On the Rise: Distributed Autonomous Organizations ("DAOs")

Article 06 July 2021 Experience

M. Ridgway Barker co-authored this article with Joseph Bambara, CIPP/US.

On July 1, 2021, Wyoming’s state Bill 38 took effect. It provides a legal framework for Decentralized Autonomous Organizations (DAO), an entity that federal or state legislatures have not even considered. The bill applies the Wyoming LLC Act to DAOs, giving them legal status as limited liability companies (LLCs). One of the risks with DAOs was the uncertainty as to how they would be treated under the legal system. There was a legitimate concern that DAO members might be held personally liable for the actions of the DAO under “general partnership” principles. Most DAO members join a DAO to participate in the DAO community’s goals and objectives. Hopefully, it will protect DAOs from being treated legally as general partnerships and solidify the rights of DAOs as legal persons providing clarity and structure to many DAO projects. While this bill does not address all DAO-related issues, it resolves the potential liability faced by members of a DAO and marks a significant step forward to recognize DAOs as legal entities. To be clear, Wyoming is not the first place to legalize DAOs. Malta began the process in 2019. Unfortunately, the Maltese legislation is complicated, and for purists, too much responsibility is vested in a manager, contrary to the purpose of a DAO. But Malta was the first to lay the legal groundwork for the DAO. Future amendments could grant DAOs additional legal personality and reduce the responsibility placed on managers. Some claim that the legal DAOs are unworkable and are wrought with potential dangers. In any case, the impact of Wyoming’s initiatives could be limited given the state’s small population, minimal ties to the financial industry, and the fact that federal securities laws are paramount in the United States.

So, what is a DAO: a DAO is a business organization where control and governance are horizontal and distributed among the members. In contrast, LLCs and corporations that are hierarchical are controlled by designated managers, officers, and a board of directors. At the core, a DAO is an organization governed by smart contracts that function autonomously without a central authority. They challenge existing constructs of legal personality for algorithmically run business entities emerging around the globe. A smart contract is computer code (typically using Solidity) executing transactions on a blockchain platform (typically the Ethereum platform) when specified conditions are met. The DAOs smart contracts include the creation and distribution of native tokens. The DAO can then spend the native token to incentivize certain activities or utilize voting mechanisms. Voting rights typically accompany the tokens, and decisions regarding the DAO are generally made through proposals voted on by the members of the DAO. What results is a fully operational autonomous organization independent from any central authority. DAO members typically use governance tokens to vote on topics such as the allocation of funds. The DAO concept has taken root in the Decentralized Finance (DeFi) space. Many DAOs exist today: e.g., Defi projects MakerDAO, Synthetix, Aave, and FlamingoDAO, for collecting non- NFTs. (See, https://www.withersworldwide.com/en-gb/insight/non-fungible-tokens-legal-issues-to-be-considered)

What are the standards of conduct for a DAO: DAO LLCs organized in Wyoming are governed by articles of organization, operating agreements, and smart contracts. All of the items can detail the rights and duties of the DAO’s members. Under the terms of the legislation, a DAO “is a limited liability company whose articles of organization contain a statement that the company is a” DAO. The DAO’s registered name would also be required to include the appropriate designation, such as “DAO,” “LAO” (limited liability autonomous organization), or “DAO LLC. A Wyoming DAO LLC management can either be vested in its members, i.e., if member-managed, or the smart contract, i.e., algorithmically managed. Under the bill, the default rule on “standards of conduct for members” states: “Unless otherwise provided for in the articles of organization or operating agreement, no member of a DAO shall have any fiduciary duty to the organization or any member except that the members shall be subject to the implied contractual covenant of good faith and fair dealing.” In other words, just like in LLCs, DAO members can always be held liable for bad faith conduct. This is similar to California law, where members must act “consistent with the obligation of good faith and fair dealing” even if the LLC is manager-managed. (See, California Corporations Code section 17704.09., subdivisions (d) and (f)(2).) Having an algorithmically managed entity will reduce the potential for managerial misconduct, which is a large source of LLC litigation. However, as long as the DAO members with voting rights are human, bad faith conduct will be part of the picture, which will lead to litigation. Courts in many jurisdictions have recognized that the right to vote in an entity is a valuable “personal property right” and that actions circumventing or frustrating an individual’s voting rights can support a legal claim.

What are the advantages to DAO LLC: Much like shareholders of a corporation, LLC members/owners are not personally liable for the LLC’s debts or legal liabilities. Standard corporations are generally burdened with double income taxation. The corporation’s profits are first taxed as income, and shareholders must then pay income taxes on any dividends. On the other hand, LLCs receive “pass-through” treatment allowing allocated profits to be taxed only once on each member’s individual income tax return. Additionally, LLC owners may be able to deduct 20% of their business income with the 20% pass-through deduction established under the Tax Cuts and Jobs Act. Establishing and maintaining a DAO LLC is less complex and burdensome than other entities. A presumption can be made that DAO LLCs will be treated just like any other LLC for tax purposes. DAOs that involve foreign members should always be cognizant of the Federal Withholding Tax, which subjects foreign nationals to a 30% standard flat-rate tax on US source income. The tax is typically withheld from payments made to foreign nationals. A DAO LLC is established by filing articles of organization with and paying a fee to the secretary of state. The filing typically includes:

• The LLC’s name.
• The location of its principal offices.
• The identity of its members.
• The planned duration of the business.
• Any other statutorily mandated information.

What are some concerns with DAO LLC: Concerns can be raised on the issue of whether registration as a Wyoming LLC tempers the fundamental “decentralized” aspect of DAOs. That is, does the US Securities and Exchange Commission (SEC) now have an identifiable entity or individuals that encapsulate network development and governance structure? The determination that such an entity or individuals are “active participants” is crucial to the third prong of the Howey Test as it relates to digital assets, whereby expectation of profits derived from the efforts of others, e.g., a manager, promoter, sponsor, or other third party or affiliated group of third parties is key in determining whether a digital asset is a security Without organizing as an LLC, one could argue that all the participants are independent and do not constitute a structured group of “active participants.” Registration under the law, however, could enable a more sustainable decentralized ecosystem. For instance, technology developments, e.g., user experience (UX), hosting, and maintenance, can be shifted to the DAO rather than being maintained by the initial development team. This change would ultimately allow the decentralized governance protocol to control or direct the control of all facets of the DAO ecosystem technology. Limited groups of people could be elected by the DAO’s governance protocol to oversee non-critical and off-chain decisions. The governance protocol could empower the elected individuals to make decisions regarding certain aspects of treasury management and asset allocation.

A DAO-driven web will spawn and solve legal and corporate governance issues: In 2016, when the first-ever DAO named The DAO nearly caused the Ethereum network’s demise. The project raised $150 million for a decentralized venture fund and was the most successful crowdfunding campaign of its time. But a code issue was exploited and caused “The DAO” to fail within weeks. Hackers stole $55 million worth of community funds. Ethereum rolled back the blockchain to recover the stolen funds. The decision secured the future of the fledgling platform, but the controversy set the development of DAOs back several years. Plus, the SEC issued an investigative report concluding DAO Tokens were Securities. (See, https://www.sec.gov/news/press-release/2017-131) Despite these setbacks, the DAO experiment has gone forward. Projects such as Aragon, DAOstack, and Colony have picked up from the original DAO. They have continued implementing DAOs for some of the largest DeFi protocols, including Synthetix, Aave, and Compound. Aragon now supports more than 1,600 communities, including the DeFi projects Aave and Curve. They use the platform and services for financial transparency, asset management, and protocol governance.

Meanwhile, the processes by which DAOs are governed are evolving alongside technical innovations. For instance, Vocdoni, a protocol acquired by Aragon, will release digital voting solutions which don’t require participants to pay fees to go on-chain to vote, thus encouraging greater participation. In fact, following the advice of Ethereum’s Vitalik Buterin that DAO’s are useless without decentralized courts, Aragon came up with Aragon Court. This judicial branch uses the Aragon Manifesto as the constitution and serves as the Aragon network jurisdiction. Users have to stake tokens to participate as jurors, defendants, or plaintiffs.

New use cases for the DAO-spring up daily: MolochDAO, which was created to manage grants to fund the development of Ethereum 2.0, a “proof of stake” scaling initiative, has been instrumental to the new wave of venture DAOs. Its developers focused on simple, smart contract solutions and expressly designed the program to minimize the possibility of an attack. In Asia, too, enthusiasm for DeFi and DAOs is growing. Fracton Ventures, a Japanese startup, is building off of the success of MetaCartel. Fracton plans to involve corporate investors in venture DAOs. These days, DAOs are not exclusive to Ethereum. Dora Factory, which is part of the Polkadot ecosystem, is building an open infrastructure for DAOs using the network’s own suite of tools. It closed its first funding round in February. But, as the NFT craze reaches its peak, it’s the DAOs formed around NFTs that have been getting attention. The PleasrDAO, which was formed for the express purpose of winning the Pplpleasr artwork, has since bought three more of the artist’s works and plans to continue investing.

In conclusion, DAO’s are here to stay. Interest in DAOs that was limited to most active members of the blockchain community is changing with the rise of NFTs and DeFi. As investor’s interests in digital assets grow, they can now understand the value of DAO’s that adhere to the rules set by the blockchain community. As it matures, the underlying blockchain infrastructure applied to DAO’s will provide interoperative ecosystems providing performant, inexpensive transactions/settlement, the immutability of contracts, and execution of smart contracts to handle ownership, authenticity, certification, governance, royalty payments, and a host of other ecosystem functionality. The decentralized ecosystem transparency will support and provide price and market efficiency. Decentralization will grow via the network effect, as the rise of innovation, performance, and resulting participation will elevate a vibrant global ecosystem of applications.

Our Withers attorneys can assist and educate clients from a legal and technical standpoint to incorporate these emerging technology trends safely and efficiently to help your businesses stay ahead of the competition. Please contact your usual Withers attorney or the authors of this piece for further information.