Behind the recent volatility in crypto asset prices is the disruptive technology of blockchain and the distributed, decentralized ethos that has spawned it. And a new type of business structure has emerged that fits the culture behind this technology: decentralized autonomous organizations.
Just as LLCs were prevalent in the 1990s, DAOs may soon become a more popular form of business. Unlike traditional corporate structures, where the goal is to centralize decision-making, DAOs decentralize control, devolving power and purpose among the token holders themselves. Not surprisingly, these organizations raise legal questions.
What is a DAO?
Traditional corporations centralize power in an officer, or board of directors, who directs the organization based on what they believe is in the best interests of their shareholders. A variant of this model is the non-profit corporation, which, in addition to the task of increasing shareholder value, can also take into account the common good.
Some companies behind crypto projects organized themselves as PBCs (before DAOs were viable options) so that their operational decisions – such as what to do with their intellectual property – and in addition to fiduciary duties to “owners” were of the best interest of their communities.” But PBCs still centralize decision-making power in the hands of a few.
DAOs decentralize control by doing away with the traditional board of directors or executive board and devolving decision-making authority to token holders. Governance is performed through a series of proposals voted on by members using blockchain. Because tokens are interchangeable and change hands regularly, the voting cohort is dynamic.
While the specific governance rules vary from DAO to DAO, generally everyone who owns a token gets one vote. With many DAOs, token holders remain anonymous and are only identified by their wallet addresses. The backbone (and much of the perceived stability or instability) of the DAO is its treasury; Some DAOs (like Uniswap and BitDAO being two of the largest) are worth millions or even hundreds of millions of dollars in smart contracts controlled by token holders.
DAOs allow for the coordination of capital and human effort from potentially thousands of individuals with a vested interest in the DAO. However, when the first DAOs were formed without any legal form or formal government recognition, token holders began to express concerns that they would be subject to unlimited personal liability for the actions of the DAO.
Without a recognized form of company, the law assumes that individuals working together in a joint venture have formed a general partnership and, unlike shareholders, token holders would not be immune from personal liability arising from the conduct of the DAO.
Currently, only Wyoming, Tennessee, and Vermont specifically allow DAOs to form as an LLC type. However, to avoid having to comply with US securities laws, many DAOs have chosen to organize in places like the Cayman Islands, where corporate regulations are more lax and tax implications are limited compared to US jurisdictions.
We’ve also seen an increase in DAOs forming under flexible LLC laws, particularly in Delaware. Forming an LLC has been opposed by some in the DAO community, in part because the inherent government interference and regulation runs counter to the ethos of decentralization. However, by incorporating under a state’s LLC laws, DAO members have increased security in terms of liability.
The emergence of DAOs as a corporate form presents significant legal challenges for attorneys advising traditional corporate clients, including those wishing to do business with or invest in DAOs:
- Where does the buck stop? In more conventional business models, the board or senior executives are publicly identified and accountable for the behavior of the organization. Shareholders can request a review of the actions of executives or file lawsuits. But for most DAOs, it’s unclear who, if anyone, is in charge. In fact, it may be difficult or even impossible to determine the identity of the token-holding members. Promoters, founding members, or those with larger roles within the DAO may be more exposed to such claims, but this remains untested.
- Who is the trustee? Contrary to the clearly defined fiduciary duties within corporations, DAOs have no specific legally defined duties for token holders acting on behalf of the DAO. This creates opportunities for proprietary trading and other issues that arise from conflicts of interest.
- is it capable When DAOs do not have a formal legal personality (like an LLC), it is unclear whether and to what extent they have the ability to take actions such as entering into contracts, hiring employees and suing on their own behalf. When entering into a contract with a DAO, it’s likely difficult to know that your contract is “authorized” unless it’s specifically approved by a vote of the token holders, resulting in potential delays and additional steps in doing business leads.
- Who am I dealing with? Companies typically conduct due diligence and know-your-customer checks on business partners. This poses unique challenges for DAOs when it is impossible to know the true identity of many members.
These are just a few of the many problems encountered when creating or using a DAO. While still in their infancy, DAOs could be the equivalent of the LLC in the 1990s in the 2020s, effectively changing the landscape of business organization and stakeholder liability.
As DAOs become more common in the United States, it will be interesting to see how they are handled in court, possibly as “pseudo-partnerships” with each token holder liable for the actions of the others. Only time (and of course the judges) will tell if DAOs are the enterprise equivalent of a digital revolution or just a flash in the pan that has been relegated to textbooks as an interesting but not widely embraced concept.
This article does not necessarily represent the opinion of the Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
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Andrew Gilbert is a partner at Croke Fairchild Morgan & Beres, where he focuses his practice on private M&A transactions, venture capital and corporate advisory.