There has been considerable conjecture in the legal academic world over the course of past year or two about how a DAO would be treated in the event of one ever being sued. Given a DAO is in effect an unincorporated association (and notwithstanding that members aren’t always in plain view) the core weakness of a traditional DAO is that, if it were to be successfully sued, all the members of the DAO would be jointly and severally liable for the judgment debt arising.
If you are looking to form/set up a DAO you will want to give considered thought to setting up a legal structure (a “Legal Wrapper”) to protect the DAO’s members from legal liability.
This article examines the options currently available in the International Market place for such Legal Wrappers.
How does a DAO work?
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.
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.
How to Form a DAO
There are typically a number of steps involved in the formation of a DAO. You’ll need to
- Define the structure of the project eg What do you expect your DAO will achieve? What are your goals?
- Decide on the type of DAO you want to create (eg a Grant DAO? Or an Investment DAO? Or a Social DAO? Or a Collector DAO? Or a Media DAO? Or an Entertainment DAO? Or a Philanthropy DAO?)
- Decide what features are to be included in the Tokens that you issue to persons wanting to be part of your DAO (eg Voting rights, Incentives/rewards, Executive participation opportunities etc)
- Create your DAO (there are several DAO startup templates one can access on the Blockchain + tools are also available in the market to help you. They can help in ascertaining the legal infrastructure of the DAO, DAO coin minting, Building teams, Finding members etc)
- Encode your rules: Get your DAU rules encoded in a smart contract (which renders the rule immutable/unable to be changed). Rules can be encoded using easy to purchase DAO tools or by simply hiring a blockchain developer to do it for you
- Create your DAO Treasury (After you’ve completed your DAO token’s ICO supply and allocation, it’s essential to guarantee that you can secure the collected funds. There are now numerous popular east to access DAO Treasury Tools including Gnosis Safe- Platforms, Juicebox- Juicebox, Llama, Parcel, Utopia etc
- You’ll need to decide on what Governance tools you want/need (eg you’ll need to implement systems for holding discussions, conducting voting, and managing funds and for depositing/managing/lending governance tokens etc).
- You’ll need to create a community (a trustworthy, independent community is the strongest pillar of a DAO ecosystem. An interactive, engaged, and strong community can help in the constant expansion of the DAO project. Moreover the success of a DAO project largely depends on how freely the community is able to participate in the decision-making and management of the DAO project).
There are a ton of resources out there that can help you sort out the above and more. Here are some examples:
I’m guessing you’ve already made the above-referred decisions which means the next thing you need to decide is what kind of legal form do you want your DAO to take?
Legal Structures for DAOs?
From a legal standpoint DAOs traditionally have been treated as unincorporated partnerships. In a partnership, each individual has unlimited liability. Therefore, if the DAO is hacked or declares bankruptcy, each member is exposed to liability for the entire amount of funds. If a lawsuit follows and the plaintiff is unable to recover completely from the “DAO partnership,” the plaintiff will turn next to the personal assets of each DAO member until their claim is satisfied. To address this weakness, ideally your proposed DAO would have to register and be recognized as a legal entity with limited liability (most clients incorporate their DAOs as a Company).
The Foreign Foundation entity structure is the most common structure currently in use by network and protocol DAOs (most commonly structured as a Cayman Islands HoldCo, with the inclusion of a B.V.I. OpCo – depending on activity and VASP reporting requirements). These structures were first utilized as non-profit vehicles to oversee the future development of blockchain networks (e.g., the Ethereum Foundation), but are now more commonly used to provide an “ownerless” legal entity structure for DAOs in which the fiduciary obligation of the entity is to the purpose specified in the formation documents rather than to shareholders.
The Foreign Foundation solves the three biggest challenges facing Entityless DAOs: (i) lack of legal existence (inability to contract or own property); (ii) inability to pay taxes; and (iii) potential unlimited liability. The full “wrapper” use case enables the vehicle to provide all DAO members with limited liability with respect to any DAO actions, but the structure can also be narrowly tailored to wrap specific DAO activities (e.g., treasury management).
In addition, the structure can provide an extremely flexible framework and, to the extent DAOs are able to navigate complexities relating to (i) international ownership and control; and (ii) risks of foreign sourced income, the structure provides DAOs with optimized taxation strategies regarding payments and reporting requirements.
Additional benefits of the structure include that it does not restrict DAO membership from being denoted by token ownership, thereby enabling efficient transferability, and does not require DAO members to disclose their identity. Finally, the structure permits the generation of profits and, subject to applicable securities laws, distribution of such profits.
All that said in the current business/regulatory climate if I were looking to create a legal wrapper for a DAO there are 3 Jurisdictions/structuring options I’d be looking at most closely ie:
- A Cayman Islands Foundation Company
- A Marshall Islands DAO LLC
- A Wyoming DAO LLC
Cayman Foundations Companies – Overview
In 2017 the Cayman Islands Government passed a new Law introducing a unique form of legal entity known as a Foundation Company (“FC”). The Caymans FC 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.
The timing of the enactment of the Law was also fortuitous as it coincided with the popularisation of decentralised autonomous organisations (“DAOs”), most of which utilise blockchain technology. As DAOs are launched with the ultimate goal of becoming fully decentralised and governed by the DAO’s community, the foundation company vehicle helps the Developers of DAOs to achieve their goals.
Like a typical company, the foundation company has legal personality to enter into contracts and undertake actions with third parties. It is also managed by directors who carry on the business of the DAO. However, unlike a company, the foundation company can be structured without shareholders. In essence, it can be ownerless – just like the DAO it represents. In place of shareholders, the foundation company can be supervised by a supervisor (or even multiple supervisors if desired). A supervisor has no ownership or economic entitlement in the foundation company but simply acts as a steward, ensuring that the directors of the foundation company observe their obligations to the DAO pursuant to the foundation company’s governing documents. Therefore, with no shareholders, all of the officers of a foundation company simply have the objectives of the DAO as their priority – similar to trustees and enforcers carrying out the objectives of a trust.
Other popular Foundation/Jurisdiction options include:
Marshall Islands DAO LLCs – Overview
Having forged a reputation as a leading IOFC (International Offshore Financial Centre) The Republic of the Marshall Islands (RMI) – thanks to some new cutting edge legislation – is rapidly becoming one of the world’s leading jurisdictions for the registration/incorporation of Decentralized Autonomous Organizations (DAOs).
The RMI offers a for-profit and not-for-profit DAO LLC (Limited Liability Company), legal entities based on the traditional Marshall Islands LLC but customized to meet the unique needs of DAOs.
Key features & Benefits Include:
- Limited liability for DAO members
- Corporate personality for owning property, signing contracts, opening bank accounts, etc.
- No trustees, directors, officers, or managers with extra liability or responsibility
- All documents and records can be kept on the blockchain
- Most members can remain anonymous (only members with 25%+ governance rights in DAO LLCs must complete KYC, providing their real name, address, and passport).
- Governance via smart contract is specifically permitted by law
- For profit and Not for profit set up options are available
- Minimal tax (maximum 3%)
- Laws based on US models (Delaware in particular)
- Low regulation – Currently, there are no digital asset, token, or protocol-related laws or regulations in the RMI, (except for companies that engage in the custody of digital assets on behalf of others).
- Solid jurisdictional reputation – The RMI is not part of any blacklists or tax evasion lists
- Limited reporting – DAO LLCs report annually by sharing their updated company agreement and having beneficial members do KYC. For-profits must report their revenue for tax collection purposes.
Wyoming DAO LLCs
Like the Marshall Islands, Wyoming has drafted a special regulation for DAO s, under which a DAO can be established in Wyoming in the form of an LLC, with certain characteristics. From our point of view, the advantages of this US jurisdiction include:
- The flexible legal system of the U.S. common law;
- Easy and relatively inexpensive establishment process;
- Quick setup—a company can be registered in as little as 2 weeks;
- Your project will be structured in the U.S., which is considered an investment Mecca;
- Wyoming offers one of the first working legal regulations for a DAO wrapper;
- Limitation of personal liability: the DAO LLC members are not personally liable for the LLC’s debts or legal liabilities;
- No Corporate tax: LLCs have a “pass-through” taxation system: the DAO LLCs receive “pass-through” treatment allowing allocated profits to be taxed only once on each member’s individual income tax return; and
- Less bureaucracy and paperwork as the registration process is very simple with minimal documentation required.
However, establishing a DAO LLC in Wyoming for the purpose of creating an investment DAO is not considered a great option due to the strict securities regulations in the U.S. There is a risk that your token (if publicly issued) will be deemed as a Security by the U.S. Securities and Exchange Commission. Instead, the Wyoming DAO LLC is usually recommended as a pure governance DAO for your project, due to the transparent and specifically designed regulation.
Other legal wrapper options for DAOs include:
- A Swiss Foundation
- A Singapore Company
- A Vermont Blockchain-Based LLCA Tennessee Decentralized Organisation LLC
- A Colorado Uniform Limited Cooperative Association
Would you like to know more? Then please Contact Us:
DISCLAIMER: OCI is a Company/Trust/LLC/LP/Foundation Formation Agency. We are not tax advisers or legal advisers. You are advised to seek local legal/tax/financial advice in regards to your local reporting/tax requirements before committing to set up or use an Offshore Company or other entity.