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Mienert, How can a decentralized autonomous organization (DAO) be legally structured?, LRZ 2021, Paragraphs 336 - 367.
The decentralized structure and automated operations of decentralized autonomous organizations (DAOs) raise complex questions about the determination of applicable law, corporate status, and external actions that cannot be adequately answered using classical theories. This article draws up the different current legal possibilities for structuring DAOs.
Distributed-ledger technology is probably the most discussed innovation in the digital transformation of the economy and society. With features such as decentralization, reliability, and anti-counterfeiting, it opens up a broad field of innovative applications and completely new forms of cooperation. Although developments often focus on payment systems and other financial instruments, large blockchain-based ecosystems and projects point to a development in which online groups coordinate at eye level and possibly pseudonymously, relying exclusively or entirely on software. This development of purely digitally existing decentralized organizations that operate autonomously without traditional leadership and hierarchy is summarized under the term decentralized autonomous organizations (DAOs). The primary aim behind the construct of a DAO is to create a virtual entity to replace the central management of previous forms of organization.
These DAOs operate under different circumstances than many of today's traditional legal entities and other business associations. DAOs will not be run by boards or managers but will be governed by democratic or highly participatory processes or algorithms.1 Rather than operating in one or a few countries, DAOs seek to span the globe and bring together thousands of members regardless of their physical location or cultural or financial background. DAOs often seek to avoid written agreements or other formalities, with members primarily agreeing to manage their affairs through software and the rules of the code.2 A single definition of a DAO has not yet emerged, because of the different ways in which it can be structured According to the definition here, DAOs can be described as a new form of scalable, open, self-organized networks that are coordinated by crypto-economic incentives as well as self-executing code on the blockchain to achieve common goals.3
In doing so, DAOs promise to extend the basic benefits of organizational structures, such as access to markets and cost efficiency. Also, by enabling groups to automatically control and coordinate certain actions and behaviors through the use of smart contracts, DAOs set new milestones for operating more efficiently and transparently. Moreover, they radically challenge key issues and definitions of a company, such as the hierarchical organizational structure, the separation of company members from market participants and the cultural or technical homogeneity of members.4
Currently, DAOs have over $14.5 billion in assets under management.5 This year alone, assets under management have increased more than tenfold. This development should also give a reason for modern jurisdictions to address this development and create a legally secure framework for DAOs. This is because DAOs can quickly pool and deploy capital, often implement low-cost and streamlined digital voting systems, and establish internal controls that protect members' assets and could help uncover the need for ramped-up monitoring to prevent fraud or other insider abuses.
Most of the currently capital-managing DAOs are focused on funding new projects by pooling capital and voting, and on decentralizing the development of existing projects to serve the community.6 It is evident that due to the ease of participation in projects, DAOs are receiving a lot of attention and popularity, so further exponential growth can be expected.
However, the decentralized structure and automated operations of a DAO raise complex questions about the determination of applicable law, corporate status, and external actions that cannot be adequately answered using classical theories. According to the current legal situation, one of the greatest risks is the nearby classification of DAOs in most jurisdictions as some kind of general partnership due to their structure. This has the personal and unlimited liability of all participants involved as a consequence.
Since many consumers participate in such DAOs, a legally secure framework should be created for consumer protection reasons alone, which eliminates this often-unknown liability risk. For example, the state of Wyoming in the U.S. already enacted a law in July of this year that allows DAOs to be formed as a limited liability company with recognition of legal personality, namely as so-called DAO LLCs. Due to the Treaty of Friendship, Commerce and Navigation between the Federal Republic of Germany and the United States of America of October 29, 1954, this law also has concrete effects on the German and European company landscape. Namely that a DAO LLC from Wyoming is also recognized in Germany as a limited liability company and can operate within Europe. This should also encourage the German and the European legislator to push ahead to create a legal framework for DAOs in order not to leave the legal design to other states and to exert influence through proactive design. It also appears essential to adapt company law to new digital structures to make Europe in general attractive as a permanent settlement and innovation location for blockchain-based business models and to counteract an exodus.7
After describing the current state and the hopeful future possibilities, it is crucial to look at how DAOs can be legally structured at the moment de lege lata. Mainly, there are four different options for setting up a legal structure of a DAO.
The first option, which is used a lot through the DeFi- Ecosystem, is not setting up a legal entity at all and trying to create a fully decentralized structure. However, this does not mean, that DAOs without a registered legal entity operate outside the law. In most jurisdictions, they will be seen as general partnerships with the corresponding legal consequences. This most significant one is the risk of the personal liability of every participant. But this means also the DAO has a legal personality and can in most jurisdictions legally own assets and also employ people. Although the participants did not register the DAO, they created a fully recognized legal entity in most jurisdictions that can sue and can be sued. This is often misunderstood.
Although this bears significant risks, as mentioned. This structure also takes advantage of regulatory arbitrage in certain areas. If there is no central entity involved and the project is truly decentralized and launched anonymous legal enforcement becomes pretty difficult. Even the SEC acknowledged, that the greater a project’s decentralization, the less likely the underlying tokens would be considered securities.8
Moreover, regarding international private law finding the applicable law and the responsible regulatory authority can be quite challenging in the case of a fully decentralized DAO. Because in the case of DAOs with economic interests, the cooperation agreement between the participants is sufficiently consolidated under conflict of laws, so that the connecting rules of international company law have to be applied. If no explicit choice of law is made, the rules of international company law reach their limits in the case of DAOs. This is because, unlike traditional software applications that reside on a specific server under the control of an operator assigned to a specific jurisdiction, DAOs run on every node of a blockchain - everywhere and nowhere. And unlike traditional organizations, which are run by individuals living in distinct and identifiable territories, DAOs are collectively managed by a distributed network of peers who contribute to the underlying blockchain-based network from anywhere in the world. Thus, a decentralized blockchain network, like a DAO, is fundamentally opposed to the traditional International Private Laws search for the cartographic center, since no spatial center of gravity can be determined. The traditional theories to determine the jurisdiction for companies in most jurisdictions are linked either to the place of incorporation or to the administrative center. In the case of a DAO, this is not really helpful, because normally both of these places cannot be determined. Besides that, other reference points also reach their limits. For example, the assets of a decentralized autonomous Organisation are, if consisting only in digital currency, spread all over the world. For that reason, the principle Lex loci rei sitae (law of the place where the property is situated) cannot be implemented. A conceivable solution would be in some cases to determine the applicable law on the ground of jurisdiction of the other contractual party if the place can be identified and a contract in the legal sense exists. But this solution does not help with determining the legal status of a DAO in the first place. Finally, it would be possible to always rely on the Lex Fori principle. This means the positive law of the state, nation, or jurisdiction within which a lawsuit is instituted or remedy sought. Apart from the legal-theoretical concerns, which the lex fori brings with it, the application also runs counter to considerable practical considerations due to the concept of the DAO. For example, it may be necessary for litigants to have to bring actions in several jurisdictions in order to obtain legal protection, and a legal dispute against a DAO may become very impracticable from an economic point of view. As a consequence, it is quite difficult to determine the applicable law for DAOs and thus the competent jurisdiction and regulatory authorities, which also makes enforcement of law as shown very difficult. Determining whether a project is sufficiently decentralized to avoid scrutiny from regulatory authorities for the unregistered sale of securities is a highly nuanced and complex process. No single factor is determinative and the regulatory authorities will look at the totality of the circumstances in making this determination. Therefore, it is strongly recommended reaching out to regulatory authorities for guidance and also seek legal advice regarding that.
The second option is setting up a DAO with a liability wrapper, which protects its members. This is an interesting option, especially for organizations willing to operate within the United States and give up some kind of decentralization. Within the US, you have a few options for which state to incorporate in.
The first step in this direction in Anglo-American law has already been taken in 2018 by the state of Vermont in the United States. Since mid-2018, it has been possible to establish a so-called Blockchain-Based Limited Liability Company (BBLLC) in Vermont, which has now opened up the possibility of establishing a limited liability DAO for the first time.9 For this purpose, a Blockchain-Based Limited Liability Company (BBLLC)10 was registered in Vermont after the deployment of the DAO on the Ethereum Blockchain by dOrg.11 By linking the DAO to this BBLLC, the DAO has an official legal status that allows it to enter into contractual agreements and offer liability protection to participants.12 The BBLLC enables full governance via the blockchain and using smart contracts.13 OpenLaw in the U.S. state of Delaware is also taking a similar approach by establishing the LAO (Legal DAO).14 The LAO provides a legal structure to allow members to invest in blockchain-based projects in exchange for tokenized shares or utility tokens.15 This structure is called a "legal wrapper," which is created by structuring the DAO as an LLC to hold the company responsible for contracts, taxes, and violations of law, but not the individuals acting on behalf of that company.16 The goal of the LAO is to limit the liability of the participants, provide clarity on the applicable law, and provide tax benefits (flowthrough/single taxation).
On April 21, 2021, Wyoming Governor Mark Gordon signed Bill 38, which allows Wyoming to recognize decentralized autonomous organizations (DAOs) as limited liability companies. The new law is essentially an amendment to the current Wyoming Limited Liability Company Act. Under the provisions of the Act, a DAO is defined as a limited liability company whose articles of incorporation include a statement that the company is a DAO.17 Concerning decision-making in a DAO, the notion of a majority of members is also concretized. Namely as the approval of more than fifty percent (50%) of the participating member interests in a vote in which a quorum of 4 members participates.18 It is also interesting to note that a membership interest is determined as a member's ownership share in a member-led decentralized autonomous organization, which may be defined in the entity's charter, smart contract, or operating agreement.19 The use of the term "ownership share" indicates a corporate reference and thus also suggests a classification as a security, even though this is not explicitly addressed in the bill.
The second part then determines the scope of application of the Wyoming Limited Liability Company Act to DAOs. In addition to a new formation, an existing LLC may also be converted into a DAO by amending its articles of organization to include the same statement. The DAO's registered name would also have to include the appropriate designation, such as "DAO," "LAO" (Limited Liability Autonomous Organization), or "DAO LLC".20 Also, all DAOs must have a disclaimer in their articles of incorporation that the rights within this form of organization may differ materially from the rights in traditional LLCs, particularly for membership rights.21 The articles of organization filed with the Secretary of State for registration must also describe the structure of the DAO as either a member-managed DAO or an algorithmically managed DAO.22 If this is not specified, it is assumed to be a member-managed DAO.23 This shows that the Wyoming legislature also distinguishes between different levels of automation of DAOs and their design.24 In addition, it specifies that an algorithmically managed DAO may only be formed "if the underlying smart contracts can be updated, modified, or otherwise upgraded".25 This is presumably intended to guarantee the controllability of DAOs in light of future technological advances.26
For the DAO formation process, the law states that any person may form a decentralized autonomous organization, which shall have one or more members, by signing and submitting an original and an exact or adapted copy of the articles of incorporation to the Secretary of State for filing.27 Each DAO must have and continuously maintain a registered agent in this state of Wyoming, as also provided in the Wyoming Company Act.28
In addition to the requirements above, the articles of incorporation must include a publicly available identifier of each smart contract used directly to manage, facilitate, or operate the DAO.29 A DAO may be established and operated for any lawful purpose, regardless of whether it is for profit. 30
Moreover, it specifies what, at a minimum, must be regulated in the DAO's bylaws, namely the relationships among its members and between the members and the DAO as a society itself.
While this formal legal framework is a step for the crypto industry and solves the problem of member liability, the new law does not address other fundamental issues. It is unclear whether DAO members are granted the right to act on behalf of the DAO and legally bind it; rather, it requires that this be clarified in the bylaws. Concerning necessary legal certainty, a statutory regulation would be desirable, at least for those cases in which this is unclear. It is also not clear who is responsible for updating the underlying smart contracts in the case of algorithmically managed DAOs.
Finally, fundamental questions regarding the regulatory classification of DAOs and DAO Tokens are unclear. First, depending on its activity, a DAO could be considered an "investment company" within the meaning of Section 3(a) of the Investment Company Act of 1940 ("Investment Company Act") and would then have to comply with the disclosure requirements and investment restrictions set forth therein. In the case of The DAO, the Securities and Exchange Commission (SEC) intentionally left this open because The DAO had not yet begun funding projects, but specifically noted the possibility. "This report does not analyze the question whether The DAO was an "investment company," as defined under Section 3(a) of the Investment Company Act of 1940 ("Investment Company Act"), in part, because The DAO never commenced its business operations funding projects. Those who would use virtual organizations should consider their obligations under the Investment Company Act." 31
Second, it is not clear whether the tokens issued by the DAO as a form of membership interest will be classified as securities under the Securities Act of 1933 ("Securities Act") and the Securities Exchange Act of 1934 ("Exchange Act"). This is likely to be the case for most for-profit DAOs following the SEC's decision in the case of the DAO. "Based on the investigation, and under the facts presented, the Commission has determined that DAO Tokens are securities under the Securities Act of 1933 ("Securities Act") and the Securities Exchange Act of 1934 ("Exchange Act")."32
The option of using a liability wrapper in the US is the best option for DAOs, which look for the most legal certainty and safety and are willing to comply with all the necessary regulations and provisions of the different states. Also, as mentioned, if the DAO decides to give out the token it needs to be carefully looked at, because in most cases it will be qualified as a security with the corresponding legal necessities (prospect, registration with the SEC, etc.)
Within the different options in Vermont, Delaware and Wyoming, the choice depends on every individual case and the goals of the DAO and its community. While Wyoming's law is most true to the DAO structure, it also requires the most information and paperwork, as explained. For Comparison in Delaware, the setup of the LLC is quite fast and cheap and provides a lot of flexibility. But it also requires that every Member of the DAO needs to be a member of the LLC and each time a member changes this would need to be updated. To go into too much detail here which states fit which structure would go beyond the scope of this paper, and require legal advice in each case, but in summary, the option of a US LLC is particularly suitable for projects that want the greatest security and are willing to comply with the numerous legal requirements.
A foundation with legal capacity under private law is an organization set up by one or more founders to permanently fulfill a purpose defined by the founder with the help of the assets dedicated to the foundation.33 In this respect, the foundation form could be considered to pack DAOs into a legal construct.
In principle, certain parallels between blockchain organizations and foundation law can be seen. The immutability principle, which is intrinsic to a Blockchain and on which trust in it is based, is similarly found in the solidification principle under foundation law. This principle states that it is not possible to update the founder's intentions after the foundation has been established. In both cases, changes are only possible under increased conditions.
In addition, the aspect of autonomy proves to be fundamental both in the legal form of a foundation and in a blockchain-based organization. Foundation autonomy enables the foundation to develop a life of its own over time. It can be completely detached from the founder, which is still tied to the purpose of the foundation and thus to the founder's will, but whose existence is no longer at the disposal of the foundation's participants. This autonomous dynamic is a core component of a blockchain-based DAO, whose goal is to act independently and autonomously from the original developers according to the previously determined code. In this respect, DAOs open up the possibility of extending and permanently consolidating the degree of independence of foundations, which is limited by the legal framework. However, it is questionable whether DAOs can be established and operated without problems within the current legal limits for foundations. The general view is that the purpose, assets and organization of a foundation are the three essential elements of the concept of a foundation.34 While the foundation purpose can be determined by an initiator given the diverse possibilities of DAOs, some issues open up with regard to the foundation assets and the legal structure. First, in some jurisdictions, it is questionable whether virtual goods, which will regularly be the case in the form of tokens in DAOs, are suitable foundation assets. The line is drawn insofar as, according to the requirement of proper asset management, the foundation assets cannot consist exclusively of highly speculative components. In addition, in many jurisdictions, the organization of foundations raises considerable legal difficulties. In almost all Western jurisdictions, the organization of a foundation requires a board of directors, which represents the foundation as a management body in legal transactions and is liable. Finding a board of directors can be difficult for DAOs with the goal of full decentralization. However, if this requirement can be fulfilled, there are some good possibilities to structure a DAO as a foundation and it has already been used by different projects in the past.
The most used jurisdictions are Switzerland and the Cayman Islands. Switzerland provides in comparison to other European jurisdictions a more flexible foundation model with a relatively easy setup and a quite moderate taxation.
Regarding the Cayman Islands, this is also a jurisdiction, which a lot of crypto projects choose, with reasonable reasons behind it. Especially the legal structure of a so-called “Foundation company” is very interesting, which was introduced as a new structure by law 2017.35 The foundation company is a remarkably flexible vehicle that operates like an incorporated trust, allowing it to function like a civil-law foundation or common-law trust while retaining the separate legal personality and limited liability of a company and tax neutrality. The foundation company also can designate beneficiaries, which will not be treated as a beneficiary under a legal or common-law trust arrangement. 36 The reason is, that the starting position under the Law is that a designated beneficiary has no rights or powers against the foundation company, only those expressly stated by the foundation company.37 Moreover, a foundation company does not need to maintain a register of its beneficiaries with their legal names under the Law.38 It can designate beneficiaries by class of persons for example as “token holders" or "node operators “and also reward those beneficiaries according to that class.39 Although anti-money laundering considerations always need to be kept in mind this could be useful for DAOs where the DAO intends to undertake distributions, airdrops of tokens, or other rewards to the DAO community.
It needs to be highlighted contrary to full decentralization every foundation must have at least one Director, Supervisor, and Secretary. These can be natural persons or legal entities, and the same entity can be both Director and Secretary if desired.
As a result, fully decentralized DAOs will have difficulties setting up a foundation given the legal boundaries. But attention should also be drawn to the many parallels between DAOs and the foundation structure, such as the high degree of autonomy and the permanent perpetuation so that corresponding considerations by legislators to adapt the foundation would be desirable. Until then, the structure is suitable for DAOs, which are willing to give up some decentralization and can designate trusted representatives.
Especially regarding the last option with an offshore foundation, a lot of projects combine this with an LLC or similar legal entity in a business-friendly jurisdiction, which employs the developers and the team, if there is one, as this can be difficult just with the foundation. Mostly, the foundation will hold the treasury and will have an agreement with the LLC in which it states, that the DAO Treasury will pay for the expenses of the LLC. Although this option can use the benefits of options two and three, it also comes with additional requirements and certain centralization aspects, which need to be considered regarding the structure.
As shown, there is no “perfect” and no onefitsall solution for DAOs.40 Until a proper legal framework for DAOs is created, which enables them to operate fully decentralized with limited liability legal recognition and easy taxation,41 every current legal setup comes with its benefits and downsides and each DAO should seek individual legal advice, which option fits the best for its needs. Especially when a DAO Token is involved, the legal setup can get even more complicated, as a Token can often be qualified as a security42 and create additional legal requirements, such as prospects or registration with the legal authorities.