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Decentralised Autonomous Organisations Part 1 : What are they in law?

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The Law Commission of UK described Decentralised Autonomous Organisations (or DAOs) as “... a novel type of organisational structure involving multiple participants online, that might rely on a blockchain systems, smart contracts, or other software-based systems (which are often open-source)”. Not very helpful in trying to understand what is a DAO (pronounced ‘dow’).

A less ‘stoggy’, more hyped description can be found in the New York Times which described it as “… a new kind of organizational structure, built with blockchain technology, that is often described as a sort of crypto co-op. (Or, alternatively, as a “financial flash mob” or a “group chat with a bank account.”)”. Still not very helpful but it gives you an idea of the difficulty in trying to understand what is a DAO.

In its purest form, a DAO is a group that is formed for a common purpose, like investing in start-ups, managing a stablecoin or buying a bunch of NFTs. ConsenSys, a blockchain organisation, defines DAOs as “governing bodies that oversee the allocation of resources tied to the projects they are associated with and are also tasked with ensuring the long term success of the project they support.

Once formed, a DAO is run by its members, often through the use of crypto-tokens and smart-contracts. These tokens often come with certain rights attached, such as the ability to manage a common treasury or vote on certain decisions. So, in theory, the rules governing a DAO (the DAO protocols) are found in its code. Someone described a DAO as a driverless car cruising around in a ride-sharing role following its programming.

Although most DAOs have been focused on cyber-related projects, they have expanded beyond the cyber realm. For example, “SPADs”—which are SPACs (special purpose acquisition vehicles) that are DAOs—have emerged to engage in the acquisition of physical target companies. Some enthusiasts, dubbing DAOs “the new LLCs,” expect that they will become a significant form of business entity in the very near term. How real is this enthusiasm remains to be seen.

What is clear is that a DAO is some sort of an organisational structure. It relies on technology, often some sort of blockchain, to group people together for a common purpose, often commercial but not always. Notwithstanding the uncertainty of what it is, according to a 2021 article by Consensys (https://consensys.net/reports/defi-report-q2-2021/ accessed on 18 June 2023), the 20 largest DAOs hold US$6 billion worth of digital assets! A lot of people have enough faith in DAOs to invest in them, legal uncertainties notwithstanding.

One last area to be covered briefly are the participants in a DAO. The key participants are first, the creators of the DAO. These are the people who conceptualise and define the goals of the DAO, set the DAO protocol, develop the code, and then launch the DAO. Second, would be the developers who may or may not also be the creators of the DAO. If they are not, they will be third parties hired to code. They are usually paid using the tokens of the DAO. The final important group will be the holders of the token. Usually, they are the investors or members of the DAO. Their investments, often in the form of crypto-currencies, will be held by the DAO in its treasury (akin to a bank account). Sometimes, these investors or members of the DAO are also the miners (proof-of-work tokens) or validators (proof-of-stake tokens) of the tokens. Sometimes the miners or validators are only the creators, developers, and early funders of the DAO. If so, the DAO is likely to have two different types of tokens: governance tokens (for that special group) and other tokens (for the others), the equivalent of voting shares and non-voting shares in some companies.

Advantages of DAOs

So long as a DAO has a valid purpose with properly programmed rules for its smart contracts, a DAO can offer its members the following advantages:

  • Direct control. A DAO gives their members direct control over the organisation’s operations, without intermediaries like directors, managers, or bankers who may misinterpret a member’s intent, make mistakes or intentionally disloyally members’ instructions.
  • Transparency. Every action taken is recorded on the blockchain and blockchain data by its very nature is easily accessible online to every member.
  • Efficiency. DAOs (in their pure entityless form) can be set up quickly and easily than traditional legal entities; have easy access to individuals worldwide to become members; and can be run without the significant overhead costs of traditional legal entities. Also, internal decision-making processes can be started easily and instantaneously with widespread and varied input from, actual stakeholders. In theory, this should lead to better decision-making.
  • Trustworthiness. DAOs operate via self-executing smart-contracts. This ensures that DAO funds cannot be used in violation of the DAO’s operating rules. Also, as the smart-contracts exist on an open-source blockchain, every transaction, modification or audit recorded on the blockchain is available to be reviewed by everyone on that blockchain. A comprehensive, immutable record is maintained, making it more difficult for any single member or stakeholder to hide a fraudulent transaction or other wrongful activity.

Disadvantages of DAOs

The nature of DAOs gives rise to the following inherent risks:

  • Potential fraud. The informal, autonomous, and decentralised nature of DAOs can result in investors being defrauded or misled after the funds are raised.
  • Crypto-related risks. As most DAOs are related to crypto projects, they also face similar risks that crypto-currencies face, most significantly the wild fluctuation in the value of the funds held in their treasuries, given the instability in pricing that is associated with crypto-currencies
  • Code flaws. Coding flaws in the blockchain software or in the smart-contracts on which they run has resulted in the loss of significant funds held by DAOs. One of the earliest of such incidents is told below in the section about “The DAO”.
  • Cybersecurity breaches. This is self-explanatory in light of the numerous reports of hacking involving theft of crypto-currencies from crypto-wallets and funds held in the DAO’s treasuries.
  • Lack of legal status and potential for unlimited liability. As discussed further below, unless a DAO is organised as a legally-recognised entity, an entityless DAO can potentially expose its members to unlimited liability if something goes wrong. The lack of legal status also makes entering into and enforcing contracts more difficult and uncertain.
  • Securities law compliance. The laws of many countries view investments into a business-related DAO and the token it issues as “securities”. Securities regulations often require disclosure of price-sensitive information, registration of the ‘investment’ managers, and the reporting of its activities. The nature of a DAO makes compliance of such regulatory requirements almost impossible.
  • Governance-related issues. The governance model of some DAOs is not as rosy as they seem. Often a small group of founders, holders of significant amounts of tokens, and/or others interested in being actively involved may become a de facto control group of decisions made by the DAO.

Notably, many things concerning DAOs continue to be somewhat amorphous. Its structures, commercial and other applications, industry norms, as well as applicable legal and regulatory schemes, are still in nascent stages of development.

The Story of The DAO

One of the early attempts to create such an organisation was aptly called ‘The DAO”. Launched in 2016, The DAO failed rather dramatically in a matter of months. The plan was for investors in The DAO to receive tokens proportional to how many Ether tokens they invested in the project. With those tokens, they could vote on which projects to fund. For selecting projects to invest in, it relied on the “wisdom of crowds,” the idea that decisions made by a large group of people voting often lead to better outcomes than a single director, or even multiple directors making the decision. If the projects that were invested in profited, the profits would be distributed back to the investors. The code was perpetual and unstoppable.

Unfortunately, there was a bug in The DAO. It allowed an attacker to steal the funds locked in The DAO. Investors watched, unable to do anything, when the attacker systematically and slowly drained The DAO of funds, as technically the attacker was following the rules of The DAO.

The solution required the intervention of Ethereum’s lead coders to reverse the transactions on the Ether blockchain, to return the funds to their rightful owners. The decision to intervene was controversial (remember that one of the tenets of the blockchain was that it is immutable) but, some would say, lead to the Ethereum of today.

The DAO was investigated by the SEC which found that the DAO tokens it issued were securities and subject to federal securities laws. The issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies. Those participating in unregistered offerings also may be liable for violations of the securities laws. Additionally, securities exchanges providing for trading in these securities must register unless they are exempt. However, in light of the facts and circumstances of the case, the SEC decided not to bring charges but rather to caution the industry and market participants.

Legalities for DAOs – What is it in Law?

The DAO story illustrates the risks involved in investing in and creating DAOs: technological, commercial, and legal. We will focus on the legal issues and risks.

Without specific legislation concerning DAOs, it will mean having to fit them within existing legal structures. Thus our first problem arises. Laws are territorial in nature while DAOs, by being decentralised are by definition, not.

A number of states in the USA (such as Vermont, Wyoming and Tennessee) have legislation covering the creation and registration of DAOs and similar block-chained based entities. Many countries do not.

Apart from DAOs registered under these laws, what then are the other ‘entityless’ DAOs? There are a number of possibilities: the two that immediately come to mind are (a) unincorporated associations and (b) general partnerships. Unincorporated associations are generally “not-for-profit” organisations and might not be suited for commercial-based DAOs. Commercial-based DAOs are likely to be general partnerships. The key weakness in either of these structures is that participants in a DAO face unlimited liabilities should anything go wrong. Further, the lack of legal status makes (a) entering into and enforcing contracts; and (b) holding property, more difficult and uncertain.

A proposed solution used for some DAOs to get around these problems is to “wrap” them in a recognised legal entity and try to adapt the rules of such entities as much as possible to the DAO-based principles. Such recognised legal entities include the Limited Liability Companies of many US states, and the Foundations of many tax heaven countries. Of course, using legal wrappers adds to the costs and complexity of organising and running a DAO and, fundamentally, contradicts the autonomous nature of DAOs. Disclosure requirements found in many such regulations might also not fit within DAOs that seek to keep the identity of its members private or anonymous.

DAO as an Unincorporated Association

There is no statutory definition of an “unincorporated association” but they are referred to in the laws of many countries. Generally, an unincorporated association is when two or more persons come together for one or more common purposes, not being business purposes, by mutual undertakings each having mutual duties and obligations, in an organisation that has rules which identify in whom control of it and its funds rests and on what terms and which can be joined or left at will. Examples include small sporting clubs, trade bodies, and charities. Adoption of the rules does not require any formality. An implicit but clear understanding is sufficient.

Unincorporated associations do not have any legal identity separate from their members, so cannot own property or enter into contracts. Usually, one or more members or committee members enter into a contract on behalf of the unincorporated association, who will be liable for the relevant obligation(s) and/or debt(s) jointly and severally unless liability is expressly limited under the contract to the amount of the association’s funds.

If an unincorporated association is a charity, its property will be held on trust by trustees for its charitable purposes. Otherwise, any property will be held by way of joint tenancy on behalf of its members and subject to the contract between them as to the rules of the association, but they will be contractually restrained from severing their share from the whole. Where the property is land or shares, one more of the officers of the association will be the legal owners of the property on ‘bare trust’ for the current members, subject to the rules of the association.

So as can be seen, a non-business DAO has many of the characteristics of an unincorporated association.

DAO as a General Partnership

So what about a business DAO? A general partnership is formed when two or more persons carry on a business together for their common benefit with a view of profit. A partner relationship arises from contract between the parties and may be either be expressly agreed or be inferred from the parties’ conduct. Each time a partner leaves the partnership or a new person joins, legally the old partnership is dissolved and replaced by a new partnership whose partners take on the assets and liabilities of the old firm and continue its business.

In determining whether a partnership has been created, a court will look at the substance of the parties’ agreement, rather than any attempt by the parties to declare whether or not the arrangement is a “partnership”. Some key features of a general partnership include:

  • The sharing of profits/losses of the business among the partners.
  • Correspondence in the name of the partnership rather than in the individual name of partners.
  • The mutual agency of the partners.
  • Joint bank account, contributions to common assets/capital by partners.
  • No tax returns by the partnership but by individual partners.
  • Non-assignability of the partnership rights/obligations.
  • A relation of mutual trust and confidence between the partners.

Like unincorporated associations, general partnerships do not have legal personality separate from the partners who constitute them, again meaning that they cannot enter contracts, own, or grant security over, assets, and importantly, carry unlimited liability for debts or obligations of the partnership. Any property is normally held in the names of individual partners as trustees for the partnership. Rights and liabilities of the partnership are actually rights and liabilities of each of the partners either against third parties or each other. However, actions can be brought by or against partners in the name of the partnership.

If a DAO is akin to a general partnership, the members of the DAO will be faced with the ‘unlimited liability for members’ problem. Some DAOs intentionally use a variety of structuring elements explicitly to ensure that the features of a partnership are not present to circumvent the ‘unlimited liability issue’. Commercially, it may be unfair or inappropriate to impose personal liability on token holders and other participants.

As a side note, the courts in England are looking into whether developers owe fiduciary duties and duties of care to users of DLT protocols and blockchain systems, such as token holders of DAOs (see Tulip Trading v Bitcoin Association for BSV [2022] EWHC 667 (Ch)).

Other Structures?

There are a few other ways to look at DAOs. I do not propose to elaborate on them but just to state them here for future consideration.

DAOs could be a form of trust structure, a joint ownership of assets, or even a collective investment scheme (CIS) although CIS is strictly just an arrangement for participation in an investment for profit. The underlying structure can be anything including an incorporated company, a limited liability partnership or a trust.

Legal Wrappers for DAOs

Some existing DAOs are wrapped in the cloak of a recognised legal entity. While it is rare for DAOs to be wrapped in an incorporated company ‘cloak’ because of costs, complex regulations and tax issues, there are other more ‘suitable’ wrappers. We will deal with a few common ones.

Ownerless foundation companies (eg. in the Cayman Islands, Panama and Switzerland). Such foundations have separate legal status; can be structured to have no shareholders, overseen by a supervisor (or supervisory authority or governing board) who has no ownership of, or economic entitlement to, the foundation itself. Although often used for charities, there purpose of the foundation need not be charitable so long as the purpose is lawful, not immoral or impossible to perform. For the purposes of a DAO, the foundation can be structured such that the supervisor (or board) acts accordingly to the best interests of the DAO and/or on the votes of DAO token holders.

Special purpose trust (eg. Cayman Islands or Guernsey). The DAO’s founders or token holders can transfer assets to trustees of the special purpose discretionary trust with no beneficiaries. Trustees manage the assets in accordance with the specified purpose set out in the trust agreement and their fiduciary duty to act in the best interests of the trust, so DAO founders or token holders can design the trust agreement to serve the interests of the DAO, including right to direct/remove trustees and transfer the assets to a different entity. An enforcer must be appointed to monitor the trustees and take action against them. There are no registration, filing or reporting obligations; but they do not have separate legal personality.

Limited Liability Companies (eg. many states in the USA, and other countries). Limited Liability Companies (LLCs) are an extremely flexible structure that confers the benefits of limited liability onto an entity that operates more like a partnership. Tax is also usually ‘passed through’ to members of a LLC, which may or may not advantagous to a DAO.

Other Legal Issues Faced by DAOs

Apart from the entity-based issues identified above, DAOs also face a number of other legal issues not discussed in this article. Key among these are the tax and money laundering issues. To discuss these issues meaningfully will require another article.

In the meanwhile, should you need help with any DAO under Singapore law, do contact us at OTP Law Corporation.