June 14, 2022
Crypto has seen better days. Cryptocurrencies are in a bear market. The hype around NFTs is cooling. Fraudsters and speculators seem to dominate recent crypto news. Regulators are issuing updated guidance to close exploits and pursuing enforcement action to protect consumers. Environmental concerns are getting more attention. Ambitions of broad adoption have not quite yet materialised. Most people still don’t really understand blockchain based technologies, let alone being keen to embrace its utopian decentralised possibilities.
All of this has given blockchain an image problem. But that need not be the case. A promising use case offering a radically different way of running organisations is a blockchain based Decentralised Autonomous Organisation (“DAO”).
What is a DAO?
A DAO is a decentralised “organisation” whose establishment, rules and functions are coded entirely in smart contracts. A “smart contract” is not a contract in the legal sense (although it could be if it meets the requirements for a contract), rather a program coded on a blockchain.
Imagine all of the functions, decisions and outcomes of a typical organisation instead as a series of conditional statements. If the predefined conditions are met, then the smart contract will execute a particular action, deterministically, every time. Lex cryptographica – “code is law”. The implications for truly democratised organisational decision-making and efficient resource pooling are profound. Maybe career board executives had better start looking over their shoulders!
Current recognition of DAOs
The UK does not legally recognise DAOs. A DAO therefore does not have separate legal personality, making it unable to own property or enter into contracts in its own name. Applying the rules of a general partnership, DAO members carry unlimited liability, not to mention the potential tax implications from token transactions. This is a non-starter for many participants.
Some US jurisdictions recognise DAOs structured as LLCs as a form of “legal wrapper”. The LLC remains liable for contractual and legal obligations and its members have limited liability protection – but at the cost of not being a true DAO. Vermont permits the registration of a “Blockchain-based” LLC whose governance may be partially or fully decentralised. Wyoming has gone further to permit registering algorithmically managed DAOs as LLCs, regulating aspects such as majority decision making, quorum, disclosure requirements, minimum requirements for regulations in bylaws and the appointment of a registered agent. There are also examples of LLCs adopting DAO concepts into their governance structure.
The reality is that the existing legal frameworks fundamentally do not fit DAOs. Applying the concepts of partners in a partnership or shareholders of a company to participants in a DAO, even in these hybrid models, ends up negating some of the key benefits presented by the DAO approach in the first place.
Legal recognition of DAOs
The only way to unlock the full potential of DAOs is to embrace it as a unique type of corporate entity with its own legal personhood while affording limited liability protection to members. Some jurisdictions are looking at this right now.
The Australian Government is acting on a report from the Select Committee on Australia as a Technology and Financial Centre which recommended establishing a brand new DAO company structure. Also helping us visualise this code-based corporate governance world is the Coalition of Automated Legal Applications which has developed the DAO Model Law (“Model Law”).
The Model Law contains revolutionary proposals to achieve functional and regulatory equivalence between algorithmically regulated DAOs and existing corporate entities. Who needs meetings when proposals can be raised and automatically put to all tokenholders instantly and transparently? Who needs directors when a DAO must execute functions if certain predefined conditions are met, deterministically, every time? Corporate registration, disclosure, and reporting requirements suddenly look very different when a DAO’s code must be open source, publicly available and subject to audit to ensure it meets minimum quality standards.
It won’t be straightforward
A deterministic corporate structure purely governed by code without the noise or conflict of human discretion is a confronting concept. There are of course some clear shortcomings with lex cryptographica. Just as there are loopholes in the law, human created code is not infallible. In 2016, over $60m of Ether was siphoned from a DAO called “The DAO” by exploiting the logic of its underlying smart contract. The “attacker” infamously posted an open letter (albeit its authenticity is disputed) to The DAO’s members and the Ethereum community defending their actions saying that they legally used a legitimate feature of the smart contract that anyone could have exploited. If the code is law, and the code permits it, then what gives?
Tokenholders faced with black-and-white outcomes from defective smart contracts may understandably demand recourse under (actual) law to address any “unfairness”. This is just one of the many issues that need to be addressed in recognising the legal status of DAOs.
DAOs are only expected to increase as an organisational model for the digital economy. As mentioned in our recent article, the UK Government has articulated its ambition to position the UK as a leading global hub for cryptoasset technology and investment. Recognising DAOs as a unique type of corporate entity, with the ability to own property and contract for itself together with limited liability for its members, would drive adoption and unlock its potential as a game-changing democratised application of blockchain technology.
Doing so of course presents significant challenges and opportunities to regulators seeking to enhance market trust, improve market operation through encouraging innovation, and prevent harm from occurring.
We’ll also be exploring some of these issues in future articles.