Legal challenges for DAO, a Japan context
On December 27, 2022, the Web 3.0 Study Group, for which the Digital Agency of Japan serves as the secretariat, released the “Web 3.0 Study Group Report” (the “Report”), which comprehensively outlines an agenda for the development of Web 3.0 in Japan.
The meaning of Web 3.0 itself has not been well defined in Japan, and various commentators talk about different images of Web 3.0 with a view to the next generation of Internet businesses. The Report views Web 3.0 as “a distributed application environment that utilizes new technologies and the worldview constructed under such an environment,” and then identifies services and tools for “finance,” “assets and transactions,” and “organizations,” which are core elements of the economy and society, as having the potential to technologically complement or replace some existing services and tools. The Report examines how Japan should benefit from this innovation and manage the inevitable risks that may arise.
The Web 3.0 agenda presented in the Report is broad, but this article focuses on Decentralized Autonomous Organizations (DAOs) and explains their institutional challenges in a Japan context.
What is a DAO?
As with Web 3.0, the implications of DAOs are not clear. In the UK, the Law Commission has begun calling for information on DAOs from around the world as a prelude to proposing a system, with the aim of capturing the Web 3.0 market, represented by DeFi, as a national power by providing a legal foundation for DAOs through the Anglo-American legal system. The central questions about DAOs in the consultation document are “what does Decentralized mean”, “what does Autonomous mean” and “what does Organization mean”. This fact is the clearest indication that there is currently no global consensus on the nature of DAOs and the elements they should possess.
In this regard, the Report broadly refers to DAOs as “a form of organization that leverages blockchain technology and smart contracts, does not have a centralized management structure, and aims to be operated autonomously by participants,” and then goes on to point out the current state of the discussion and various issues (such as risks and incorporation of DAOs). While in some respects this is unavoidable, since the actual status of DAOs themselves is unknown, the overall description is vague and imprecise, and it is ultimately unclear what direction the Japanese Government is taking with regard to DAOs. In this article, I will take a more basic look at the background of the current worldwide discussion about DAOs.
Originally, people organized themselves to achieve certain common goals. Organizations typically articulate a guiding purpose (in modern parlance, a purpose) and invite people who share that purpose to join. Those who wish to join become members by agreeing to abide by the organization’s discipline. Organizational discipline is usually systematized, and the Charter, which serves as the fundamental norm, defines the purpose of the organization, qualifications of members, rights and duties of members, mechanisms for governance, authority to establish, amend, or abolish the Charter and subordinate rules, rules for dissolving the organization, and so on.
In addition to organizations, there are other mechanisms of cooperation between people, such as contracts. Contracts are characterized by incompleteness, which means that not all matters can be fully specified, and it is said that a “bundle of contracts” of N-to-N organizations is more efficient for accomplishing complex projects than one-to-one contracts because it reduces transaction costs. It can be said that organizations are a legal technology that scales more efficiently than contracts.
The difference between DAOs and conventional organizations is that DAOs differ from conventional organizations in that conventional organizations have achieved the economic efficiency of organizations compared to contracts by supplementing the incompleteness of organizational discipline with laws, based on the premise of an analog infrastructure. The difference between DAOs and traditional organizations is that DAOs, based on the current digital environment, seek to achieve the economic efficiency of organizations through digital technology, not through the legal system of the organization.
What would an “organization” look like if it were reinvented from the ground up in a digital environment, and what kind of legal support is needed for such an organization to function efficiently as intended? This is the perspective from which to consider institutional measures for DAOs.
Digital Technologies Supporting DAOs
In order to determine the nature of the organization that the DAO is trying to reinvent, it is necessary to properly understand the digital environment that the DAO assumes.
The first thing to note is the Internet as the digital environment in which DAOs are established.
Traditionally, organizations always had a location. There was a principal place of business, and jurisdiction and venue were determined as if the organization existed at that location. A physical location was also essential for people in the organization to communicate and keep records. With the Internet, “location,” which was a natural assumption for analog organizations, can now be transferred to cyberspace. The importance of sharing the same space face-to-face had been advocated to maintain organizational unity, but people’s perceptions have been renewed in the corona environment, and it has been confirmed that communication in cyberspace can also secure people’s bonds to a considerable extent. This trend is irreversible, as the generation of digital natives, who communicate in real time using communication tools from childhood and play games remotely, should feel more and more comfortable with building relationships in a non-face-to-face way.
Second, blockchain is indispensable to the digital environment that supports DAOs, as it enables economic activity in the digital space that goes beyond mere communication and gaming, etc. The indispensability of blockchain technology for DAOs can be summarized in two points.
The first is the smart contract function, which supports the governance of DAOs. In the context of digital transformation for analog organizations, digital technology is positioned as a tool to achieve efficient organizational management. In contrast, for DAOs, which are digital organizations, the smart contract function is positioned differently as an essential element in making the organization viable. Fair operation is the lifeline for the organization to be maintained, and governance rules exist for this purpose. The smart contract function of the blockchain is what makes it possible to systematize these rules, enforce them without room for human intervention, and make their enforcement publicly available and verifiable by anyone. The DAO will use the smart contract function, for example, to ensure the fairness of community voting, which is a collective decision of the DAO, to ensure the appropriateness of the exercise of authority by management personnel to whom the DAO has delegated authority, and to prevent the misuse of DAO property.
The innovation theme of efficiently achieving compliance by implementing rules in code to replace human commands with machine commands, thereby creating an environment in which human misconduct is impossible, is widely referred to as Regtech. The DAO’s approach to governance is fundamentally the same as that of Regtech. In DAOs, which focus on achieving goals through cooperation among members who do not necessarily have a sufficient level of trust based on the premise of a face-to-face meeting, organizational control through smart contracts is secured by replacing some of the “trust” that is a prerequisite for people to cooperate through the organization with trust in the system, which is commonly referred to as “Regtech”. This is a more critical element than the use of technology by Regtech in general, in that it is secured by replacing part of the “trust” that is a precondition for cooperation among people through the organization with trust in the system.
Blockchain technology is also an essential element in aligning the incentives of stakeholders to make a DAO organization work; for a DAO to realize its goals, it must continuously motivate stakeholders to voluntarily act toward the realization of its goals. Digital tokens are an excellent means of visualizing and rewarding stakeholder contributions to the achievement of goals. When operated under an appropriate distribution and ring-fencing strategy, digital tokens can be a tool for making the entire community function as an ecosystem, not only within the DAO organization, but also with external collaborators. Digital tokens can be broadly classified into fungible tokens (FT) and non-fungible tokens (NFT), with the former being used as community currency and the latter being used as membership tokens and digital items in DAOs. The type of economy (a.k.a. tokenomics) used to achieve this goal is determined on a project-by-project basis. Currently, each DAO project is in the process of exploring and learning methodologies for constructing efficient tokenomics.
Legal Challenges
In the above, we have traced DAOs back to the economic significance of the organization, not the existing legal system, and have reviewed the environment in which the concept of DAOs is currently feasible, specifically the elements of digital technology that support DAOs. Based on these premises, I will analyze the legal system necessary for DAOs to take root in society.
First, there is the argument that a cyberspace-native DAO, which is not defined by its physical location, may need to be brought under the application of the legal system of one of the jurisdictions.
Some of the supporters idea of DAOs might be that if they exist in cyberspace and can efficiently achieve their goals through technology and human cooperation, they do not need to be protected by law. It may be possible to evaluate such an idea as consistent with Internet-like values, at least in the early years.
However, such an idea cannot be considered legitimate now that the meaning of cyberspace in society has changed drastically and cyberspace has become an important arena for people’s activities, including economic activities.
First of all, for an organization to be recognized as a business entity, which is more than a mere individual entering into a business relationship through a contract, it must be supported by a legal system. Only law, not technology, can create a legal entity that recognizes a business entity as a group that transcends the individual. When libertarians say they want to eliminate rules and let the market decide, they often forget that the market itself is created by rules, and they make the same mistake when they say that DAOs do not need laws.
The question the DAO should be asking is whether the legal system should recognize the concept of business entities in cyberspace that have no physical location and create rules to determine which jurisdiction’s legal system applies to such entities. Developing rules to determine the governing law of business entities in cyberspace in the Internet environment, where cloud technology has no connection to physical facilities such as server locations, would be a new institutional challenge for Japan and other countries as well.
And this rule will require international harmonization as an issue related to taxation, as discussed below. In other words, it is not something that can be completed by the domestic legal regime of a single country. Currently, the UK Law Commission has launched a similar initiative on smart contracts as a separate project from the DAO, and within this initiative has launched the project “Digital assets: Which law, Which court?” to address the issues of applicable law and jurisdiction in the virtual world. This topic is relevant to the metaverse and will be an increasingly important issue in the digital economy in the future, and should be studied in depth by Japan, too.
Second, assuming that DAOs are brought under national law, an important institutional question is how to define the external legal effect of DAOs.
In other words, even if DAOs are able to ensure organizational unity and sustainability by establishing discipline among their members through their Charters, subordinate rules, and smart contracts, how DAOs are to regulate their relationships with those outside their organization to whom these disciplines do not extend cannot be resolved without institutional backup, i.e., law. There are two types of people outside the DAO: those with whom the DAO does business, and those who do not do business with the DAO.
Of these, the relationship between the DAO’s business partners and the DAO should, in principle, be governed by a contract between them. However, if the DAO is merely a group of people with no legal basis, it is unclear with whom exactly one should enter into a contract with a DAO. It is also unclear from whom one should demand performance of contract if the DAO fails to fulfill the contract, or from whom one should demand performance if the court system is to be used.
If the activities of DAOs are not merely informal activities, but provide value to the outside world by providing services, etc., then there will naturally be outsiders whose legitimate interests will be harmed by the use of DAOs. On the other hand, a third party who does not enter into a business relationship with a DAO may be able to foresee in advance the disadvantages that may result from entering into a business relationship with a DAO, and may be given the opportunity to use various techniques to defend his interests when entering into a business relationship. On the other hand, a third party who does not enter into a business relationship does not have the opportunity to protect its own interests by contract, nor does it have a choice as to whether or not it will be harmed. In order to protect the legitimate interests of such non-business third parties, it is necessary to impose discipline on DAOs and to be able to determine the party against whom a lawsuit is to be filed, but rules are needed to determine the addressee of the lawsuit.
The most fundamental argument for determining the external legal effects of the actions of DAOs boils down to the question of whether to grant legal personality to DAOs, that is, whether the activities of DAOs should be separated from the activities of individual members and considered as the activities of a separate legal entity. Under the current legal system, there are legal techniques that recognize a legal entity separate from its members and legal techniques that recognize a certain degree of legal subjectivity but do not recognize a legal entity separate from its members (general partnerships, etc.), and which legal form is adopted is determined by the strength of personal ties among the members. With respect to DAOs, a legal entity should be recognized for large DAOs with many members, while there may be cases where a legal entity is not required for small DAOs with strong personal ties, and DAO legislation should be inclusive of both those that require a legal entity and those that do not. DAO legislation should be inclusive of both those that need a legal entity and those that do not.
Then there is the question of how to divide the external liability between the DAO and its members for each DAO with and without legal personality.
In other words, even if a DAO is granted legal personality and a system is established whereby DAOs can be entities that hold assets and enter into contracts externally, it is a separate issue whether this is the case and whether only the DAO or its members bear liability to outsiders for the DAO’s external activities (e.g. a general partnership company under the Companies Act of Japan has legal personality, but its members also bear external liability). Conversely, even if a DAO is not granted legal personality, it is possible to design a system in which the members do not assume the external liability of the DAO (e.g. limited liability partnership).
In addition to private legal liability, tax liability is also an issue. In Japan, the legal system is relatively simple: if there is a legal entity, the legal entity becomes the taxpayer and is liable for taxation, and if there is no legal entity, the members are liable for taxation. However, exceptionally, if a certain organization has the substance of an association without legal personality, it is considered a corporation and its members are not liable for taxation.
The issue of taxation is particularly important for DAOs whose members are of different nationalities. This is not only important for the DAO and its members in determining whether taxation of the DAO’s income is imposed on the DAO or its members; if the granting of legal personality to a DAO results in the DAO’s income being subject to taxation in the jurisdiction of the primary jurisdiction of incorporation, a DAO without a sense of place is likely to choose its governing law of incorporation primarily based on considerations of tax efficiency. Since this issue also affects the basic authority of the state in terms of tax collection rights, a mechanism must be developed in conjunction with the DAO and its members to prevent them from easily manipulating it.
There are other institutional issues for DAOs.
For example, among the digital tokens issued by DAOs, substitutability tokens fall under the category of securities (security tokens), if a mechanism is adopted to return the proceeds of DAO business, the Financial Instruments and Exchange Law of Japan is fully applied to their issuance and distribution, and no mechanism is adopted to return the proceeds (unless it is linked to legal tender), it falls under the category of Cryptoassets under the Funds Settlement Act of Japan. If NFTs representing DAO membership are issued separately from digital tokens, the same consideration of their security nature should be applied to them as well.
The Financial Services Agency of Japan takes the position that the financial regulations do not constitute obstacles under current law, as long as the relevant regulations are complied with in a straightforward manner. However, the FSA should admit that the current regulatin, particularly in the area of securities law, does not presume a situation in which a DAO operates under fully transparent organizational control through smart contracts. In particular, membership in DAOs deployed on a small scale would have the same effect as an outright ban on such DAOs, as the cost of compliance would exceed the cost of issuance and operation of its interests if their sales were subject to strict regulation under the current FIEA. The projects that would be desrupted by this are often “seeds of innovation”, such as local projects and controversial business ideas that are valuable and could be the hope of Japan in the future, but which do not shed on light. We should be mindful of innovative regulatory design, so as not to “prevent” even the possibility of the emergence of valuable projects by focusing on preventing the risk of misuse of DAOs.
Future Outlook
As outlined above, DAOs, digitally native business organizations that are free from the concept of location, are equipped with an organizational control system based on smart contracts and an incentive system using community currency and other digital tokens. DAOs seek to “reinvent organizations” to achieve their goals through collaboration. From an institutional perspective, in order to achieve the future vision envisioned by the DAO, it will have to undergo a major reform, which is difficult to proceed gradually while ensuring legal and institutional consistency.
In order to overcome these major challenges, it is difficult to do so through cabinet bills that must pass the review of the Legislative Bureau in stacked form, and it is necessary to consider the possibility of legislators submitting bills directly to the Diet. In this sense, the “Interim Proposal on Web3 Policy” released in December 2022 by the Web3 Project Team of the LDP’s Digital Society Promotion Headquarters deserves attention. After acknowledging that there are multiple options for a legal system to realize DAOs, the Interim Proposal recommends that DAOs using limited liability companies (LLCs) be realized by first establishing special laws under the Companies Act and the Financial Instruments and Exchange Act, and then refers to the method by which this can be achieved through legislation by lawmakers. Specifically, the report focuses on changing the rule that members must be listed in the articles of incorporation, which is a fatal obstacle to using an LLC for DAOs, and paves the way for tokenization of member interests, as well as allowing room for issuing fungible tokens other than member interests.
When I explain how DAOs work, traditional companies and their employees always ask, “How does this help our business?” But that misses the point of the question. The real question is, “What kind of organization will my child work for in the future?” If you have ever seen children in a video game, slaying monsters or creating buildings together while chatting with friends on Discord after dinner, you will understand what I mean to say.
