DAOs: essential legal issues

DAOs: an essential definition

DAOs can be defined as "non-hierarchical organizations that perform and record routine tasks on a peer-to-peer, cryptographically secure, public network, and rely on the voluntary contributions of their internal stakeholders to operate, manage and evolve the organization through a democratic consultation process" .

The operation of the DAO, its structure, organization and the interactions that its participants enact, are contained within a blockchain.

DAOs are also described, as suggested by the same acronym, as decentralized, autonomous and organized organizations, and it is precisely from the integration of these principles that the phenomenon emerges as a "new organizational design".

Some peculiar features of DAOs, considered by a large proportion of scholars as advantageous elements, are:

• stability: every transaction is recorded and stored;
• anonymity: participants can register with their usernames, avoiding exposing their identities;
• knowability: transactions are validated and can be easily verified;
• transparency: the proposals made, the decision-making process, and the allocation and content of powers and duties among participants are knowable.

Distributed and decentralized

Decentralization is imposed by the use of DLTs (Distributed Ledger Technologies) and operates on two distinct levels:

• on the one hand, it eliminates the need for an intermediary in product placement procedures;
• on the other, it marginalizes the role of the corporate model in the conduct of business activity.

The revolutionary profile of DAOs lies in the second of these issues, considering that the token-holders – i.e., those who have obtained, as a counter-performance of the made contribution of cryptocurrencies, tokens attributing the right to vote – directly control the organization and the management of the entity, without the said function being delegated to another entity, tending to be different from the owner, and thus eliminating those so-called agency relationships (and costs) that characterize corporations.

In other words, hierarchical and centralized authority (typically the managers) is dispensed with a structure based on cooperation and equality of its participants.

It is precisely the decentralized nature of the DAO that allows to distinguish (partially) such organizations from the increasingly common entities established through Initial Coin Offerings or through crowdfunding activities.

Autonomous and automated

DAOs operate according to the rules contained in the whitepaper, drafted and signed by the founders, which are encoded in a smart contract that in turn is executed automatically using the blockchain protocol. Essentially, the smart contract is a computational program consisting of a series of provisions that are applied automatically and autonomously, irreversibly, and which, thanks to blockchain technology, are recorded and stored over time. The rules contained in the code, therefore, enable the operation of the organization without the need for human intervention and coordination.

In other words, the smart contract constitutes the foundational element of the DAO, which defines the DAO's self-regulation, according to the fundamental rule-of-code principle, and preserves its assets by tracking its movements.

Again, the automatisms arising from this technology enable the implementation of trust in the organization while reducing transaction costs and costs related to the exchange of information between participants.

Organized and ordered

Blockchain technology, together with the clearly defined rules on it, allows for full transparency regarding the powers and duties of both members of the organization (token holders) and other stakeholders. This transparency allows for increased trust in the functioning of the organization and efficiency of management.

The distinction between DOs and DAOs

Part of the doctrine distinguishes between DAOs and DOs: in the former, the functions are automatic and self-executing, as the blockchain and smart contracts constitute the communication protocol to enable interaction between algorithmic systems; in the latter, the decision-making and consultation role of the human being is included, while the algorithm acts only as a function of streamlining and automating the governance of the group.

Some authors distinguish instead between “participatory DAOs” in which smart contracts are used to collect votes from participants, and “algorithmic DAOs” organizations that are entirely algorithmic in their operation.

DAO formation

The establishment of a DAO is a complex procedure, carried on by the so-called founders, as it involves an intersection between empirical-technological profiles, concerning the elaboration of the underlying IT structure of the DAO, and purely legal profiles.

For further details see: DAO formation.

DAO governance

The peculiarities of DAOs, deriving in particular from its decentralized nature, are reflected in the decision-making processes of its participants, which constitute the essential core of Corporate Governance. The horizontal structure of the organization actually has advantages and disadvantages, and its specificities with respect to traditional corporations still need to be explored.

What is certain is that if, on the one hand, an attempt has been made to identify certain essential rules of its functioning, such as the principle of collegiality, the principle of one-token-one-vote or the principle of the rule of code, it is also true that some of them suffer inevitable exceptions, which constitute full demonstration of the complexity of the structure.

For further information see: DAO governance.

DAO subjects

According to some scholars, a fundamental challenge in the elaboration of a good governance scheme “is the creation of clearly delineated organs whose members have certain rights and duties”. In this sense, DAOs should establish organs for core developers, miners, and token holders.

The legal status of the DAO: doctrinal proposals

DAOs, a phenomenon that has developed essentially online without serious reflection on their legal structure, often operate without a clear and predetermined legal status. This leads to uncertainties about the relationship between token holders and between them and the DAO, with the risk that, as they carry out business activities, they are qualified as partnerships. Consequently, there is a risk that the participants will find themselves subject to unlimited liability for corporate obligations, in the absence of adequate awareness of this. It is therefore appropriate that a legally secure framework be created, or at least employed, primarily for the consumers themselves who participate in the business of the DAO.

Most common solutions:

• Establishment of DAOs in the form of corporate entities. Among corporations, the creation of DAOs in the form of a joint stock company seems more difficult, while creation as a limited liability company seems feasible. Obstacles may arise from the impossibility of representing quotas by means of tokens, which would introduce a circulation mechanism similar to that for shares. An assimilation to one of the partnerships is suggested.
• Establishment of DAOs in the form of a foundation. The DAO is comparable to the foundation by the tendency of immutability of purpose (in the one, the founder's purpose; in the other, the purpose set out in the code) and autonomy from the founder and developers. Among the most commonly used jurisdictions for establishing DAOs as foundations are Switzerland, which has a more flexible foundation law, and the Cayman Islands.

The purpose of the organization

The analysis of the legal models used for the establishment of DAOs and the sectors in which they are concretely employed suggests that DAOs can be used for the pursuit of both lucrative and non-lucrative purposes.

In particular, those entities that could potentially benefit by operating as a DAO are:

• Charities or other non-profit organizations. The lack of transparency in modern charitable organizations is a significant concern, leading to a loss of trust between donors and these organizations. However, DAOs offer a solution to this problem, since they operate transparently on a blockchain, making all activities and transactions visible and auditable by donors.
• Financial industry. As the case study of MakerDAO suggests, DAOs could address some of the challenges in traditional banking systems. DAO-based currency systems have the ability to connect the vast number of unbanked individuals worldwide, estimated to be around 1.7 billion adults. This connectivity could enable these individuals to participate in investment and borrowing activities. Although financial DAOs are unlikely to replace traditional financial institutions entirely, they provide a new avenue for investing and engaging in financial activities, resembling traditional financial markets.
• E-government systems. In this sector, DAOs could offer significant benefits, since current government systems are often complex, centralized, and prone to errors due to human involvement. These systems lack transparency and often involve lengthy and costly processes. By incorporating DAOs into government services, operations can be automated, leading to increased efficiency and improved transparency, accountability, and resource management.
• Healthcare industries. In healthcare, a blockchain-based health information exchange (HIE) could reduce transaction costs and data errors. It would enable efficient sharing of patient medical records among healthcare providers, giving patients control over their data sharing.
• Insurance industry. In this sector, applying a decentralized and autonomous approach can reduce information asymmetry, administrative and operational costs and enables regulators to detect suspicious transaction patterns. Automation of insurance business processes can improve security by ensuring confidential client data accessible only to authorized parties.

Limits to the purpose that can be pursued may be imposed by individual national jurisdictions. This means that depending on the jurisdiction and the legal form in which the DAO is incorporated, there may be specific limitations to the purpose.

The Coalition of Automated Legal Applications (COALA)’s “Model Law for Decentralized Autonomous Organizations (DAOs)”, recently published in its finalized version, expressly acknowledges that a DAO may not only be a for profit entity, but may be used for multiple non-commercial purposes. For this reason, it suggests that “the DAO is a legal entity than can be used for commercial, mutualistic, social, environmental or political purposes, the nature of which will be specified in its By-Laws” (Article 1).

The applicable law and jurisdiction

A further issue of complexity concerns the difficulty of identifying the jurisdiction to which the DAO belongs.

As regards the determination of the applicable law, two criteria can be abstractly followed: criterion of incorporation or criterion of actual seat.

The problem is that if the DAO is not incorporated in a particular place, as is the case for companies, the first criterion cannot be applied. At the same time, with respect to DAOs, the second is difficult to apply, as they typically do not have a physically identifiable material organization in a given place; they are managed by nodes from all over the world; they are not connected to servers that could serve to identify a physical place of activity since they run on the nodes of a blockchain, and thus everywhere and nowhere. They are structurally 'open to the world': naturally vocated to attract participants from all over the world and to operate worldwide via distributed nodes. They are therefore by their very vocation opposed to the traditional search for a spatial center of gravity, to the law of which to subject them.

The same problem arises with regard to the identification of the competent judge in disputes involving them.

Current form of regulation of DAOs: an overview

In order to solve the uncertainties relating to the absence of a clear legal form and the identification of the applicable law and court of jurisdiction, there has been a tendency to set up DAOs according to clear legal models. In this sense, DAOs are sometimes established in the form of a company or a foundation, thus relying on general models that, due to their characteristics, are suitable for incorporation of DAOs. Moreover, in recent years, several countries have introduced ad hoc forms of regulation of the phenomenon, such as:

• Wyoming Decentralized Autonomous Organization Supplement (Wyoming, U.S.A.), which regulates the so-called DAO Limited Liability Company;
• Decentralized Autonomous Organization Act (The Republic of the Marshall Islands), which instead introduces the so-called MIDAO LLC.

For further details see: DAOs' current forms of regulations: an overview.

Case study: The Dao

The DAO was “the first high-profile realization” of a decentralized autonomous organization (DAO) running on the Ethereum platform, the history of which, with its splendors and failures, could be read on “The DAO”.

References

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• Coalition of Automated Legal Applications (COALA), Model Law for Decentralized Autonomous Organizations (DAOs), 2021, available at: https://coala.global/wp-content/uploads/2022/03/DAO-Model-Law.pdf