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What Kind of Legal Entity is a DAO?

The term DAO stands for Decentralized Autonomous Organization. It is commonly thrown around in the crypto space, but does it have any legal significance? The following is not legal advice. Also, some of it is bullshit and I welcome correction. But you must be wrong before you can be right.

Let’s begin by using the following definition of a DAO*:

A DAO is an organization whose governance is determined based on the ownership of a token represented on a blockchain

There’s a lot of ambiguity here, but I don’t want to get too bogged down just yet. From a legal perspective, as soon as such an organization is formed it can be recognized as an “association” based on the following principle.

Any time you join together to accomplish a goal, the law recognizes an association

Some important entities on the blockchain may not even be considered associations. For example, the structure of Bitcoin may be considered uncoordinated/emergent in some sense so that owners of Bitcoin don’t form a legal association.**

Aside from completely decentralized entities like Bitcoin, one key distinction is whether an association is organized to make a profit. If not, it might be able to form as a non-profit organization. But let’s assume that it is looking to profit. Then by default, it is likely to be considered a general partnership.

If the purpose of the association is to make a profit, by default it can be considered a general partnership***

One problem with a general partnership is that the members (in this case, the token holders) have liability for the actions of the association. That is, if something goes wrong someone could potentially go after all your assets just because you own a governance token.

General partnerships have unlimited liability

Traditionally, governments have created various ways to avoid the problems associated with unlimited liability. The main way is to create a corporation or a limited liability company. In a sense, forming a corporation does not create a new legal entity (because an association was formed as soon as people started cooperating for a profit). If just gives a corporation certain additional properties, such as limited liability.

An organization obtains limited liability by registering as a corporation

However, if you register as a corporation, you may have certain reporting requirements. For example, it may be necessary to keep track of the identities of the owners, and you may be considered a security by the SEC, even if the legal entity is an LLC.

Shares in an LLC will be considered security unless all of the members actively participate in the management of the company.

So at first blush, it looks like DAOs are stuck between a rock and a hard place, specifically: they either operate as a general partnership with unlimited liability, or they must register as a corporation and submit to being considered securities. (Of course, they might be considered securities anyway, but that is another story).

There are a few basic strategies for avoiding either of these fates:

  1. Be so decentralized (like Bitcoin) that you aren’t even considered an association
  2. Form an LLC and make sure that everyone who owns tokens participates in the management of the DAO
  3. Register as a non-profit
  4. Form a trust with the token holders as beneficiaries, and only take legally significant actions through the trust

The last option is probably the most difficult to comprehend, and it might not even work. So let’s examine it further. Here is simplified version of one potential model:

Credit for this idea goes to various members of the LeXpunK Army, especially Larry Florio

As a reminder, the purpose of this model is that:

  1. token holders can vote on the direction of the DAO
  2. token holders don’t have unlimited liability
  3. token holders don’t have to directly participate in management
  4. someone can directly participate in management decisions

In this model, a trust is created that owns an LLC, with the token holders as a beneficiary.

To avoid being considered a general partnership, the token holders have to avoid taking any action that could be construed as coordinating together to make a profit. The standards for that are far from clear, but for now I am going to assume that simply making an advisory vote about the proper direction of a community does not make you a general partner. The details of what limits should be imposed on the DAO to avoid unlimited liability are yet to be worked out, but limits there must be.

The trust is there to create a connection between the (purposefully amorphous) group of token holders, and an LLC that can actually act on behalf of the community. All of the members of the LLC can participate in management of the LLC directly, so they can avoid being considered a security.

The Trust contract can specify that the Trustee should act on behalf of the token holders, taking DAO votes as evidence of what is considered in the best interest of token holders. In other words, the actions of the DAO are simply limited to voicing a vision of the world, and they never actually do anything about it. The LLC (owned by the trustee) takes all actions toward achieving that vision.

One other issue that should be mentioned is how the Trust/LLC should be funded. A few considerations on that point:

  • The DAO itself may need to avoid having a wallet that sends coins in order to avoid the appearance of being a general partnership (because sending coins might be the kind of thing that looks like cooperating for a profit)
  • If the Trust/LLC takes money from unknown sources it can be subject to anti-money laundering laws

Without going into too much detail, one possibility is for the Trust/LLC to create a funding token that initially have little to no value, and then create a liquidity pool on a decentralized exchange. People in the DAO (or anyone else) can then participate in the exchange, thereby lending the tokens value in a decentralized way.

If this idea is terrible, all the blame is on me

Maybe this funding method is too cute, but it represents an attempt at a decentralized method for a community to create value in a legal entity such as an LLC.

So that’s it for now…would love to hear your thoughts and criticisms of any aspect of this (admittedly half-baked) thought process.

Updates:

*As some have pointed out, this is not actually a good definition of a DAO. DAOs don’t necessarily have tokens, and some tokenized organizations might be too centralized to be considered a DAO.

**One difference between truly decentralized organizations and simply democratic organizations is the existence of an executive power. If individual votes lead to an action taken by a single, indivisible executive power, that might be democratic, but not truly decentralized. Think of the difference between a school of fish and an boat of democratic pirates. The movement of a school of fish is simply the sum of individual movements. But once pirates vote, they are all in the same boat.

***This is also not strictly true, and you don’t have to be a GP to have unlimited liability…the point is that associations don’t have limited liability, that is something granted to particular kinds of legal entities

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Redbeard

Redbeard

Patent Attorney, Crypto Enthusiast, Father of two daughters