DAOs: In Search of Legal Personality & Limited Liability

Overview- Establishing traditional legal entities.

When you decide to establish a company, the first thing you have to do is to choose between different company classifications under the law. A company can be defined as a body corporate, or an incorporated business organisation registered under an applicable companies act.  

In many countries, corporate entities are classified according to their legal structure, ownership, liability, and the way they are taxed. Keep in mind that exact types and definitions may vary by country and jurisdiction.

Here are some common types of company classifications: 

a. Sole proprietorship

Sole proprietorship is a business owned and operated by a single individual that is responsible for all debts and obligations that arise in conducting business. Therefore, sole proprietorship carries the weight of personal liability.

b. Partnership

Partnership refers to a business owned by two or more individuals that share profits and losses. Two main types of partnership are general partnership and limited partnership.

c. Limited Liability Company (LLC)

This hybrid form is commonly a popular choice when establishing a company because it combines the limited liability protection of corporations with the tax benefits of partnerships.

d. Corporation

There are several types of corporations, but their common feature refers to them being separate legal entities from their owners and shareholders, with their own rights, obligations, and liabilities.

The only time human liability can be established is in the case of piercing the corporate veil. In more simple terms, piercing the corporate veil means looking beyond the company as a legal entity. When humans protected by the company's limited liability have been breaching the law, statutory law provides this tool that basically pierces or lifts the corporate veil to bring human actors to justice.

Technology challenges existing legal structures

Developments in technology have revolutionised the way we work and have challenged traditional corporate structures in many ways. Apart from the need to adapt to new market conditions to remain competitive, technology brought to the table new forms of organisations.

The rapid development of blockchain technology and Web3 is beginning to challenge existing structures of legal personality for non-human business entities worldwide. The concept of a Decentralised Autonomous Organization (DAO) is changing the way we see corporate structures. Instead of relying upon static mechanisms and human intervention to regulate governance, such entities provide algorithmic governance mechanisms that execute at the speed of code. 

If you are a frequent reader, you probably remember that we examined decentralised autonomous organisations a couple of times. From describing the meaning of DAOs in our 'What's a DAO?' to the main benefits of DAOs and the rapid formation of Ukraine DAO for funding the country's defence, we have tackled this topic from many aspects.

Since legal frameworks around the globe are structured as they are, DAOs maintaining their unincorporated legal status produces negative legal implications. Without wrapping such associations legally, DAO members are exposed to unlimited risks.

Recently, a number of U.S. states and some other countries started to deal with the legal personhood of such organisations. This question has been in the air for a while now and a topic of many legal debates. Legislators basically asked themselves what they should do with such organisations, and the answer is just around the corner.

What are Decentralised Autonomous Organizations (DAOs)?

We can illustrate DAOs as attempts to create organisations based on community governance and the benefits of blockchain technology. Basically, someone came to the idea that governance should be expressed mathematically to put into motion a logical and objective structure.

If you want to know more about the meaning of DAO, check out our ‘What’s a DAO?’ article. 

Building upon the flaws of traditional corporate structures based on a hierarchical system of humans with decision-making powers and a central point of authority, decentralised organisations provide a flat structure based on tokens and the execution of code that is visible and auditable on the blockchain. 

How does DAO Function?

So far, DAOs have been non-incorporated business entities based on blockchain technology that are controlled directly by those who have invested. Aside from flat governance procedures, a common objective has been one of DAO's main features as well.

Looking from the technical perspective, DAOs work on the basis of smart contracts, that present the foundational framework which dictates how a particular DAO will operate. Decentralised autonomous organisations function solely by using smart contracts instead of any human intervention. In fact, DAOs can be seen as a complex example of a smart contract, where the organisation’s bylaws are embedded into the code.

In simple words, founders gather to create a smart contract that defines the common purpose and governance token rules and put it into motion. The smart contract is visible and verifiable on blockchain. Since it can be audited publicly, every member can check it out to gain an understanding of DAO’s functioning. 

If you are not quite familiar with the concept of smart contracts, why not read this article: 'How to use crypto: What are Smart Contracts?'.

Before establishing such an organisation, it needs funding to function seamlessly; Just as it is important to have adequate capital when forming a traditional type of company to cover initial costs and ongoing expenses until the business becomes profitable. The method is different since DAO funding is gathered using tokens. The organisation sells tokens in exchange for funds. Sales happen through public or private offerings, and the money raised goes to the DAO's treasury. Token holders are given voting rights based on the number of tokens they have purchased. 

Since getting too much into theory can be exhausting, learning from examples might do the trick. When the war in Ukraine started, the country needed funds for its defence. People worldwide quickly joined a decentralised autonomous organisation that was faster and more efficient in collecting donations in comparison to traditional organisations. We asked ourselves back then if UkraineDAO can act as a model for future nonprofits.

You can read about it in this article: 'UkraineDAO: How a DAO is funding the Ukraine defence?'

How is a DAO different from traditional organisational structures?

To start off gently, DAOs differ from traditional corporations through the use of blockchain technology and a community-based approach that facilitates governance by holding a native crypto token.

Main differences can be spotted in DAO's core features. To gain a better understanding of this concept, here are three main differences:

Flat structure instead of power hierarchy

Traditional legal entities usually have some kind of hierarchy such as a board of directors and upper management that present a basic structure of power. The emergence of DAO legal entities flattens the hierarchy since they rely on blockchain technology and smart contracts that cannot be altered without the consent of the majority. In other words, decentralised governance took over the place usually reserved for a central authority.

Overall transparency

Transparency is a bump on the road when it comes to traditional corporations since total transparency is usually reserved for the top of the hierarchy. Even companies with innocent intentions leave out a bunch of information due to building up their brand image or being more competitive in the market.

In most cases, traditional companies don't have a way to show their members their dealings in an entirely transparent way. Since DAO is based on blockchain, digital ledgers record the history of all dealings and ensure their transparency to the whole community.

Equal ownership

While in most traditional businesses it is almost impossible to break the top division of power once it has been established, DAOs provide assets and direction to each participant based on their contribution to the project. Each individual that contributed capital has an equal voice in this flat system of decentralised governance. DAO-based governance principles directly foster a sense of community and cooperation towards achieving a common goal.

These main differences can be, at the same time, viewed as the main advantages of a DAO structure. You can find out more about its benefits in our 'What's the benefit of a DAO?' article.

What is the personhood of a legal entity?

The construct of legal personality emerged centuries ago and played a huge role in the economic development of the world. The basic definition refers to the ability of an entity to have legal rights and obligations. Recognizing an entity as a legal person provides the capacity to enter into contracts, own property, sue, and be sued. 

Legal personhood enables legal entities to fully engage in all economic and social activities. It encompasses a list of elements such as existence under law, legal capacity, separate legal identity, perpetual succession, governance, and accountability. 

Not incorporating a legal entity or conducting business in a grey zone can lead to the unlimited liability of founders and members. The recognition gives rise to separating the organisation's legal identity and avoids unlimited legal liability and all its negative consequences.

There are other wide-reaching implications as well. For example, issues may arise with respect to sharing competitive information among, and collaborating with, individual members that may be competitors. The problem is that certain antitrust violations carry with them the potential for criminal liability as well.

Despite the fact that DAOs govern themselves through a community-based approach as we described in the 'What's the benefit of a DAO', a broad number of individual members without a resolved legal status may amount to such legal implications.

The Ooki DAO case: Can you sue a DAO?

Lack of regulation doesn’t mean that DAOs can avoid the courtroom. The need to recognize DAO’s legal personhood can be seen in the legal battle of CFTC v Ooki DAO which was closely monitored by the crypto community. The court was asked to determine whether and how Ooki DAO could be sued. In December 2022, judge Orrick of the US District Court for the Northern District of California held in a procedural decision that Ooki DAO could be sued because it was an unincorporated association.  

The Commodity Futures Trading Commission (CFTC) claimed that Ooki DAO was intentionally formed as a DAO to avoid regulatory oversight. Since DAO members that are holders of the organisation’s native token communicated through an online community forum and voted their tokens on issues related to the organisation’s business, the CFTC claimed that it was an unincorporated association of token holders.  

Even though a number of supporters filed amicus briefs to the court claiming that Ooki DAO was a technology instead of an entity and not an unincorporated association, the Court interpreted the matter differently. Several U.S. states, including California, recognize unincorporated associations and define them as unincorporated groups of two or more persons joined by mutual consent for common lawful purpose, whether organised for profit or not. Typically, such organisations include non-profits, charities, golf clubs, social clubs, neighbourhood associations, and sometimes even general partnerships.

Remember that we mentioned how UkraineDAO could be a model for future non-profit organisations? According to judge Orrick, there are no barriers to say that UkraineDAO is legally recognized under an existing framework. In simple terms, it may be an unincorporated nonprofit association that is liable in the eyes of the law. 

The court concluded that token holders joined Ooki DAO voluntarily and that the trading Protocol of the organisation wasn’t illegal. Therefore, Ooki DAO fitted into the existing legal structure as an unincorporated association. Some states don’t recognize unincorporated associations, but that doesn’t mean avoidance as well. It could still fit into the definition of a common law general partnership that includes unlimited liability of members. For example, if Ooki DAO was sued in another state or even continent, it could be facing unlimited liability.

The same thing applies to many European countries founded on the basis of the European continental law system as opposed to the Anglo-Saxon common law.  Even though the legal status of DAOs in European law is still developing and there is no uniform legal framework, most countries consider DAOs may be legal persons, either as a contractual entity on the basis of the smart contract implementation or as a corporate entity, if registered as a company, foundation or association.  

The legal recognition of DAOs worldwide

The need to define DAOs within a specific regulatory framework has been put in motion. Recently Utah and New Hampshire decided to join the U.S. bandwagon of DAO legal interpretations. On the other hand, Europeans are waiting for the official enactment of the Markets in Crypto Assets (MiCA), a regulation that is a part of the EU’s Digital Finance Strategy which aims to regulate the digital currency market in the EU.

https://twitter.com/EuCInitiative/status/1633469755633078273

MiCA tackles DAOs in its provisions regarding crypto assets service providers. It stipulates that only persons with a registered office and authorization from competent national authorities would be allowed to provide such services. Whether you are a newcomer in the crypto community or a more experienced user, it is always good to be prepared.

We suggest reading this article to gain a better impression of MiCA: 'What is Markets in Crypto Assets (MiCA)?'

At the moment there is no one-size-fits-all legal framework, but a number of countries have been taking steps to define DAOs legally. Until that is done, DAOs shall be defined within existing boxes of legal entities. The thing that most regulators are trying to do now is to create a separate box for Decentralised Autonomous Organizations. 

Defining DAO legal entities: US leads the way

Wyoming as an early adopter

Wyoming was the first jurisdiction that enacted a law granting a limited liability legal status to DAOs in 2021. The law is known as the Decentralised Autonomous Organization Supplement. It enables DAO members to form a decentralised organisation in the form of a Wyoming limited liability company (LLC). 

The new law prescribes two types of DAOs – a member managed DAO and an algorithmically managed DAO. Unless the organisation stated in its Articles of Organization that it was algorithmically managed, it is presumed that DAO is member-managed. Member-managed DAOs closely resemble traditional limited liability entities.  

If a DAO is registered as algorithmically managed, members must add in the Article of Organization a publicly available identifier of the smart contract that runs the organisation. The reasoning behind that lies in the possibility of a conflict between the Articles and the smart contract; the law says the smart contract shall prevail. 

To register a DAO in Wyoming, you need to comply with a few requirements such as having a registered agent in Wyoming, a business name that includes ‘DAO’, ‘LAO’ (Limited Autonomous Organization’ or ‘DAO LLC’; and the statement that it registered in accordance with Wyoming law. 

Even though it resembles LLC closely, there is a significant difference. Members of DAO LLC do not have fiduciary duties of care to the legal entity and other members. Instead, they are only subjected to an implied contractual covenant of acting in good faith.

To explain this more simply, a fiduciary duty is a legal construct that implies that a person in a position of trust, such as a real estate agent, broker, attorney, or executor, must act in good faith and honesty on behalf of a client. It is a legal obligation of the highest degree.

Even though Wyoming legislation moved the legal status of DAOs forward, uncertainties remain when it comes to tax treatment, legal standing outside the state, and the nuances of applying securities laws to tokens.

In Tennessee, DAOs are 'DOs'

In April 2022, Tennessee became the second U.S. state to create a specific legal entity for DAOs. The new Tennessee law enables limited liability companies to register as decentralised organisations. This framework provides members of a decentralised organisation limited liability protection similar to a traditional LLC. 

To register as a decentralised organisation (DO), a few requirements need to be met. For example, at least one member must sign and deliver the Articles of Organization to the secretary of the state for filing. Further, governing documents must contain a statement that the company is a decentralised organisation, and organisational documents need to include particular notices regarding restrictions on duties and transfers in a DAO.  

Similar to the Wyoming solution, a DO can be member-managed or smart contract-managed. The reasoning behind the enactment of this law was to make Tennessee attractive to blockchain investors. 

Forming s DAO LLC in Delaware

Delaware established a legal DAO as ‘LAO’ (Legal DAO). Such a structure enables members to invest in a decentralised platform in exchange for utility tokens. Forming a DAO in Delaware provides flexibility in deciding whether to make smart contracts public or private, and to conduct on-chain operations more freely. 

The legal status is referred to as a DAO legal wrapper. The legal wrapper means that a DAO has been structured as an LLC and that clarity has been provided on issues such as applicable law, taxes, and the limited liability of participants. Wrapping a corporate form around DAO ensures limited liability.

Switzerland is DAO-friendly

In the article regarding UkraineDAO, we mentioned that one of the main problems of DAOs is related to regulatory gaps and that jurisdictions such as the U.S. and Switzerland decided to act fast in embedding DAOs as legal entities into their existing legal framework. 

Even though Switzerland has no special regulations for forming a DAO, it has been recognized as a DAO-friendly country due to its effective practice of application of existing legislation. The Swiss Code of Obligations, along with the Swiss civil code, provides a decent environment for setting up a DAO, despite the fact that these pieces of legislation have not been initially designed to include DAOs. The country is also known as a popular jurisdiction for big crypto companies and investors.  

There are two ways to establish a DAO within the Swiss existing legal framework. The first one refers to the creation of Decentralised Autonomous Associations (DAAs). These are non-profit DAOs that can have various structures such as an assembly, delegates, and member community. DAAs established for non-economic purposes obtain their legal personhood immediately after the intention to establish them has been expressed in the founding agreement. Remember what we said about UkraineDAO and being recognized by law? It seems that Ukraine DAO could fit right into the Swiss framework. 

The second option would be to establish a foundation as a DAO legal wrapper. Swiss legislation basically permits the existence of a standard structure of a DAO in which members may vote in compliance with rules prescribed by the smart contract and the charter as the constitutional document of the foundation. However, there are some complications when setting up a DAO legal wrapper since the process is very expensive and the constitutional documents cannot be amended easily due to bureaucracy procedures. 

The Maltese approach

Since we mentioned the upcoming EU MiCA, we must add that DAOs getting legal status by Malta, a member state of the EU, is astonishing. Back in 2018, Malta enacted a trio of new laws: the Virtual Financial Assets Act, the Malta Digital Innovation Act, and the Innovative Technology Arrangement and Services (ITAS) Act. 

Under the ITAS Act, a particular organisation may apply to the Maltese Digital Innovation Authority for recognition. There are a few requirements such as an auditable smart contract and having a registered agent and technical administrator. The Act stipulates in one of its provisions that an organisation may be registered even if it doesn’t have legal personhood. If we go back to 2018 when these laws have been enacted, we may see that this was a way to remove obstacles to DAO formation. 

It seems that Malta is way ahead of the EU. That is exactly what Maltese regulators stated back in 2018 at a FinTech and Digital Innovations summit in Brussels.

https://twitter.com/SilvioSchembri/status/968533816729112577/photo/1

Estonia's supportive environment

Similar to Switzerland, Estonia doesn’t have specific laws that govern DAOs, but the country’s existing legal framework provides many possibilities for digital entities. What differentiates Estonia from other countries is that it didn’t specifically recognize a DAO legal entity and that the country has been acknowledged as a tech hub. Rather than providing a statutory DAO recognition, it provides a supportive environment for different tech undertakings. 

Existing law in Estonia enables the formation and operation of entirely virtual general meetings; in other words, members are not required to attend in person. Members of all legal entities under Estonian law have the power to adopt resolutions without calling general meetings. This suits DAOs pretty well. If you add the e-Residency program, the idea of forming and operating a DAO seems easy. 

Hunting for solutions

As explained, there is currently no perfect solution for DAOs. The world is moving towards regulating DAO as a legal entity. While some states introduced specific laws on DAO formation, a few states even managed to fit DAOs into existing legislative boxes. A few U.S. states made a big step forward by introducing DAO-tailored legislation, but a satisfying solution would be reached when the whole U.S. produces such laws in a uniform manner. 

DAOs will probably encounter problems until there is a proper legal framework that enables such organisations to operate fully decentralised and with a limited liability status and easy methods of taxation. Since DAOs use tokens, the problem of whether to qualify such a token as a security or not should also be resolved in the future.  

The question of whether too much regulation could hurt the crypto industry arises. A while ago we discussed this issue in our ‘What is the threat to crypto from regulation?’ article.

It is well known in law that overregulation, the same as lacking regulation, can have negative implications. Burdening the crypto industry excessively with rules and regulations could have a negative impact in the long run, but leaving this area underregulated and vulnerable to risks of unlimited liability wouldn’t be a wise thing as well. Both in life and in crypto, balance is the key.