Decentralized Autonomous Organisations attempt to decentralize the operations of collective entities by making financial and functional information transparent and encouraging token holders to propose, vote on, and enforce changes. DAOs have recently experienced explosive growth, especially in the decentralized finance sector. They are used to achieve purposes as diverse as networking, investing, governing, decentralized applications, and driving social impact. The weakness is displayed with all their strengths and benefits when there isn’t an organized framework of DAO regulations. Without clear legal status, DAOs cannot take advantage of the same protections as other legally-recognized entities.
This article discusses the seven crucial legal implications associated with DAOs, with possible solutions. But before we get into that, let’s briefly understand the basics of DAOs.
What are DAOs?
DAOs are short for Decentralised Autonomous Organisations. They are blockchain-based entity structures with no central governing body. In DAOs, smart contracts, i.e., computer codes, dictate decision-making. All the members of a DAO participate in managing and developing the operations of a DAO. Because there is no central authority, the power in DAOs is distributed across token holders who cast votes on different proposals. All votes and activity happening on the DAO are recorded on a blockchain.
A DAO can be created for virtually any purpose. Typically, there are eight kinds of DAOs:
Protocol DAOs: It focuses on the governance of decentralized protocols and supports the development and management of dApps or the infrastructure used by dApps.
Grant DAOs: It focuses on funding and fostering projects and ventures in the decentralized finance (DeFi) space. Grant DAOs may be independent or a charitable extension of a larger project. They are responsible for distributing capital assets in the web3 ecosystem to enable non-profit donations.
Collector DAOs: Pools the funds of the members of a DAO to ensure that the DAO as a whole is capable of investing funds into NFTs or other collectibles.
Philanthropy DAOs: They are focused on supporting social responsibility initiatives aligned with a shared goal of delivering a positive impact in the web3 ecosystem.
Investment DAOs: It is also called Venture DAOs, they pool member funds intending to invest in early-stage web3 start-ups, protocols, and off-chain investments.
Social DAOs: Here, members collectively manage a shared social space, own something of artistic value, and/or cultivate culture and events for their members. The main aim of these DAOs is to bring together social communities around entertainment, arts, etc.
Media DAOs: It encourages the creation of community-driven content where instead of giant corporates, it is individuals within the media network who gain profits.
SubDAOs: It refers to a subset of DAO members responsible for managing specific functions, for example, partnerships, marketing, grants, operations, etc.
Why should you consider building a DAO?
It would be pretty evident that after hearing about different types of DAOs, you must think, “Should my company also create a DAO?”. It is natural to ask such questions considering DAO has entered a lot of industries in recent years. If your industry is also one among the above-mentioned types, then take a look at some of the key benefits of DAO:
Decentralization
The biggest benefit of DAO is decentralization. There is no central authority, and it enables a community with clear goals for the organization’s future. In DAOs, the members rely on collective participation rather than a single individual. In the case of a traditional publicly traded organization, the Chief Executive Officer and the board of directors have the final say on company decisions and initiatives. In DAO, members can express their voices for the organization’s future.
Community Development
One of the primary goals of DAO is to build a community and turn ideas into existence in the Web3 world. It’s 2022, and you are not too old to join a DAO community and contribute your expertise. DAOs are diverse in nature, so before joining a DAO, please check its type, guidelines, governance models, etc. The common entry point to join a DAO community will be a Discord server (in most cases). After joining the community, don’t be shy to engage with fellow members.
Full Transparency
Since the building block of a DAO is blockchain, all the transactions recorded are transparent on this public ledger, where the transactions relating to the DAO are recorded. This removes traditional organizations’ bureaucratic factors and offers members transparency.
Smart Contract Implementation
DAO is fully autonomous and transparent because of the integration of smart contracts. Smart contracts establish the ground rules, execute the pre-determined regulations and proposals, vote, and even the contract itself can be publicly audited at any time by the members. This systematic process ensures transparency and trust.
DAO regulations to look-after
DAO regulations in the form of unresolved questions mostly revolve around legal status, applicable laws, licensing, and data privacy. These issues boil down to 7 main concepts:
- Formation & Contract Law
- Securities Law
- Licensing, Copyright, and Software Code
- Trademark Law
- Intellectual Property Infringement
- Data Privacy Law
- Taxation
Formation & contract law
Since DAOs are not traditional organizations, they do not fit neatly into existing legal frameworks. This is among the reasons why the formation of DAO has presented certain challenges for individuals and enterprises wishing to adopt this model. While jurisdictions such as Vermont, Wyoming, and the Marshall Islands have provided a clear pathway to integrate DAOs into existing legal structures, many jurisdictions still don’t recognize DAOs as legal entities.
Encoding and making a DAO available to the public does not create a legal entity. To such DAO regulations, developers need to deploy solutions such as the following:
Unwrapped DAO
An unwrapped DAO is a form of organization generally unrecognized by current U.S law. It is, therefore, not protected by the limited liability afforded to LLCs, limited liability partnerships, and other corporate legal entities.
In the absence of legal forms, the courts may be inclined to conclude that the members of the DAO had formed a general partnership as a matter of law and each individual member of the DAO takes on personal liability for the activities of the entire DAO. This can be a significant concern for participants since many may not intend to expose themselves to legal and compliance risks that could arise in connection with a DAO.
Additionally, suppose a DAO without any associated legal entity is found to be a general partnership. Any DAO member can theoretically enter into contracts and bind the other members without their knowledge and/or consent.
Furthermore, even though DAO members can authorize a single member to enter commercial contracts on behalf of the entire organization, both the authorized member and other members of the DAO still might be vulnerable to unlimited personal liability for any claims arising from such an agreement, especially if the passive DAO members did not individually contract with the counterparty to impose limitations to their individual liability.
Also, because of the absence of further regulatory or legislative action, the rights, obligations, and potential liabilities for the members of unwrapped DAO and contracting counterparties are highly uncertain in a majority of jurisdictions.
Wrapped DAO
In a wrapped DAO, one or more subsets of the members create a formal business organization that manages and/or owns certain functions of the DAO’s ecosystem. This organization is often a corporation or LLC and takes care of functions such as smart contracts and the treasury of the DAO.
This model can provide a framework for limited liability, improving the DAO’s ability to contract and exchange payments and services with third parties while engaging in general commerce.
Though there is an additional certainty in wrapped DAOs, this model is by no means a perfect solution. To function most efficiently, the LLC or other corporate organization set up for the DAO should have an adequate connection to the entire DAO ecosystem. This is important to assure DAO members and counterparties that the DAO as a whole is included under the corporate form.
Even in light of these solutions, not all DAOs adopt this structure, mostly because many worries that forming an LLC strips DAOs of the element of decentralization. However, lawmakers in several states have stepped in to tackle these challenges.
Wyoming, for instance, enacted a statute last year that allows the formation of a new legal entity, a DAO LLC. The state defines DAO as “a limited liability company whose articles of organization contain a statement that the company is a decentralized autonomous organization.”
Wyoming extends to an algorithmic and member-managed DAO, the same legal protections and personality afforded to a traditional LLC, with a few exceptions. The key features of a Wyoming DAO LLC are mentioned below:
- DAO LLCs must keep a registered agent in Wyoming.
- A DAO LLC is presumed to be member-managed unless the Articles of Organisation define it as algorithmically managed.
- A DAO’s legal name must include the words “DAO” or “LAO” (Limited Autonomous Organisation) or “DAO LLC”.
- The Articles of Organisation must include the smart contract on which the DAO works. This must be amended each time the smart contract is updated. In case of any conflict with the Articles of Organisation, the smart contract will prevail.
- A DAO LLC will automatically be dissolved if it does not take action or approve any proposal for one year.
- The laws that govern regular Wyoming LLCs will apply equally to DAO LLCs unless specifically modified by the DAO law.
- DAO members do not owe any fiduciary duties unless the articles state otherwise.
Securities law
Given the nascent stage the DAOs are currently in. It is still unclear under what circumstances the Securities and Exchange Commission (SEC) would view the tokens issued by DAOs as securities. The Supreme Court’s Howey test lists four elements that an investment contract needs to satisfy to be considered a ‘security’:
- An investment of money,
- In a common enterprise,
- With a reasonable expectation of profits, and
- To be derived from the efforts of others
Courts are yet to address DAO regulations, such as if the tokens are securities. Therefore, when issuing tokens not registered with the SEC, the DAO organizers should either accept that such tokens are not securities or ensure that an exemption issues them from registration.
In July 2017, the SEC prominently asserted that the Howey analysis applies to cryptocurrency. However, after the German start-up, The DAO was hacked, and litigation ensued, the SEC found that:
- The Ethereum contributions that token holders had made in exchange for tokens of The DAO constituted an investment of money.
- The efforts of the founders and curators of The DAO were important to the optimal functioning of The DAO.
- The founders and curators had pooled Ethereum to fund projects which could yield a profit for The DAO token holders.
Based on these facts, the SEC concluded that The DAO’s tokens fell within the Howey purview and constituted security. After this followed the 2017 Munchee cease-and-desist order that laid out additional factors to be considered when determining if a cryptocurrency or DAO token is a security. These factors focused on the immediate usability of the tokens, the way tokens were advertised, the presence of tokens on the secondary markets, and the way proceeds from an offering will be used.
The SEC’s interest in challenging unregistered securities offerings in the sphere of cryptocurrency has only been intensifying. In February 2022, the SEC joined other state enforcement agencies in charging BlockFi Lending LLC with failing to register its crypto lending product as a security.
BlockFi had advertised its ability to create returns for investors loaning digital assets to BlockFi. These assets were pooled, loaned, and invested solely at the organization’s discretion to generate profits.
The SEC found that even though BlockFi’s investment product met the criteria of the Howey test, the offering of this product to retail investors did not qualify for an exemption from registration. BlockFi was ordered to pay $100million in penalties to resolve this enforcement action.
No DAO to date has been successful in registering its token offering. When DAOs attempt to register their token offerings as securities, its imperative to recognize that the registration statement disclosures must be sufficient and complete. When CryptoFed DAO LLC attempted to register two digital tokens in 2021, the SEC brought an action against the organization, alleging that the registration statement of the DAO did not include sufficient information about its tokens.
This instance serves as a reminder for DAOs who wish to register their tokens with the SEC to ensure that their disclosures are free of material misstatements and/or omissions and completely disclose the risks associated with investing in the tokens.
Licensing, copyrights, and software code
The participants of a DAO will inevitably face the challenge of ensuring the ownership and enforcement of the intellectual property (IP) they generate and acquire as they grow and develop. Suppose the underlying software of a DAO is creative enough to be called an original work of authority. In that case, it is likely to be protectable as a matter of law, given that a discernible entity authored and owned the software and can assert it against another discernible entity.
In the case of wrapped DAOs, copyright ownership may be a straightforward issue if the DAO implements traditional IP ownership assignments. However, in the case of unwrapped DAOs, there is an open question regarding the exact ownership of the underlying software, especially considering the total number of members in the DAO and the contribution of each in developing the software.
There may also be uncertainty concerning the identity of the licensor or licensee, especially in cases where DAOs seek to license either valuable software code or copyrights related to other DAO assets, such as NFTs.
It is interesting to note that there has been pushback in the DeFi world against DAOs attempting to enforce their IP rights because the practice is seen as contradictory to the open-source culture of DeFi. Critics worry that this can stymie innovation or discourage developers from joining DAOs.
However, innovative proposals to tackle these challenges are coming up. Curve DAO, for instance, put forward a proposal suggesting that it should hire counsel in the U.S. and other relevant jurisdictions to prevent other DAOs from ‘wholesale copying’ of its code. This proposal was developed after Saddle DAO allegedly copied Curve DAO’s code, claimed ownership, and granted a license to that code to anyone worldwide. Curve DAO’’s solution for the situation gives hope that DAOs may, after all, start taking steps to protect their valuable intellectual property more rigorously.
Trademark law
Similar to contracting and licensing, the ability of a DAO to own and enforce a trademark may vary according to its organizational structure and legal status. Wrapped DAOs can identify the entity using the trademark associated with the organization in commerce and assert an action for the enforcement of that trademark.
Unwrapped DAOs may face more complex trademark issues owing to the view held by federal case law from the Ninth Circuit and a couple of other circuits where unincorporated associates can own trademarks. While unwrapped DAOs can try to enforce a trademark under this theory, they may have difficulty proving that its mark is an indicator of the source.
Intellectual property infringement
Another challenge IP enforcement can face is determining the defendant(s) in cases where the infringing entity is an unwrapped DAO. The plaintiff may have all the appropriate legal structures to enforce its IP but may be uncertain when considering what party or parties to be named.
If the members of a DAO are easily identifiable, it may be possible to hold them collectively liable as a general partnership. But if they aren’t easily identifiable, the plaintiff can locate as many DAO members as possible, name them as parties to a lawsuit, and move forward with the joint and several liabilities theory.
However, this approach wouldn’t be ideal because the concept of anonymity in the DeFi and DAO worlds might make it challenging or impossible to find all relevant entities, keeping the aggrieved party from obtaining full relief of infringement.
Data privacy law
With the legislation on cybersecurity and consumer data privacy becoming more robust, enterprises are responsible for providing careful oversight when collecting, storing, and using data related to individuals. The GDPR considers individual consumers as data subjects who have the right to be informed, to access data collected about them, to revise any incorrect data, to erase data, etc. These rules apply to data controllers (who own the responsibility for data) and data processors (who handle consumer data for data controllers).
In a DAO, members are generally assumed to have partial ownership of the organization and its governance. That is to say, members actively contribute to the underlying protocol, making it difficult to categorize who owns/controls the data for privacy purposes. Moreover, the public, permissionless, and, most importantly, immutable nature of blockchain protocols eliminate the option to erase the collected data.
In light of these points, numerous questions regarding data privacy laws in DAOs remain unanswered:
- How will highly decentralized DAOs comply will data privacy law?
- Which data privacy laws apply to DAOs?
- How will data privacy laws be enforced against DAOs with anonymous members?
Taxation
U.S tax laws may be complex, but they are well-developed concerning traditional structures such as partnerships, corporations, LLCs, and trusts. But there is limited guidance regarding cryptocurrency, NFTs, and other assets on a blockchain. These assets include DAOs as well.
Until the authorities release more specific guidelines, DAOs must look into the existing legal framework that applies to entities similar to DAOs and make judgments.
If a DAO chooses to operate through forms of U.S or non-U.S. legal entities, it would be taxed according to the rules that apply to such entities. Interestingly, a DAO that does not operate through a legal entity and exists only through a contractual arrangement among the owners on the blockchain may, irrespective, be treated as an entity for U.S. tax purposes owing to the broad definitions stated by applicable tax regulations.
A contractual joint venture will be considered a partnership for tax purposes if “participants carry on a trade, business, financial operation, or venture and divide the profits.”
This definition appears to include many DAOs that work intending to carry out traditional investment activities or operate on a traditional business structure.
Future of DAOs
It is still early to make any finite predictions about DAO regulations. The structure, uses, and functions of DAOs may change unimaginably. That said, it is important to resolve all questions about the legal rights and responsibilities of these entities and their members. So far, the state governments are leading the way. We can only hope for more federal regulation to come into effect promptly.
