What are DAOs?
To the uninformed, Decentralized Autonomous Organizations (DAOs) likely come off as simply one of the latest marketing ploys in the crypto space, but to the informed, they fundamentally change how companies can be run and governed.
In the simplest terms, DAOs are organizations that operate under the same basic concepts as a traditional company, but where no traditional managerial hierarchy exists. In its place instead is a flat hierarchy where all members are given a right to vote on strategic decisions usually reserved for management.
Take, for example, Amazon. Jeff Bezos, as CEO, has controlling authority over executive decisions, such as whether the company will accept cryptocurrencies as payment on its platform. Imagine if, instead, all Amazon Prime account owners had this decision-making power and voted on whether Amazon would accept cryptocurrencies. This represents a shift from central management to a collective decision-making process.
In more technical terms, a DAO is an organization governed by a series of smart contracts which enable the organization to function autonomously, without the need for a central intermediary or authority as members interact with each other and make decisions according to the protocol specified in code and enforced on the blockchain, i.e., software-codified bylaws and articles of incorporation for an organization.
For those unfamiliar, smart contracts consist of immutable computer code that runs on top of a blockchain protocol that self-executes pre-determined transactions when defined conditions are met, allowing for trustless transactions to be carried out by anonymous and independent parties around the globe. Tasks ranging from decision making to voting, to automatic profit distributions can be done through smart contracts. Thus a DAO brings forward the concept of organization-as-code, or an organizational setup based on rules and policies that are encoded as computer code, and run automatically independent of human intervention.
As to making such a form of corporate governance possible, DAO smart contracts generally include the creation and distribution of some form of native or governance token, that the DAO would not only use as a reward mechanism but would use in voting on member-proposed strategic decisions. Such governance token holders would be considered de facto members of the DAO, and while a token is often enough to make one a member, there may be benefits to owning larger amounts. For example, token holdings sometimes determine the weight of one’s vote in strategic decisions related to the DAO.
What results is a fully operational autonomous organization, independent from any central authority and able to exist, even when members neither know nor trust each other. If one is new to the concept of a DAO, you may be asking if they are truly necessary. However in the abstract DAO’s can resolve issues often found in the traditional organizational hierarchy, such as how good ideas may struggle to reach the top of the hierarchy, to lack of transparency in decision making, to failure to tap into the wisdom of the organization’s collective.
Today, DAOs are frequently deployed for many purposes such as decentralized finance (DeFi) governance, fundraising, exchanges, etc., with notable players including MakerDao, Aragon, and Digix to name a few. However, they can be used for a much broader range of applications, including but not limited to: developer collectives, worker collectives, art collectives, community collectives, social media, metaverses / virtual worlds, trust funds, sports clubs ownership, media/entertainment intellectual property, and politics.
Smart Contracts as Legally Binding Contracts
At the risk of repeating the aforementioned, DAOs can be boiled down to corporate governance agreements written in computer code and interpreted by a blockchain. This achieves uncompromisable autonomy given smart contracts execute code exactly as written, exactly as programmed. This is a double-edged sword; a smart contract’s code once deployed on a blockchain is immutable. Thus in creating a DAO, one must take care in utilizing either well-thought-out articles of associations and bylaws or methods which allow for the governing documents to be amended with ease.
Although DAOs may opt to adopt terms and conditions that govern a member’s participation in the DAO, the DAO’s codified articles of association and bylaws will control over all other documents. Any and all explanatory terms, descriptions, or disclaimers offered by the DAO are merely offered for informational purposes and do not supersede or modify the express terms of the DAO’s governing smart contract.
How are DAOs treated in Court?
Given DAOs are a relatively new form of corporate governance, it is worth asking whether these kinds of organizations are legally recognized, how would courts view such organizations, and what protections under the law would be afforded to them as well.
For purposes of this Article, when thinking of DAOs, it is best to keep three types in mind: i.) an “unformed DAO”, ii.) a “wrapped DAO” and iii.) a “true DAO”. The first, a DAO run by members in an unassociated partnership scheme; the second, a DAO that utilizes a traditionally recognized legal entity structure, with DAO features built into the company’s governance structure, articles of association, and bylaws; and the third, organizations formed as recently recognized DAO LLCs (e.g., Wyoming’s DAO LLCs).
What are the Differences Between Unformed DAOs, Wrapped DAOs, and True DAOs?
As to unformed DAOs, most states in the U.S. under current laws would treat DAO participants as “partners” in a common-law partnership, as often is the case with an association of two or more persons for the pursuit of profit. Such a designation not only ultimately exposes a participant’s personal assets to the DAO’s potential liabilities (e.g., tort or bankruptcy-related liabilities), but it may also mean that token-holders also owe each other fiduciary duties as partners. Practically speaking for the industry as a whole, such risks may dissuade potential members from participating in such organizations.
A wrapped DAO on the other hand would make it so that creditors and litigants can only reach the LLC’s assets. Whatever a DAO’s purpose, how you form the underlying legal entity depends on where you are. Every jurisdiction has its own corporate law and registration requirements.
That said, general concepts will apply across the board when initially incorporated. At a minimum, requirements include: i.) registering/filing with a Secretary of State’s office, in the Corporations Department, etc.; ii.) pay a filing fee; and iii.) file articles of association, by-laws, shareholders agreement,s or other similar governance documents as required by the chosen jurisdiction. There are of course subsequent ongoing responsibilities, such as filing requirements, annual reporting requirements, annual fees, etc.
Although any form of legal entity can theoretically work, given the goal of a DAO is to allow for a flat hierarchy where all members have the right to control the DAO’s governance, one should opt for a member-managed LLC where allowed, given a corporation inherently has the traditional organizational hierarchy built into its corporate governance, i.e. a board that makes all strategic decisions, etc.
Taking things one step further from wrapped DAOs as formally recognized legal entities, true DAOs enjoy the same limitations on individual liability afforded to members of traditional limited liability companies. Protection for DAO members is formalized by prohibiting lawsuits against DAOs as general partnerships and enforcing the rights of DAOs as legal persons in state court, thereby protecting members individually.
Why formally recognize a DAO LLC as its own legal entity?
Take, for example, The DAO and its infamous loss of $3,600,000 worth of Ether in June 2016 caused by a hacker exploiting a bug in the DAO’s software. Because The DAO was decentralized, there were no terms and conditions or governing laws, which arguably meant that the exploitation could happen without legal repercussions as there would be no breach of some duty or right.
As new DAO use cases emerge, it is important to clarify the legal status of these entities given that without legal recognition, members are not protected under limited liability laws, and are potentially subject to personal liability, meaning that members’ individual assets may be seized in order to satisfy the DAO’s obligations, etc. Further, DAOs have the added legal complication that the members may be global, and so only members in the country where the case is being heard may be liable. This makes the risks of running an Unformed DAO without the protection of an LLC even higher. For example, if an American forms a DAO with citizens of other countries, non-American members may inadvertently not be held liable if an American sues the DAO, because the damages would primarily be recovered from the American’s personal assets through the legal system. It would then be up to the Americans to try to recover the damages from the other non-American members, which would prove difficult if not impossible. If one utilizes a Wrapped or True DAO format, only the DAO’s assets would be at risk if the DAO was sued.
In terms of why jurisdictions should look to legally recognize DAOs, they should do so in order to protect against systematic risks made possible by a DAO’s decentralized nature. Unformed DAOs for example are inherently stateless and faceless, given membership is often pseudonymous since only a governance token is necessary to participate in one. Disclosures in the code of the DAO, or in the technical specifications of a project proposal may help identify the creators of a DAO, but more often than that, this may not be the case. If individuals were defrauded by a DAO, how would they seek relief in a court? A lawsuit naming a DAO as a defendant would likely stall immediately because of the difficulty of identifying a proper representative with standing to represent it. Jurisdictions can mandate that DAOs have a registered agent in the chosen jurisdiction of incorporation so that lawsuits may properly be served in order to ensure that DAOs are subject to the legal system, as any other organization may be.
In writing relevant legislation, jurisdictions can aim to clarify a variety of other questions that may affect lawsuits seeking relief from DAOs. Jurisdictions can answer whether it necessary to obtain jurisdiction over any person who represents a DAO where the injured plaintiff resides; whether litigants may be required to bring actions in multiple jurisdictions to obtain relief; or other relevant questions such as who has standing and who may bring claims against whom.
Where are True DAOs Recognized?
The Wyoming DAO Law was created to address these issues. On March 17, 2021, Wyoming’s state senate passed the Decentralized Autonomous Organizations Supplement (DAO Supplement), a bill aimed at providing a legal framework for an entity that had not yet been contemplated by federal, state, or foreign legislatures.
Under the new law, a DAO is a limited liability company whose articles of organization contain a statement that the company is a decentralized autonomous organization. The law mandates that a DAO must maintain a presence in the state through a registered agent and would need to include in its name a proper designation such as “DAO”, “DAO LLC” or “LAO”. Further, the law makes it so that the DAO can be “member-managed” or “algorithmically managed”, as set forth in its articles of organization (if the latter, the underlying smart contract must be able to be updated, modified, or otherwise upgraded). The articles of organization and/or the smart contracts of the DAO will also govern such aspects as relations among the members, rights, and duties of each member, voting rights, transferability, distributions, and amendments. In addition, unless provided for in the articles of organization or operating agreement, no member has any fiduciary duty to the DAO or any member other than the implied contractual covenant of good faith and fair dealing.
As of the writing of this Article, true DAOs are only formally recognized in Wyoming, whereas the proposals for recognition are currently underway in Australia.
Other Considerations for DAOs
- If capital is being raised, you also need to think about securities laws issues — in the US, both federal and state law may be implicated.
- An Unformed DAO cannot have a bank account in most jurisdictions, for example in the United States., a tax identification number is required.
- Depending on the area of operations the DAO is intended to focus on, members may need to consider insurance in order to limit liability
- If one forms a Wrapped DAO or True DAO and does not respect the laws and requirements that they are subject to (e.g., using the DAO’s funds as one’s personal funds to make purchases unrelated to the DAO’s purposes), a court can disregard the entity in later litigation, i.e. piercing the corporate veil.
- Caution must be exercised in choosing a DAO’s purpose and function. For example, if a DAO is offering a banking or insurance product, regulatory requirements will undoubtedly be triggered.