If you read the previous article you already know some things about DAOs. At least the fact that they have something to do with blockchain technology. There are people praising the — still — unregulated nature of the blockchain ventures, and they take it as a feature. For those, there is no sense in trying to become a registered entity. However, if you are thinking of creating a DAO you have to understand that sooner or later you’ll have to interact with the real world. When that time comes, a question will pop: on what ground will your DAO interact with the regulated framework?
We get the whole anarchy-cyberpunk vibe that is present in some of you. Still, you have to understand that regulation is not necessarily a bad thing, and being unregulated is not one of the promises of blockchain. Decentralisation and immutability are. In fact, when the regulation is adopted which will fully recognize a DAO, it will be a moment of joy because we made the states recognize an obvious reality. Actually, that’s the way a regulatory system should work: the society evolves, creates stuff, and then the legislative body officially recognizes the new status quo.
Anyway, I digress, so, until a possible brighter future, let’s see what the current regulation is. Can we conduct business as a DAO legally or are we bound forever to be pirates that sails the ups and downs of crypto?
In most parts of the world, the current regulatory framework fails to account for the decentralised and autonomous nature of DAOs and instead tries to classify these according to the traditional legal theories, which can pose significant risks for its members. The majority of today’s DAOs are created as fully decentralised organizations on the blockchain and have no association with a legal entity. From a legal perspective, this does not mean that DAOs are not covered by the law, but instead that in most jurisdictions they are classified as general partnerships based on their inherent nature (individuals partnering to conduct an activity).
DAO as a General Partnership
The classification as a general partnership grants DAOs a legal personality in spite of these not being registered in any jurisdiction. The good news is that this should allow a DAO in most jurisdictions to legally own assets, employ services, and people, and even sue or be sued. The bad news is that in case of any legal action against the DAO, every individual risks being personally liable to an unlimited amount, as general partnerships do not benefit from any of the protections granted by a limited liability company (where shareholders are only liable for the invested amount).
If that worries you, you’re not alone, but if the DAO is indeed created and operated in a decentralised and anonymous manner there is still one big hurdle any claimant would have to overcome when bringing legal action against the organization. You see, current international law uses the location of incorporation or the headquarters of a company to determine the applicable laws and in the case of a DAO that runs on the blockchain with nodes scattered around the world, that is in most cases not possible.
Another used method would be to determine the applicable law based on where the DAO has entered into a legal agreement (e.g. a contract for goods), which is easy to determine but can only happen if the organization chooses to enter into a traditional contract.
One could even choose to bring legal action against the DAO in all the jurisdictions in which it operates or in which it has entered into a legal agreement in order to ensure that their case is raised against the entire organization, but that would be highly impractical and will have a significant cost.
To conclude, DAOs that choose to have no traditional legal registration and be created only on the blockchain will have, in most jurisdictions, the status of a general partnership with all the benefits and risks it entails.
DAO as a Limited Liability Company (LLC)
Luckily, if you’d like to have a clearer regulatory framework for your newly created DAO, there are some available options, if you’re willing to give up some of the decentralisation and be subject to the applicable laws and regulations.
The first available option is linking your existing DAO to an LLC as regulatory frameworks in some of the United States have been quick to adapt to blockchain-based enterprises.
For instance, Wyoming was the first state to introduce a bill in 2021 that recognizes the DAO as a legal entity and allows for the formation of special DAO LLCs. The bill recognizes the unique structure of DAOs and their modus operandi, stipulating that the decision-making process needs to occur with the approval from the majority of members, distinguishing between community-based and algorithmic governance. The problem is that if for example your DAO is governed algorithmically you have to put in place certain rules for updating the underlying smart-contracts.
An algorithmically managed decentralised autonomous organization may only form under this chapter if the underlying smart contracts are able to be updated, modified or otherwise upgraded.
This provision, as you may have figured, is somehow in contradiction with the “autonomous” part. A purist may say that the rules of a DAO aren’t immutable and self-enforincing, that entity could be hardly named a DAO.
Anyway, let’s say that not every aspect regarding the operation of DAOs has been clarified or thought clearly. On top of that, the uncertainty remains around how and which members can act on behalf of the DAO and whether issued tokens are classified as securities.
Another state which has taken steps in this direction is Vermont which allows for the formation of BBLLCs — Blockchain-Based Limited Liability companies. A BBLLC is a special type of LLC that allows for the creation of a company governed by smart contracts and enables the organization to enter into legal agreements and offer liability protection to its members.
While this type of legal entity was not designed with DAOs in mind and does not offer the same clarity regarding the operations of the organization as the one in Wyoming, it still is a good option for DAOs to obtain a clear legal personality and function within the confines of the existing legal system. A notable example of a BBLLC being used by a DAO is dOrg, a community of Web3 developers, which in 2019 has linked its organization to a Vermont-based legal entity.
Moving away from the United States, DAOs have historically also been registered as traditional LLCs in other countries, with the most notable occurrence being the original Ethereum DAO. In this particular case, the founders created a LLC in Switzerland named DAO, like a link to the offchain world. The Swiss law allows for a company to “take money from an unknown source as long as you know where it’s going.”
Nevertheless, due to the dismantling of the original DAO, the legal implications regarding the functioning of a DAO under a traditional LLC are unknown and there are many questions about how the current legal framework would treat such an endeavor.
For DAOs that desire a clear legal framework and liability protections for their members, US-based special purpose LLCs seem to be the best option if they are willing to comply with all the associated regulations and reporting requirements. One important aspect to keep in mind when considering the formation of a DAO LLC is the issuance of tokens which in most cases might be classified as securities and would require the lengthy process of disclosure and approval by the SEC.
DAO as a Foundation
The Cayman Islands offers a very interesting legal entity, the “foundation company”, which can operate as a traditional foundation while still having the separate legal personality and limited liability of a company. The “foundation company” imposes no set governance or decision-making rules which makes it a particularly good fit for DAOs, as their programmatic governance can be replicated in the structure of the legal entity.
Additionally, it allows for the foundation to have beneficiaries whom it can distribute funds to, and not only that, but these beneficiaries are in no way legally liable for the actions of the foundation. Furthermore, it is not necessary to maintain a registry of these individual beneficiaries but these can be designated as a category, for instance, “DAO token holders”, making it ideal for the mode in which a DAO operates.
The one downside of foundation companies is that these do not enable DAOs to be 100% decentralised as they still require at least one director, one supervisor, and one secretary “licensed to provide company management services in the Cayman Islands” to be able to legally function. So, true decentralisation is killed by the need of a physical secretary. Ironic or what?
DAO as an Unincorporated Nonprofit Association
In cases where the DAO’s purpose is not to generate revenue and distribute it to its members, a viable option could be the one proposed by the general counsel for crypto of a16z, Miles Jennings: the Unincorporated Nonprofit Association (“UNA”) a entity regulated by the United States.
In their analysis, the case is made that even though most DAOs have governance tokens that may appreciate in value, this is not indicative of a for-profit endeavor. They exemplify this through the case of homeowner associations, where owners group together to improve the surroundings of their neighborhood which may lead to an increase in the value of their homes and result in a gain for the individual members, but cannot be considered a for-profit association as the purpose is not to generate revenue which is distributed to members.
The same can be said about a DeFi protocol that organises as a DAO. Even though the governance tokens may appreciate in value as the technology of the protocol is developed and gains more users, if the DAO does not distribute revenue to its members, it cannot be considered for-profit.
This type of legal entity does not even prohibit the association to generate revenues, as long as these are not distributed to members but used to pay for services, employ personnel or further develop the association in any way. In this matter, the act governing UNAs is clear:
“Many existing unincorporated nonprofit organizations engage in activities that are intended to produce a profit, e.g., a bingo parlor operated by a church where the profits are used to buy food for a homeless shelter. This type of profit-making endeavor should not disqualify the organization from being a nonprofit association if it otherwise qualifies.”
The advantage of a DAO registering as a UNA is that it grants the DAO a legal entity that is separate from its members, that can own assets, enter into legal agreements, and sue or be sued. Therefore, this type of association is able to grant members limited liability, while also allowing the DAO to function in the current legal framework.
One important aspect to consider when considering the registration of a DAO as a UNA is the particular laws of each state, as some states do limit the scope of nonprofit associations to only charitable purposes which may severely limit the allowed activities of a DAO. Thus, legal consultation should always be performed when considering the registration as a UNA in a particular state.
In fact, hell, let me add the disclaimer here - you should take certified legal advice if you are taking in consideration any of the above mentioned potential solutions. We are no lawyers and this subject matters a lot, so just don’t take action only because you read this and “now you know it”.
Looking at the available options and their limitations, it is abundantly clear that the international legal framework is not prepared for the autonomous and decentralised nature of DAOs and that it is necessary for governments to develop a comprehensive legal framework that takes the particularities of Web3 organizations into account.
However, certain steps are taken in the right direction but the main conclusion that is here to be drawn is not as intuitive as you may think: the final legal framework is yet to be created and the future regulation will be molded by every DAO that activates out there, based on its behavior. If the decentralisation is just an excuse for obfuscating your identity while trying to con others, the regulation will kill core functionalities of what makes a DAO - a DAO. So, tread softly because you tread on the dreams of many.
Again, keep in mind that we’re just some passionate guys writing about Web3 and this in no way constitutes legal advice, so be sure to consult a lawyer before taking any action.