Recent legal developments spotlight the importance of DAO planning and structuring.
Content
- Introduction.
- A DAO by any other name.
- (TL;DR) What is a DAO?
- A DAO by any other name … is a Duck?
- Unincorporated Associations and Ooki DAO rulings.
- The fix. Or perhaps salve.
- Conclusion.
Introduction.
As a regular participant in the Web3 ecosystem, HLV is uniquely situated to witness the growth and development of DAOs. While many projects over the years have yolo’d their DAO roll-outs, recent developments remind us why a more coordinated approach is required.
A DAO by any other name.
An idea in the “ether” only a few years ago, the use of Decentralized Autonomous Organizations (DAOs) as governance vehicles is the norm for crypto projects nowadays. New tokens launch with DAOs ready to go. Existing projects roll out DAOs to communities who have grown accustomed to participating in their favorite projects’ governance. And, let’s face it, projects are also rolling out DAOs in an effort to further decentralize and reduce perceived regulatory risks.
Governance DAOs are not traditional legal structures. In fact, they require no legal form at all. Like many novel aspects of Web3, DAOs push into gray, uncertain areas of the law.
While crypto enthusiasts may cry that “code is law,” the law believes that persons — both natural and legal — are responsible for all decisions of an enterprise. To this end, there have been a number of initiatives (Wyoming and the Marshall Islands to name a few) to expressly authorize a DAO as a “legal person.” Meanwhile, the crypto legal community has debated for years whether it would behoove — or, as some would argue, be necessary — for DAOs to adopt conventional legal forms in order to address members’ legal liability exposure. Recent court decisions in the Ooki DAO (aka bZx DAO) cases bring those long-held concerns to the forefront.
(TL;DR) What is a DAO?
A DAO is a community-led entity with no central authority, where smart contracts set the foundational rules and execute decisions of community participants acting collectively. These autonomous bodies are transparent and proposals, voting, and the underlying code itself are public.
Importantly, DAOs are not companies. No corporate filing is required. No board of directors or officers need to be appointed.
At least in theory.
Whether it’s a Special Council with veto power to protect the DAO ecosystem or the undemocratic impact of “Whale” voting, the real world has a tendency to intervene in DAOs at various points of intersection. It is undeniable that anticipating and managing these real-world intersections is essential for a DAO’s founding framework to succeed.
A DAO By Any Other Name … is a Duck?
Of course, just because you say you’re not a company doesn’t mean the rest of the world will agree. And that’s where we find the problem.
Courts and regulators have a long history of applying the “duck test” (If it looks like a duck, walks like a duck, and quacks like a duck, then it just may be a duck). Regulators will not hesitate to conclude that, upon review of the facts and circumstances, a law or regulation should be applied to a person or entity, who would argue such law does not apply to them because they are, in name or based on some technicality, “not a duck.”
Crypto lawyers have long-expressed concern that DAOs existing without a legal form may fail the “duck test” and be treated — by default due to the failure to select another legal structure — as an unincorporated association or partnership.
Unincorporated Associations and Ooki DAO rulings.
While every jurisdiction has its own specific definition, generally, an unincorporated association or unincorporated partnership is formed when a group of people work together to achieve a common goal, often under a trade name presented to the public. Whether or not you know or intended it, if you’ve got people working together to the same ends, you’ve formed a partnership whether or not the proper paperwork is ever filed. As a result, unincorporated associations, whether organized for profit or not, may sue and be sued under their assumed name.
The problem, however, isn’t that a DAO can be sued. The problem is that this default treatment of legal form — that a DAO may be treated as an unincorporated association/partnership in the absence of other legal forms — means that its members have no protection from unlimited liability. A partnership lacks the shields to personal liability found in other legal forms (corporations, LLCs, LLPs, etc.). As such, the partners — here, DAO members — risk being exposed to unlimited liability for DAO actions, its debts, and judgments and all members could be jointly and severally liable.
Such is the issue now confronting Ooki DAO and its community.
In January 2023, in response to an action brought by the Commodities Futures Trading Commission (CFTC), a federal district court concluded that, indeed, Ooki DAO could be sued as an unincorporated association comprised of token-holders and entered a default judgment against the Ooki DAO, which had not responded to the charges. Then in March 2023, in a putative class action against the protocol’s founders, the DAO, and other parties relating to losses relating to a hack, a federal district court concluded that the Ooki DAO was an unincorporated association and ownership of the governance tokens constituted co-ownership of the association.
The fix. Or perhaps salve.
No token community wants to wake up one day and find out that a court may find participating token holders may face liability from US regulators or be liable for millions in hacked funds.
For this reason, many crypto lawyers advise their clients to “wrap” their DAOs in a corporate shell, foundation, or other legal entity. While certain U.S. crypto lawyers are supportive of initiatives such as the new “DAO LLCs” set up by a number of States, others in the legal community are hesitant (and no one wants to be the guinea pig!). With ongoing legal uncertainties in all things blockchain in the United States, coupled with the untested nature of DAO LLCs, offshore legal wrappers are often preferred. In that regard, we’re seeing a number of large projects utilize offshore foundations which, true to the DAO ethos, can be structured to have no shareholders.
Of course, using an offshore foundation adds other elements of complexity. Structuring a DAO wrapper requires an element of balance between the statutory roles of players such as directors, supervisors, administrators, and token holders. Typically, these DAOs require special councils in order to manage the statutorily required players such as foundation directors, supervisors, and/or administrators. These responsibilities are in addition to the other ecosystem security functions special councils perform.
We’ve also seen the rise of “insurance funds” to protect members from the costs of litigation risk. Several projects have allocated a portion of their DAO treasuries to legal protection funds. Given the likelihood a token value could collapse in the event of a regulatory action, these allocations may then be diversified into stable coins or other assets, instead of solely the non-native token.
Conclusion.
DAOs offer the means for token holders to have direct participation in a token ecosystem. Proper planning, however, is required in order to bring about efficiencies without losing transparency. Recent court rulings and regulatory activity, also highlight the need to properly employ a legal structure and related tools and solutions.
