DAOs — The Future of Corporate Governance?

We’ve been writing a lot about NFTs over the past few months. Meanwhile, many NFT projects have struggled to stay relevant and to deliver on the promises to their NFT holders and communities. However, some of the most successful NFT projects to date, are those where the project’s vision and future are dictated primarily by its community members, as opposed to its founding team.

To this end, many ‘community-first’ NFT projects have begun incorporating advanced gamification features into their roadmap in an effort to build out on project utility and have enabled their holders to vote on certain aspects of such gamification and token usage. To facilitate this, NFT and P2E gaming projects are forming DAOs, a term which we are hearing more and more frequently of late, to serve as a platform for community-based decision-making and implementation.

DAOs are a unique organizational structure in that they are not subject to a central, top-down organism, led by corporate leaders or other third-party decision-makers.

What are DAOs?

DAOs, decentralized autonomous organizations, are an integral part of Web3. In this article, we will explain what they are, some of the regulatory challenges that they face, and the advantages they pose as an alternative corporate entity structure.

Blockchain technology continues to grow at an impressive speed. At its core is a decentralized system that operates without any central authority. Blockchain applications have already been implemented to provide decentralized solutions for finance, corporate governance, and management of complex organizations, databases, and structures.

The concept of a ‘decentralized autonomous corporation’ was first briefly introduced in a 2013 blog post by Vitalik Buterin, founder of the Ethereum blockchain. A year later, Vitalik launched Ethereum, which revolutionized the way issuers connect with users, and introduced the smart contract technology upon which DAOs operate today.

The first DAO, which ironically called itself ‘The DAO’, launched in 2016, and was able to raise over $150 million in funding in what was the largest crowdfunding effort amount at the time. In doing so, it demonstrated the possibility of using decentralized organizations to pool a large number of assets among a large number of people. Unfortunately, shortly after its launch, users exploited a vulnerability in The DAO’s code, to siphon off a large portion of the sum raised, forcing the Ethereum community at large to hard-fork its blockchain in an effort to restore the stolen funds. In addition, The DAO faced another hurdle when the SEC determined that DAO tokens sold on the Ethereum blockchain were ‘securities’ and therefore possibly in violation of U.S. securities laws. Since then, developers and thinkers have attempted to address not only the technical shortcomings that the original DAO had but also the need to synchronize the legal aspect of a DAO with its technical aspects.

DAOs are a unique organizational structure in that they are not subject to a central, top-down organism, led by corporate leaders or other third-party decision-makers. In a DAO, decisions are made from the ground up, governed by a community organized around a specific set of rules and carried out by elected members that automatically execute certain actions without the need for intermediaries, all encoded on open-source blockchain protocols, and thus, 100% transparent to the public. As these rules are embedded in a computer system, they are executed automatically, ensuring greater efficiency and transparency

Let’s take a look at some of the characteristics of DAOs, which may make them an attractive organizational structure for some companies and organizations.

Fully Decentralized and Autonomous (i.e. not based on a hierarchical management structure) — Due to the code-based components of a DAOs’ anatomy, DAOs don’t typically have directors, managers, or employees. DAOs are not hierarchal organizations where authority and power flow down from investors/shareholders through a board of directors to management, and eventually the staff. These are replaced by automated protocols and community decisions and blockchain-based smart contracts take the place of articles of association or bylaws.

Member-led decision making — Each member of the DAO has the right and ability to express an idea or submit a proposal regarding the governance or management of the DAO. Indeed, membership can determine how voting and other key parts of the DAO work. Some of the more popular decision-making processes are (i) Token-Based Membership, in which any holder of the DAO’s native token may vote (e.g. MakerDAO — its native token, MKR, is widely available on numerous decentralized exchanges, allowing anyone who buys and holds it to obtain voting rights on decisions determining the future of the Maker protocol); and (ii) Share-Based Membership, in which any potential member can submit a proposal to join the DAO, usually by offering a tribute of some value in the form of tokens or services. Shares represent direct voting power and ownership, and members can leave at any time with their proportional share of the treasury. This model is typically used for more cohesive, human-focused organizations such as charities, worker groups, and investment clubs. A well-known example is MolochDAO, focused on funding Ethereum projects, which requires potential members to submit an application so that the group can assess whether applicants have the necessary experience and capital to make informed judgments about potential beneficiaries. Access to MolochDAO cannot be traded or purchased on the open market.

DAOs are not recognized as a formal legal entity in most jurisdictions — Lack of recognition causes DAOs to face (i) significant obstacles to public awareness; and (ii) unclear legal status. Without legal recognition, a DAO does not have to comply with the registration provisions of the particular jurisdiction, however, at the same time, cannot benefit from any of the privileges — such as limited liability — which are typically afforded to traditional incorporated entities. However, this is already beginning to change in certain jurisdictions. For example, under the Vermont Limited Liability Company Act, a DAO can register as a blockchain-based LLC and thus provide limited liability to its members. In addition, Wyoming has become the first state to recognize in its legislation the legal status of DAOs and grant them the same rights as limited liability companies in a law that became effective July 1, 2021. This new law does more than just provide recognition of DAOs in Wyoming, it sets the tone for other states and countries to follow suit.

Anonymity and vague regulatory framework — Most, if not all, traditional corporate entities are subject to strict anti-money laundering and know-your-customer (AML/KYC) procedures. This refers to safeguards that are put in place so that the corporate entity only deals with individuals who pass certain identity verification checks in order to ensure minimum exposure to individuals and funds which may be associated with money laundering and terrorism funding. With a DAO, individuals are typically anonymous. As a result, compliance with AML/KYC policies is very complicated, if not impossible. In addition, because DAOs typically consist of members from all across the globe, the laws of multiple jurisdictions are in play. Deciding which country’s laws apply can be difficult and is likely to result in protracted legal battles if a dispute arises.

Choosing the Appropriate Legal Structure for Your DAO.

Since the emergence of the DAO model, the benefits of a decentralized corporate body have become clear and its adoption as an alternative corporate structure has become increasingly widespread. DAOs provide a safe, flexible tool, for large groups of individuals, who may be anonymous except for their wallet address, to collaborate, pool funds, and make collective decisions that impact the entire group. However, given the challenges we noted above, DAO stakeholders may be exposed to regulatory inconsistency and in some cases, may find themselves personally liable for a debt or legal action taken against another DAO member.

There are several options for setting up a DAO’s legal structure. Below we will take a closer look into each of the different options, in an effort to understand some of the pros and cons of each.

Option №1: DAOs without a registered legal entity

The option of not creating a legal entity at all and trying to create a fully decentralized structure is widely used in the DeFi ecosystem. However, this does not mean that DAOs without a registered legal entity operate outside the law. In most jurisdictions, such unregistered DAOs will be considered as ‘general partnerships’ with corresponding legal consequences (the most significant being the risk of personal and unlimited liability of each member). However, as a ‘general partnership’, the DAO will have obtained legal entity status (albeit not its preferred status) and thus can, in most jurisdictions, legally own assets and employ individuals.

However, as previously noted, DAOs without a registered corporate entity expose all of their members to unlimited personal liability, which is a huge step backward in terms of risk management. Indeed, even if the DAO is not formally registered, its creation constitutes, de facto, the formation of a recognized legal entity in most jurisdictions that can sue and be sued. Furthermore, if the DAO is hacked or goes bankrupt, or is liable to a third party, each member will likely be exposed to shared liability for all indebted amounts.

Despite the aforementioned risks, 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 launched anonymously, legal enforcement becomes quite difficult.

Moreover, finding the applicable law and the responsible regulatory authority can be challenging in the case of a fully decentralized DAO, making enforcement very difficult. This is because DAOs, unlike traditional organizations run by individuals living in distinct and identifiable territories, are collectively managed by a distributed network of peers who contribute to the underlying blockchain-based network from anywhere in the world.

In any event, determining whether a project is sufficiently decentralized to avoid regulatory scrutiny for the unregistered sale of securities is a highly nuanced and complex process. No single factor is determinative and regulatory authorities will take into account the totality of the circumstances in making this determination. It is, therefore, very important to obtain competent legal advice in this regard.

Given the above challenges, one plausible alternative DAO structure is a registered, limited liability DAO.

№2: A DAO with a limited liability incorporated as BBLLC or Legal DAO (LAO) in the U.S.

Since mid-2018, it has been possible to establish a Blockchain-Based Limited Liability Company (BBLLC) in Vermont. By linking the DAO to the BBLLC entity, the DAO obtains formal legal status which allows it to enter into contractual agreements and limit its members' liability, while governance is carried out through the blockchain and using smart contracts.

Another option is the Legal DAO (LAO), launched in 2019 and powered by the smart-contract initiative, OpenLaw. Smart contracts handle the mechanics related to voting, financing, and the allocation of the funds raised. Members receive tokenized shares or utility tokens. The OpenLaw protocol generates entity formation documents and member subscription agreements. The LAO is anchored by ten founding members, and other interested parties can potentially buy interests through a public sale. OpenLaw serves as administrator of LAO but does not exercise any control unless directed by members.

Ultimately, these structures are not “purely” decentralized, however, they’re still good options as far as member protection is concerned, especially for organizations willing to operate within the United States and forgo certain aspects of decentralization.

№3: The DAO Supplement: Wyoming DAO LLC

In 2021, Wyoming introduced a bill — ‘The DAO Supplement’ — which allows Wyoming to recognize DAOs as limited liability companies managed by rules encoded in smart contracts that are built on distributed ledgers, with minimal human input.

The DAO Supplement was created to provide liability protection for members of DAOs that are organized as Wyoming LLCs that may otherwise be personally liable for DAO actions and obligations. The DAO Supplement shields DAOs from being treated as general partnerships in legal disputes. While members of an LLC have a fiduciary duty to the organization, members of a DAO are subject only to the implied contractual covenant of good faith and fair dealing. Furthermore, the DAO’s articles of organization can either define the DAO as member-managed or algorithmically managed. Algorithmically managed DAOs may only form if the underlying smart contracts are able to be updated, modified, or upgraded.

The DAO Supplement requires that in order to be considered as a DAO LLC, each DAO must: (i) include in its articles of organization the publicly available identifier for any smart contract directly used to manage, facilitate, or operate the DAO; (ii) include either the abbreviations or wording (such as DAO, LAO, or DAO LLC) in its registered name to specifically denote its status as a DAO; (iii) amend its articles of organization if there is a change in the DAO’s name, a false or erroneous statement in its articles of organization, or an update or change to the DAO’s smart contract; and (iv) continuously maintain a registered agent in the state of Wyoming.

While this new legal framework does not address all DAO-related issues, it does clear up the potential liability faced by members of a DAO and mark a significant step forward for the recognition of DAOs as legal entities.

№4: Decentralized Autonomous Associations (DAA), Switzerland

Another available structure is a Swiss DAA. By using an existing Swiss legal construct, this third-generation DAO takes the Swiss Civil Law Association and adds a decentralized smart contract layer to replace the centralized governance process.

A Swiss DAA consists of a community of members in which each member has one vote and which is not capital-driven, but is a voting and membership-driven legal entity. It is formed by a group of individuals who express their intention to form such a legal entity. No legal action before a notary or formal registration is required to form a DAA. To create a DAA, individuals meet as a group, draft the statutes of the association, define the purpose and how the purpose will be financed, and identify the membership fee, as part of a smart contract.

The main objective of a DAA is to establish a decentralized and democratic legal entity structure with minimal hierarchy and centralization, combining the benefits of a recognized legal entity structure with the efficiency, transparency, and democracy of blockchain-based governance. However, the biggest challenge this structure presents is a technical one given that in the event of any error in the drafting or deployment of the DAO’s smart contract, the resolution of a code problem is not solved as simply as in a ‘traditional’ dispute.

№5: A DAO as an NGO

Although many DAOs are for-profit organizations, they can also be set up as non-profit organizations (NGOs) to aggregate capital and finance specific projects (environmental, charitable, housing, social, etc.) based on the votes of the members.

The NGO is a remarkably flexible vehicle that functions as an incorporated trust, allowing it to function as a civil law foundation or a common-law trust while retaining the separate legal status and limited liability of a company and tax neutrality. Furthermore, an NGO does not need to keep a register of its beneficiaries with their legal names, rather it can designate beneficiaries by class of persons, for example, “token holders” or “node operators”, and also reward those beneficiaries according to that class. While AML considerations should always be kept in mind, this could be useful for DAOs intending to make distributions, token airdrops, or other rewards to their community, while retaining the anonymity characteristic of web3.

It should be noted that, unlike fully decentralized bodies, each NGO must have at least one director, one supervisor, and one secretary. These can be individuals or legal entities, and the same entity can be both Director and Secretary if desired.

Summary

Within the world of technology and web3, the formation of DAOs is an important step in the way individuals can come together, democratically, on their own terms to achieve their own goals. In the past, laws, and values could only be enforced if key members at the top of the pyramid allowed it. Now, DAOs are eradicating the top-down approach by automating processes and democratizing control. This ‘more power to the people’ approach is reflective of a change we’ve begun to see in many facets of world evolution (not just in corporate governance) and may play a key role in resolving many of the current challenges traditional corporations face.

Taking this thought process to a deeper level, one of the great things about the blockchain industry is that the boundaries of what is valid and accepted in society are constantly expanding and moving forward. Cryptocurrency has forced us to question what we consider a currency and DeFi has shown that financial ecosystems can exist outside of traditional structures. If the growth of DAOs continues, it could become a standard within the world at large, putting an end to old problems and creating a more efficient and equitable corporate structure.

In this sense, DAOs are undoubtedly the next generation of financial and business innovation. DAOs offer many advantages over traditional enterprises, such as decentralization, member voting and decision making, automatic code execution through smart contracts, and pooling of resources and funds. However, the creation of a DAO without a legal entity may face numerous legal challenges and give rise to potential enforcement actions and civil liability, not only at the organization level but against individual participants, exposing each member to personal, uncapped, liability. Issues of public policy, market, economics, and technical limitations may also arise.

In an effort to gain a more steady footing, DAOs are constantly and rapidly evolving. As such, if you are thinking of setting up a DAO, or becoming a member of one, it is important to consult with competent legal counsel to understand the various regulatory hurdles which may apply to you.

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DLT LAW’s legal team includes highly professional blockchain lawyers and industry specialists. Our lawyers write about the legal and regulatory aspects of the emerging worlds of blockchain, crypto, DeFi, NFTs, metaverse, and Web3, drawing on their vast experience in these fields.

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Yitzy Hammer

Yitzy Hammer

Partner @ DLT LAW | Commercial lawyer | Blockchain, NFT, crypto, metaverse and Web3 investor and strategic advisor.

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