Tackling legal issues: how to set up and run a DAO

In its many shapes and forms, the DAO, or Decentralized Autonomous Organization, has emerged as a novel structure that’s especially popular among crypto-native communities. Whether set up to serve as collective investment schemes analogous to Limited Liability Companies, or as public DAOs that are run much like public companies, there are many ways to approach administrating these organizations.

For our much-anticipated panel, “Navigating murky legal waters,” we invited four experts to share their perspectives on the legal issues around DAOs. The panel was part of Finoa’s “Through the DAO prism” event that took place during the 2022 Berlin Blockchain Week.

This article summarizes the conversation between Dr. Nina Siedler (Partner at MHL), Christoph Simmchen (Co-Founder at Safe), Daniel Resas (Co-Founder at Bubbles), Aurelia Nick (Legal Advisor at MME), and the Berlin crypto community. It gives an overview of the legal risks and responsibilities of DAO members and offers some guidance for tackling some of the common challenges facing DAOs today.

Why should DAOs have a clear legal structure?

Having a defined legal entity is helpful because it can shield members from liability while offering flexibility and a way to circumvent securities laws regulation. In most cases, a “legal personality” or representation for DAOs is needed to deal with questions of taxation, but also to own property, and enter contracts.

Depending on the regulatory jurisdiction, structures such as cooperative societies, associations, and foundations can be set up to represent the DAO. As Dr. Nina Siedler pointed out, among the three options mentioned, the foundation (Ger. “Stiftung”) is the least advantageous because of its non-democratic management process.

In a German association, the law is such that the foundation is exclusively governed by an association, and rules are enforced by a Managing Director. Other regulatory jurisdictions such as Switzerland offer advantages because they can provide substance to the legal representation of DAOs while offering certain tax benefits. The high number of crypto startups registered in the small town of Zug, Switzerland, stands as proof of the benefits afforded by the regulatory clarity in this jurisdiction.

What risks must DAO members reckon with?

One particular aspect that DAOs must keep in mind is whether the shares they are managing (such as their token treasury) can be viewed as tradable securities. If the regulators identify the DAO’s tokens as securities, members can be made responsible for securities trading and be held accountable according to local law.

The second aspect that can make DAOs susceptible to regulatory control is whether the organizational structure is such that a single person can be identified as a “provider” of the service that the DAO is supposed to provide. As such, decentralization is not just a feature to strive for but needs to be incorporated into the structure of DAOs.

The risk of liability is especially high for DAOs that offer services such as DEXs. As token exchanges are regulated under MiCA, regulators will look for a singular owner who will have to shoulder the bigger part of the risk.

Who is responsible for liability claims in a DAO?

Dr. Nina Siedler said that, in the case of liability claims, the first step is to look at the structure and see whether there is a defined entity or not. In Germany, the default entity is the civil law partnership, which needs no notary approval. “When you have more than one person working on a mutual goal, that’s a civil law partnership,” she added.

There are similar structures in any developed jurisdiction. The civil law partnership structure implies unlimited liability for all the members, meaning that DAO participants need to find solutions to shelter their personal lives from liability.

What challenges come up once the DAO is set up?

Even after you’ve found a structure that accurately represents the organization, the main challenge is to involve members. With typical participation rates in the single digits, involvement with DAOs is comparable with retail investors’ participation in the traditional capital markets.

According to Daniel Resas, another challenge lies in establishing appropriate information flows that can streamline communication and resolve both information overload and information asymmetries.

“Failing at communication means jeopardizing the success of your project”, added Resas. In the same way that investor relations are underrated in the traditional capital markets, DAOs should prioritize communications to keep their contributors engaged.

“Flawed communication can lead to a drop in participation, especially when members are asked to vote on protocol updates that they don’t understand,” continued Resas.

How can DAOs solve communication problems?

Christoph Simmchen believes that decentralization brings with it higher information and coordination costs: “Delegation is one solution, but it cannot solve everything.”

Financial incentives have the potential to improve participation. Schemes like “govern to earn” are poised to attract more subject-matter experts who can work on strategic projects.

“The project is always changing under the influence of secondary markets, and that means you need a core team who can work on strategy,” added Simmchen.

When asked about using Discord as a communication tool, Daniel Resas said that it can be a great tool, but that curation layers are needed to introduce structure and prevent information overload.

“The ‘garbage in — garbage out’ problem will continue to persist if there is no effective curation. Mismanaging investor relations can be a big issue for projects, and most projects existing today are not very good at communicating with their community of token holders.” — Daniel Resas, Co-Founder at Bubbles.

How can DAOs enable more contributors?

Safe Co-Founder Christoph Simmchen suggested that to activate more contributors, there are three essential areas of innovation:

• The ways of assessing the quality of individual contributions
• Streamlined communications that take into consideration different levels of expertise (especially for members without a technical background)
• Financial incentives, such as “govern-to-earn” schemes.

If I were to build a DAO tomorrow, what should it look like?

To answer this question from the public, Dr. Nina Siedler commented that there isn’t one structure that fits all. She added that the structure of a DAO should more closely resemble state governance rather than corporate governance. In addition, it should be membership-based and group different stakeholders into different entities.

“In the case of validators, it makes sense that they should group under a co-operative, as this association clearly has an economic goal. But every structure is, above all, dependent on the purpose of the association,” added Dr. Siedler.

The key recommendation is to build a roof on top of the entities, so as to have an association of entities that helps to differentiate the stakeholder groups and their respective interests.

Final thoughts

It’s clear that every decentralized organization must consider its own goals and long-term vision when finding an appropriate legal structure. Depending on the motivations of their members, DAOs have the challenge of coming up with innovative ways to enable contributions that take into account the informational challenges posed by decentralized governance.

Above all, DAO members have to be careful about the ways in which they get involved and seek regulatory clarity in order to limit individual liability and find ways to ultimately drive the success of the organization.