Introduction: What Is A DAO?
A decentralized autonomous organization (“DAO”) is a collectively owned and managed entity with a set of rules written in computer code. They are organized around a set of rules on the blockchain and structed with smart contracts—self-executing codes that automatically enforce the pre-defined rules. DAOs have no centralized leadership. They are managed by the members who are responsible for decision-making authority and community participation.
Creating a DAO is relatively simple. First, the smart contract is created and the DAO´s governance structure is developed. These rules are embedded on the smart contract. Next, the DAO project needs to raise capital to launch. DAOs typically receive their funding by issuing DAO token. These tokens give the members voting rights in the DAO. Lastly, the DAO´s operation is then implemented. Everything is transferred to the blockchain. If the DAO needs to make a decision, the community members must vote upon such changes. That said, there are a few key factors to be aware of when considering forming a DAO. This article, drafted by the blockchain attorneys at Oberheiden, P.C., explains DAOs and key factors you should consider when creating a DAO.
“People everywhere are starting to use DAOs as alternatives to organizing and managing a corporation. They offer flexibility and decision-making based on consensus of the group. However, they lack the legal recognition of a corporate entity and a stable, consistent regulatory framework. As a result, federal agencies are more likely to scrutinize a DAO´s formation and management. Also, the DAO’s native token may be deemed “securities” and therefore any liability exposes the members to potentially unlimited liability. If you thinking about creating a DAO, contact an attorney experienced in DAO formation, structure, and how federal agencies are currently treating DAOs.” – Dr. Nick Oberheiden, Founding Attorney of Oberheiden P.C.
5 Things to Know for DAO Creation
1. DAOs are fully decentralized autonomous organizations and are not based on a hierarchical management structure.
DAOs do not follow the corporate hierarchy of a Board of Directors and corporate executives at the top and employees at the bottom. DAOs do not have a hierarchical structure. With traditional entities such as corporations, one must have incorporators, promoters, articles of incorporation, bylaws, board of directors, and so on. This is a centralized management system. Further, most corporations are private entities. DAOs are distinct. A DAO´s organization is structured as a series of code, or smart contracts, on the blockchain that automatically execute the entity´s decisions. No single individual or group of individuals owns or controls a DAO. Because DAOs use blockchain technology, they are transparent to the public. This is a fully decentralized management system.
Even though DAOs have no hierarchy, they can still be successful and execute significant decision-making authority by its members. If a member has a management or operational idea, the process of getting the idea heard is substantially easier compared with traditional corporate entities. With a DAO, the member need only tell the DAO members the idea, and then everyone can consider and vote upon the idea in a democratized manner.
2. Most DAOs do not protect their members from unlimited liability.
DAO members do not generally enjoy the usual protections against liability as do corporate shareholders. This is because a DAO is not typically formed as a corporation or LLC. Therefore, the potential liability of each member in a DAO is unlimited.
Corporations were established as a means to carry on a business without each individual exposing themselves to personal, unlimited liability. The shareholders in a corporation, or the members in an LLC, only risk their capital contribution. In other words, they are only liable for the percentage of ownership interest they contributed or are entitled to.
DAOs do not follow this pattern. As unincorporated entities, they do not need to follow the legal formalities of incorporation such as registration, bylaws, and contracts. As a result, DAOs are treated as unincorporated partnerships. In a partnership, each individual has unlimited liability. Therefore, if the DAO is hacked or declares bankruptcy, each member is exposed to liability for the entire amount of funds. If a lawsuit follows and the plaintiff is unable to recover completely from the “DAO partnership,” the plaintiff will turn next to the personal assets of each DAO member until their claim is satisfied. To address this weakness, DAOs would have to register and be recognized as a legal entity with limited liability.
3. Decision-making in a DAO is carried out by DAO members
Decision-making authority in a DAO is made from the bottom-up. Each member in the DAO has the right and ability to voice an idea or submit a proposal about the DAO´s governance or management. Then, every member with a stake in the DAO considers and votes on the proposal. Voting depends on the DAO´s governance tokens—which is the cryptocurrency for the particular DAO project at issue. In other words, every member in a DAO can influence the DAO´s future by either voting on a proposal by another member or initiating a new governance or management proposal themselves. This is in sharp contrast to traditional corporations where the decision-making authority is based on authority or position and where voting is conducted with major changes.
In addition, the financial resources of a DAO are more protected and better utilized with a DAO compared to traditional corporations. Their treasuries are generally accessible only upon approval by the DAO members. This makes DAOs less susceptible to financial abuse since there is no single or small group of individuals with sole access to financial resources. More tools that you can use to build a DAO For management Gnosis Safe – A multi-sig wallet that is widely used to handle community treasury.
4. DAOs are not recognized as a legal entity in a majority of U.S. states.
DAOs face significant hurdles to public awareness and recognition largely because a majority of states do not recognize the DAO as a legal entity. Without legal recognition, a DAO does not have to comply with the state´s registration provisions and, as a result, does not receive any of the corporate privileges—such as limited liability—available to traditional incorporated entities. In addition to the possibility of unlimited liability, a DAO´s lack of legal status may prevent it from entering into certain commercial contracts with other entities or with the government. This limits the type of business the DAO can perform and can prevent DAOs from achieving their full profit potential.
There are only a couple of notable exceptions to a DAO´s legal recognition. Under Vermont´s Limited Liability Company Act, a DAO can register as a Blockchain Based LLC (“BBLLC”) and therefore provide limited liability to its members. Additionally, Wyoming passed legislation in April 2021 that allows a DAO to be legally recognized as an LLC.
5. DAOs are inconsistently regulated, exposing their formation and operation to various legal challenges.
There is no consistent regulatory framework for DAOs. Because they are unincorporated, many DAO are defaulted to partnership status—which imposes unlimited liability on its members and creates various legal issues. For instance, many traditional corporate entities have to comply with anti-money laundering and know your customer (“AML/KYC”) policies. These are safeguards that ensure that the corporate entity is dealing only with customers, token holders as well as members that pass various identity verification checks and that pose low money laundering risks.
With a DAO, individuals are often anonymous. As a result, compliance with AML/KYC policies is very complicated, if not impossible. Sometimes, these burdens will prevent a DAO from being formed in the first instance. Also, because DAOs can include individuals from around the world, multiple jurisdictions´ laws are at play. Deciding which country´s laws apply can be difficult and is likely to result in protracted legal battles if a dispute arises.
This regulatory uncertainty can also lead to internal federal investigations. The most notorious example involved the SEC´s 2017 investigative report on “The DAO”. In this report, the SEC concluded that The DAO sold DAO tokens as "securities" without being properly registered, thus violating multiple federal securities laws provisions.
Conclusion
DAOs are taking the world by storm as the next generation of financial and business innovation. DAOs offer many advantages over traditional corporations such as decentralization, member-empowered voting and decision-making, automatic code execution via smart contracts, and pooling of resources and funds. That said, DAOs face numerous legal challenges because they are not recognized as a legal entity. Their lack of legal status defaults a DAO to a general partnership, which potentially exposes every member to unlimited liability. Further, the multiple jurisdictions that can be involved along with the anonymity of DAO members make any attempts at compliance very challenging for DAOs. Only a consistent regulatory framework can provide the legal certainty needed for DAOs to flourish without being hindered by regulatory inconsistency and gaps.
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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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