a member of the DAO. These are the core issues which need to be resolved by a DAO law so that emerging types of blockchain-based organisations can operate effectively.
The Wyoming Solution
Much like the DAO model law proposed by the Coalition Of Automated Legal Applications (COALA), the Wyoming law (see Wyoming’s DAO law ) attempts to resolve the above-referred issues. At a high-level, the Wyoming law prohibits lawsuits against DAOs as general partnerships and enforces the rights of DAOs as legal persons in state court to protect individual DAO members. As a result, the law extends traditional legal protections to DAO members in aims to minimise the risk of DAO members being held personally liable by a DAO.
That’s not to say the new law has been free of criticisms. Since Wyoming’s recognition of DAOs, there have been some strong opinions shared on the law, including questions about the additional and allegedly unnecessary burdens it creates for DAOs, an “unsound definition of smart contracts” as a form of a constituent company document, and the law’s lack of significant guidance for the ways in which a DAO company in Wyoming practically differs from a traditional company in Wyoming. The discourse is all useful for any jurisdiction that may wish to follow Wyoming in formulating a DAO Legal structure.
Comments from US lawyers note the approach of Wyoming’s DAO legislation is to give maximum effect to the freedom of contract principle, including by waiving the fiduciary duties of DAO members by default. Under the new law, while members of traditional Wyoming companies still owe fiduciary duties of loyalty and care to the company and other members, DAO members participating in a DAO company are only subject to an implied contractual covenant of good faith and fair dealing.
The Wyoming DAO Company Law – Details
The Wyoming DAO recognition law is a supplement to the existing LLC Law, which was notably the first in the nation. The law allows the creation of DAOs as limited liability companies, conferring legal status and identity on such entities for the first time.
As a supplement to the LLC Law, the DAO Supplement is viewed as providing exceptional coverage for DAOs, but the rest of the LLC Law applies to them, where not specifically carved out. The technical requirements include using DAO, LAO, or DAO LLC in the name of the organization to distinguish it from current LLC usages. The Article of Organization must include a specific notice to alert all potential members that the DAO may eliminate fiduciary duties and restrict transfers of ownership interests, withdrawal, or resignation from the DAO, return of capital contributions and dissolution of the DAO.
The Articles of Organization, or alternatively, the Operating Agreement of the DAO, must indicate whether it will be member-managed, with at least one person who is a member in order to conduct the business of the DAO LLC, because management shall be vested in its members. The Articles of Organization will govern a range of activities generally undertaken by corporations, including: members’ rights, duties, relations, voting rights, DAO activities and how they will be conducted, means of amending the articles or operating agreement, distributions to members, transferability of membership interests, withdrawals of members and their contributions, dissolution and distribution to members upon dissolution, procedures for amending, updating, editing or changing applicable smart contracts, and a publicly available identifier for any smart contact used to manage, facilitate or operate the DAO. Much of the information necessary to operate the DAO will be available in the white paper of the entity creating the DAO and publicizing its advantages to potential members.
Alternatively, the DAO may be “algorithmically-managed”, by the underlying smart contract without human intervention. It is not necessary for the DAO to reveal the workings of the smart contract(s) used for transacting the business of the DAO, but the law requires that the underlying smart contracts must be “able to be updated, modified or otherwise upgraded.” This requirement can work a hardship on many DAOs, because one of the main attractions of using blockchain and smart contracts is that the record is immutable, so having the contracts readily modified is not really possible without an entirely new contract to replace the prior version.
Potential members should be aware that the law specifically precludes rights of inspection of records because transactions will be transparent on the blockchain and therefore there is no need for additional documentary transparency. “Open blockchain” means a blockchain as defined in W.S. 34-29-106(g)(i) that is publicly accessible, and its ledger of transactions is transparent;”
The Usefulness of the DAO Supplement
The DAO Supplement anticipates that DAOs will be used to transact business using digital assets, which are defined as “a representation of economic, proprietary or access rights that is stored in a computer readable format and is either a digital consumer asset, digital security or virtual currency;” or digital consumer security, defined as “a digital asset that is used or bought primarily for consumptive, personal or household purposes and includes:(A) An open blockchain token constituting intangible personal property as otherwise provided by law;(B) Any other digital asset which does not fall within paragraphs (iii) and (iv) of this subsection.
Wyoming has enacted a Digital Identity statute that provides some additional support for the use of DAOs under the DAO Supplement. The state legislation can be used in a complementary manner to enable the creation of a DAO with members using digital identities and even to undertake limited in-state crowdfunding efforts to create the treasury needed to support the projects the DAO undertakes. No other jurisdiction has combined these approaches in such a complementary fashion.
The future of DAOs?
As has been noted, DAOs have the potential to become the future of businesses or organizational structures not only in the Metaverse, but in the real world. At the Thomson Reuters Institute’s recent 2021 Emerging Legal Technology Forum, a Lawyer colleague sat on a panel discussing the evolution of blockchain and tossed out a prediction that a DAO will own a major sporting franchise within the next four years. The comment was received with a collective gasp in the room. Imagine the ability for you and others to vote on which players the New York Giants pro football team acquires… yet, by owning tokens of the NYGiantsDAO or whatever it may come to be named, you in combination with others who own said tokens could vote to acquire the next greatest player or even possibly vote on who to bench in the next game. The implications are profound.
The sums of money that DAOs will raise likely will be staggering, such that they could overwhelm current ownership models with a flood of money from massive numbers of private individuals interested in participating. We have seen this with ConstitutionDAO now having raised more than $40 million and counting in just six days.
DAOs in Every day Life
Here is one simple example of a DAO translated into real life. Think about the interaction you have with a vending machine. In essence, it is a legal contract that you are entering. You approach the machine in your breakroom, and it takes your money via credit card. You choose your confectionery, and the machine dispenses the snack. As a DAO, it uses that money to re-order more Snickers or Mars bars, when it knows that that row is nearly empty. It can also order cleaning services and pay the rent all by itself. As you put money into that machine, you and its other users have a say in which snacks it will order and how often it should be cleaned. Ultimately, it has no managers, and all of those processes were pre-written into its code.
Most initial DAOs will have a board or controlling entity, of course, but they will use code and voting rights-governing models to establish equitable means of responsibility and decision-making. However, ultimately it is a system whereby the code could be fully autonomous, meaning a business could be established and run nearly or completely autonomously.
Decentralized Finance
In the Decentralized Finance (DeFi) space, many of the exchanges are code-based executions of asset swapping or purchases of assets like cryptocurrency or synthetic assets that mirror stocks. These organizations are increasingly DAO-centric and will eventually not have much human intervention, because much of its operations should be programmed into the organizational structure, only needing tweaks of code voted on by the DAO members.
DAOs are the future of organizations. They will create an amazing world of possibilities, but simultaneously disrupt many structures we currently have in place now. On the legal side, there is incredible opportunity for Lawyers in both transactional practice areas as well as the eventual litigation side of the business. When regulation comes, it will be fascinating to watch how Lawyers embrace and adapt to this decentralized model with the current lens.
Compliance
What will be the Finance/Securities Regulators approach be to regulating DAOs? On the one hand, if a DAO is about trading different types of cryptocurrencies, no doubt it will be regulated because of the close similarities to equity investment vehicles or exchanges. On the other hand, many DAOs will not necessarily be about the value of the tokens used to transact business of the DAO, but more about how to deploy resources to more efficiently work cooperatively to achieve a goal that the members of the DAO agree is something they want accomplished.
What Does Compliance Look Like for DAOs?
Key regulatory authorities have begun to identify the prime characteristics of anti-money laundering (AML) programs that will be acceptable. “An AML Program will in most cases need to include, at a minimum:
- policies, procedures, and internal controls reasonably designed to achieve compliance with the provisions of the BSA and its implementing regulations;
- independent testing for compliance;
- designation of an individual or individuals responsible for implementing and monitoring the operations and internal controls; and
- ongoing training for appropriate persons.
Rules for some financial institutions refer to additional elements of an AML Program, such as appropriate risk-based procedures for conducting ongoing customer due diligence.”
At a minimum, smart contracts will probably have to bake into the code some aspects of this list in order to become more widely acceptable and useful to businesses and individuals seeking to employ these new technologies seamlessly.
How to Make a DAO Work
One of the most promising benefits of DAOs is the low barrier to entry for individuals and small businesses who otherwise are not participating in the stock market, banking, and lending, or making their services or goods available to broader markets. The possibility of greater inclusion and grouping of like-minded individuals to undertake projects for the common good of the group is something new and inherently more democratic than most existing organizations.
Being internet-native organizations, DAOs have several advantages over traditional organizations. One significant advantage of DAOs is the lack of trust needed between two parties. While a traditional organization requires a lot of trust in the people behind it — especially on behalf of investors — with DAOs, only the code needs to be trusted. Trusting that code is easier to do as it’s publicly available and can be extensively tested before launch. Every action a DAO takes after being launched has to be approved by the community and is completely transparent and verifiable. Such an organization has no hierarchical structure. Yet, it can still accomplish tasks and grow while being controlled by stakeholders via its native token.
The lack of a hierarchy means any stakeholder can put forward an innovative idea that the entire group will consider and improve upon. Internal disputes are often easily solved through the voting system, in line with the pre-written rules in the smart contract. By allowing investors to pool funds, DAOs also give them a chance to invest in early-stage startups and decentralized projects while sharing the risk or any profits that may come out of them.
DAOs solve the principal-agent dilemma through community governance. Stakeholders aren’t forced to join a DAO and only do so after understanding the rules that govern it. They don’t need to trust any agent acting on their behalf and instead work as part of a group whose incentives are aligned. Token holders’ interests align as the nature of a DAO incentivizes them not to be malicious. Since they have a stake in the network, they will want to see it succeed. Acting against it would be acting against their self-interests.
In summary, DAOs provide an inherently evolutionary means to create organizations on a cooperative, democratic, and unbiased basis to accomplish goals held in common by the members and displayed transparently in the smart contracts underlying the operation of the DAO. While some DAOs may be engaged in investment activities that warrant supervision by the SEC and CFTC and their equivalents, many will certainly have other goals that could well permit regulation as cooperative associations in which the members manage and control the organization in a non-hierarchical manner and the sharing of profits or dividends is equitable and democratically governed.
Legal structures for DAOs
Currently, many DAOs are not established as legal entities, potentially exposing their members to a number of risks and liabilities. That said there a number of legal personalities that could be applied to and/or be used as a protective coating for the average DAO. Let’s consider the options…
Option 1: DAOs without a registered legal entity
The first option, commonly seen throughout the DeFi- Ecosystem, is to not set up a legal entity at all but rather, to try and create a fully decentralized structure. This does not mean, that DAOs without a registered legal entity operate outside the law. In most jurisdictions, they will be seen as general partnerships with the corresponding legal consequences. This most significant one is the risk of the personal liability of every participant. But this means also the DAO has a legal personality and can in most jurisdictions legally own assets and also employ people. In such a case, although the participants did not register the DAO, they created a fully recognized legal entity in most jurisdictions that can sue and can be sued. This is often misunderstood.
Although this bears significant risks, as mentioned, this structure also takes advantage of regulatory arbitrage in certain areas. If there is no central entity involved and the project is truly decentralized – and is launched anonymously – legal enforcement becomes challenging. Even the US SEC has acknowledged, that the greater a project’s decentralization, the less likely the underlying tokens would be considered securities.8
Moreover, regarding international private law, finding the applicable law and the responsible regulatory authority can be quite challenging in the case of a fully decentralized DAO. Because in the case of DAOs with economic interests, the cooperation agreement between the participants is sufficiently consolidated under conflict of laws, so that the connecting rules of international company law have to be applied.
If no explicit choice of law is made, the rules of international company law reach their limits in the case of DAOs. This is because, unlike traditional software applications that reside on a specific server under the control of an operator assigned to a specific jurisdiction, DAOs run on every node of a blockchain – everywhere and nowhere… And unlike traditional organizations – which are run by individuals living in distinct and identifiable territories – DAOs typically are collectively managed by a distributed network of peers who contribute to the underlying blockchain-based network from anywhere in the world. Consequently, a decentralized blockchain network, like a DAO, is fundamentally opposed to the traditional International Private Laws search for the cartographic center, since no spatial center of gravity can be determined!
The traditional theories to determine the jurisdiction for companies in most jurisdictions are linked either to the place of incorporation or to the administrative center. In the case of a DAO, these theories have little application, because typically neither of these places can be determined.
In addition to the above referred situs conundrum, other historical reference points also have limited application to DAOs. For example, the assets of a DAO can be, if consisting only in digital currency (as if often the case), spread all over the world. For that reason, the principle Lex loci rei sitae (law of the place where the property is situated) cannot be implemented.
A conceivable solution would be in some cases to determine the applicable law on the ground of jurisdiction of the other contractual party if the place can be identified and a contract in the legal sense exists. But this solution does not help with determining the legal status of a DAO in the first place.
Finally, it would be possible to always rely on the Lex Fori principle. This means the positive law of the state, nation, or jurisdiction within which a lawsuit is instituted or remedy sought. Apart from the legal-theoretical concerns, which the lex fori brings with it, the application also runs counter to considerable practical considerations due to the concept of the DAO. For example, it may be necessary for litigants to bring actions in several jurisdictions in order to obtain legal protection, meaning a law suit against a DAO may become very impracticable from an economic point of view.
As a consequence, it is quite difficult to determine the applicable law for DAOs and thus the competent jurisdiction and regulatory authorities, which also makes enforcement of law very difficult. Determining whether a project is sufficiently decentralized to avoid scrutiny from regulatory authorities for the unregistered sale of securities is a highly nuanced and complex process. No single factor is determinative and the regulatory authorities will look at the totality of the circumstances in making this determination. Therefore, if you are looking to launching a DAO and are concerned that the governing Tokens might be considered a “Security” it is strongly recommended that you reach out to regulatory authorities for guidance and also seek legal advice pre launch.
Option 2: Setting up a DAO with a liability wrapper or as a DAO LLC
The second option is setting up a DAO with a liability wrapper, which protects its members. This is an interesting option, especially for organizations willing to operate within the United States and give up some kind of decentralization. Within the US, you have a few options for which state to incorporate in.
Model Blockchain-Based Limited Liability Company (BBLLC) Vermont and Delaware LLC
The first step in this direction in Anglo-American law has already been taken. In 2018 US state of Vermont pass a law making it possible to establish a so-called Blockchain-Based Limited Liability Company (BBLLC) in Vermont. This opened up the possibility of establishing a limited liability DAO for the first time. For this purpose, a Blockchain-Based Limited Liability Company (BBLLC) was registered in Vermont after the deployment of the DAO on the Ethereum Blockchain by dOrg. By linking the DAO to this BBLLC, the DAO has an official legal status that allows it to enter into contractual agreements and offer liability protection to participants. The BBLLC enables full governance via the blockchain and using smart contracts.
OpenLaw in the U.S. state of Delaware is also taking a similar approach by establishing the LAO (Legal DAO). The LAO provides a legal structure to allow members to invest in blockchain-based projects in exchange for tokenized shares or utility tokens. This structure is called a “legal wrapper,” which is created by structuring the DAO as an LLC to hold the company responsible for contracts, taxes, and violations of law, but not the individuals acting on behalf of that company. The goal of the LAO is to limit the liability of the participants, provide clarity on the applicable law, and provide tax benefits (flowthrough/single taxation).
Option 3: Model Wyoming Decentralized Autonomous Organization Supplement DAO LLC
On April 21, 2021, Wyoming Governor Mark Gordon signed Bill 38, which allows Wyoming to recognize decentralized autonomous organizations (DAOs) as Limited Liability Companies (LLCs). The new law is essentially an amendment to the current Wyoming Limited Liability Company Act. Under the provisions of the Act, a DAO is defined as a limited liability company whose articles of incorporation include a statement that the company is a DAO. Concerning decision-making in a DAO, the notion of a majority of members is also concretized. Namely as the approval of more than fifty percent (50%) of the participating member interests in a vote in which a quorum of 4 members participates.
It is also interesting to note that a membership interest is determined as a member’s ownership share in a member-led decentralized autonomous organization, which may be defined in the entity’s charter, smart contract, or operating agreement. The use of the term “ownership share” indicates a corporate reference and thus also suggests a classification as a security, even though this is not explicitly addressed in the bill.
The second part then determines the scope of application of the Wyoming Limited Liability Company Act to DAOs. In addition to a new formation, an existing LLC may also be converted into a DAO by amending its articles of organization to include the same statement. The DAO’s registered name would also have to include the appropriate designation, such as “DAO,” “LAO” (Limited Liability Autonomous Organization), or “DAO LLC”.20
Additionally, all Wyoming DAO LLCs must have a disclaimer in their articles of incorporation that the rights within this form of organization may differ materially from the rights in traditional LLCs, particularly for membership rights. The articles of organization filed with the Secretary of State for registration must also describe the structure of the DAO as either a member-managed DAO or an algorithmically managed DAO. If this is not specified, it is assumed to be a member-managed DAO; This shows that the Wyoming legislature also distinguishes between different levels of automation of DAOs and their design.
Furthermore, the Wyoming DAO LLC law specifies that an algorithmically managed DAO may only be formed “if the underlying smart contracts can be updated, modified, or otherwise upgraded”. This is presumably intended to guarantee the controllability of DAOs in light of future technological advances.26
For the DAO formation process, the law states that any person may form a decentralized autonomous organization, which shall have one or more members, by signing and submitting an original and an exact or adapted copy of the articles of incorporation to the Secretary of State for filing. Each such DAO must have and continuously maintain a registered agent in this state of Wyoming, as also provided in the Wyoming Company Act.28
In addition to the requirements above, the articles of incorporation must include a publicly available identifier of each smart contract used directly to manage, facilitate, or operate the DAO. A DAO may be established and operated for any lawful purpose, regardless of whether it is for profit.
Moreover, it specifies what, at a minimum, must be regulated in the DAO’s bylaws, namely the relationships among its members and between the members and the DAO as a society itself.
While this formal legal framework is a step forward for the crypto industry and solves the problem of member liability, the new law does not address other fundamental issues. For example it is unclear whether DAO members are granted the right to act on behalf of the DAO and legally bind it; rather, it requires that this be clarified in the bylaws. Concerning necessary legal certainty, a statutory regulation would be desirable, at least for those cases in which this is unclear. It is also not clear who is responsible for updating the underlying smart contracts in the case of algorithmically managed DAOs.
Finally, fundamental questions regarding the regulatory classification of DAOs and DAO Tokens are unclear. Firstly, depending on its activity, a DAO could be considered an “investment company” meaning (depending on where its members are located) it would then have to comply with the disclosure requirements and investment restrictions set forth by law in the Member’s home jurisdiction.
Secondly, it is possible that the tokens issued by the DAO as a form of membership interest could be classified as a Security under the applicable law of the Member’s home jurisdiction/s. Certainly where American members are involved this is likely to be the case for most for-profit DAOs following the SEC’s decision in the case of the DAO. (Based on the investigation in that case, and under the facts presented, the Commission determined that The DAO Tokens are securities under the Securities Act of 1933 and the Securities Exchange Act of 1934.
DAO LLCs Summary
The option of using a liability wrapper is probably the best option for most DAOs, particularly those looking for the most legal certainty and safety (and for those who are willing to comply with all the necessary regulations and provisions of the different Member jurisdictions). Also, as mentioned, if the DAO decides to give out the Token it needs to be carefully looked at, because in most cases it will be qualified as a security with the corresponding legal necessities (prospect, registration with the local SEC, etc.)
Within the different options in Vermont, Delaware and Wyoming, the choice depends on every individual case and the goals of the DAO and its community. While Wyoming’s law is most true to the DAO structure, it also requires the most information and paperwork. By way of comparison in Delaware, the setup of the LLC is quite fast and cheap and provides a lot of flexibility. But it also requires that every Member of the DAO needs to be a member of the LLC and each time a member changes this would need to be updated. To go into too much detail here which states fit which structure would go beyond the scope of this paper, and require legal advice in each case, but in summary, the option of a US LLC is particularly suitable for projects that want the greatest security and are willing to comply with the numerous legal requirements.
Option 3: Setting up a DAO as a Foundation
A foundation with legal capacity under private law is an organization set up by one or more founders to permanently fulfill a purpose defined by the founder with the help of the assets dedicated to the foundation. In this respect, a Foundation format could be considered to pack DAOs into a legal construct.
General Structure
In principle, certain parallels between blockchain organizations and Foundation law can be clearly seen. The immutability principle, which is intrinsic to a Blockchain and on which trust in it is based, is similarly found in the solidification principle under Foundation law. This principle states that it is not possible to update the founder’s intentions after the foundation has been established. In both cases, changes are only possible under increased conditions.
In addition, the aspect of autonomy proves to be fundamental both in the legal form of a foundation and in a blockchain-based organization. Foundation autonomy enables the foundation to develop a life of its own over time. It can be completely detached from the founder, which is still tied to the purpose of the foundation and thus to the founder’s will, but whose existence is no longer at the disposal of the foundation’s participants.
This autonomous dynamic is a core component of a blockchain-based DAO, whose goal is to act independently and autonomously from the original developers according to the previously determined code. In this respect, DAOs open up the possibility of extending and permanently consolidating the degree of independence of foundations, which is limited by the legal framework.
That said, it is questionable whether DAOs can be established and operated without problems within the current legal limits of the typical Foundation. The general view is that the purpose, assets and organization of a foundation are the three essential elements of the concept of a foundation.
While the foundation purpose can be determined by an initiator given the diverse possibilities of DAOs, some issues open up with regard to the foundation assets and the legal structure. Firstly, in some jurisdictions, it is questionable whether virtual goods, which will regularly be the case in the form of tokens in DAOs, are suitable foundation assets. The line is drawn insofar as, according to the requirement of proper asset management, the foundation assets cannot consist exclusively of highly speculative components.
In addition, in many jurisdictions, the organization of foundations raises practical challenges for a DAO. In almost all jurisdictions, the organization of a foundation requires a board of Councillors (the Foundation equivalent of a board of Directors in the case of a Company), which represents the foundation as a management body in legal transactions (most jurisdictions will allow for a Foundation to be established with as little as one Councillor). Finding a board of Councillors can be difficult for DAOs with the goal of full decentralization. However, if this requirement can be fulfilled, there are some good possibilities to structure a DAO as a foundation and it has already been used by different projects in the past.
Swiss Foundation and the Cayman Islands Foundation Company
The most used jurisdictions are Switzerland and the Cayman Islands. Switzerland provides in comparison to other European jurisdictions a more flexible foundation model with a relatively easy setup and a quite moderate taxation.
Regarding the Cayman Islands, this is also a jurisdiction, which a lot of crypto projects choose, with reasonable reasons behind it. Especially the legal structure of a so-called “Foundation company” is very interesting, which was introduced as a new structure by law 2017.
The Caymans foundation company is a remarkably flexible vehicle that operates like an incorporated trust, allowing it to function like a civil-law foundation or common-law trust while retaining the separate legal personality and limited liability of a company and tax neutrality. The foundation company also can designate beneficiaries, which will not be treated as a beneficiary under a legal or common-law trust arrangement. The reason is, that the starting position under the Law is that a designated beneficiary has no rights or powers against the foundation company, only those expressly stated by the foundation company. Moreover, a foundation company does not need to maintain a register of its beneficiaries with their legal names under the Law. It can designate beneficiaries by class of persons for example as “token holders” or “node operators “and also reward those beneficiaries according to that class. Although anti-money laundering considerations always need to be kept in mind this could be useful for DAOs where the DAO intends to undertake distributions, airdrops of tokens, or other rewards to the DAO community.
The Foundation Option – Conclusion
Fully decentralized DAOs may have difficulties setting up as a Foundation given the legal boundaries. But attention should also be drawn to the many parallels between DAOs and the foundation structure, such as the high degree of autonomy and the permanent perpetuation so that corresponding considerations by legislators to adapt the foundation would be desirable. Until then, the structure is suitable for DAOs, which are willing to give up some decentralization and can designate trusted representatives. In particular a Foundation structured as a Purpose Foundation could have strong potential as a model DAO (For details as to what a Purpose Foundation is click on this Link: https://offshoreincorporate.com/what-is-a-purpose-foundation/ )
Combinations of the different options
A lot of projects combine a Foundation with a Company incorporated in low regulation (eg an IBC or an LLC), business-friendly jurisdiction. In this structure The Foundation owns the Company. The Company typically employs the developers/management team and or runs the commercial side (ie the money making objectives) of the organization. Mostly, the foundation will hold the treasury and will have an agreement with the IBC/LLC in which it states, that the DAO Treasury will pay for the expenses of the IBC/LLC. Although this option can use the benefits of options two and three, it also comes with additional requirements and certain centralization aspects, which need to be considered regarding the structure.
Summary
As shown, there is no “perfect” and no onefitsall solution for DAOs. Until a proper legal framework for DAOs is created, which enables them to operate fully decentralized with limited liability legal recognition and easy taxation, every current legal setup comes with its benefits and downsides and each DAO should seek individual legal advice, which option fits the best for its needs. Especially when a DAO Token is involved, the legal setup can get even more complicated, as a Token can often be qualified as a security42 and create additional legal requirements, such as prospects or registration with the legal authorities.
Concerns
DAO’s are still a relatively new concept, built on the relatively new technology of the blockchain. With the advantages of this innovation also come some growing pains, namely those of security flaws and a higher potential for future changes in government regulation.
Within a stakeholder-voting structure, security flaws are far more difficult to address in DAO systems than in traditional LLC’s, a result of the sluggishness when implementing changes compared to traditional management structures . Even for obvious flaws, a DAO still requires all issues to be voted on by its stakeholders. This can lead to delays when fixing flaws in the structure behind a DAO’s operations, which in the context of security breaches can be detrimental to stakeholders and their holdings within the DAO.
Algorithmic management structures are also subject to security flaws, but in a slightly different way. Flaws in algorithmic decision making may be harder to catch than flaws in the decision making of humans, and as such have a higher potential to be exploited by malicious parties.
Potential for Legal Changes
Decentralized autonomous organizations are completely legal, however as with all new technologies, DAO’s are subject to significant changes in regulation. Current Wyoming legislation under Bill-SF0038 (effective 07/01/2021) dictates that the management of DAO LLC’s has many of the same requirements of traditional LLC’s, with some additional criteria for the more complex management structure and backend required for its operation.
Conclusion
Whilst the Private Foundation will have attraction to certain DAO Founders (particularly those forming more for altruistic purposes) by treating DAOs as a distinct legal entity with the same limited liability protections as traditional LLCs, Wyoming has become an attractive place to form a DAO. A DAO LLC can provide all the advantages of an LLC with additional capabilities to fulfill a wide variety of possible needs that a traditional LLC is not capable of.
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