Is DAO the New Form of a Corporation?

Is DAO the New Form of a Corporation?

by Angelina Gomez, counsel at Clifford Chance; Co-founder and director of the Digital Law Association

Introduction

The Hon T F Bathurst, former Chief Justice of New South Wales, in a speech to the Francis Forbes Society noted that the “…corporate form is a ubiquitous part of modern commercial life and has a significance to our economy which it is difficult to overstate” with its “separate legal personality, perpetual existence, transferable shares and limited liability for members”. 1

However, regardless of its ubiquity, with the emergence and adoption of blockchain and smart contracts in modern commercial life, we seem to be moving with some speed towards a decentralised future, and away from the hierarchical structures of corporations, with its board of directors and shareholders. This acceleration is mostly due to the fact that decentralisation encourages participation and transparency.

This can be clearly seen in the 2020 rise of decentralised finance (DeFi), which has rekindled interest in Decentralised Autonomous Organisations (DAOs), as being the appropriate vehicle to take advantage of DeFi, to engage in digital transactions and the endless possibilities for its members to act with common

purpose, for example, to invest, fundraise and to collect NFTs and other assets. The crypto community is predicting that DAOs will become the “next big trend”. 2

ASIC Chair, Joe Longo at the Australian Financial Review’s Super & Wealth Summit in November 2021, admitted “to a certain fascination with DAOs”, and raised the following questions:

What are they? What do they do? How can DAOs be regulated? … To paraphrase a concept familiar to corporate lawyers, to whom does ASIC turn to ascertain the directing mind and will of a DAO? It is not clear who is accountable if things go wrong, or don’t go as intended or anticipated. Nor is it clear how a DAO itself can be held accountable in a court of law. 3

So what is a DAO? The building blocks of DAOs are blockchains 4 and smart contracts, 5 and they work together to effect the decisions of the members of a DAO. Are DAOs the new corporate paradigm? This article will examine the characteristics of most DAOs (bearing in mind that DAOs are not homogenous), the legal issues they raise and possible solutions.

What is a DAO and how does it work?

DAOs are organisations that operate on decentralised blockchain infrastructure, essentially, they are exclusively ‘online’, generally using open source code to carry out their operations. While DAOs can come in all shapes, sizes and protocol, a DAO is essentially a group of people who have agreed to achieve a common goal or mission, from the purchasing of digital assets to building a media empire.

Each DAO has its own system of governance but a common feature is that it is not managed by a board or any other form of central authority. Instead, it is a democratised organisation and its governance is based on a community of members. DAOs operate on a flattened hierarchy, and decisions are made collectively by their members. A DAO’s members comprise a group of, for the most part, anonymous people/entities, located anywhere in the world, who may never have met (and may never meet) one another in real life, who agree to abide by certain rules to participate in the DAO.

Members (or governance token holders) of a DAO make decisions on what a DAO does, shaping the DAO’s future through voting. As token holders, they own a stake or ‘equity’ in the DAO, but not all token holders have voting rights, for example, only masternode operators are allowed to vote on funding community projects supporting the Dash ecosystem. 6 However, with those that can vote, usually they do so on equal footing. There are a number of ways a person can join a DOA and obtain voting rights, they can buy governance tokens or be rewarded governance tokens for their work done for the DAO or through ‘airdrops’ (which are distributions of DAO tokens to members or potential members), for example, to encourage adoption or as a reward for early participation.

Any member can propose a project, the community of members will then discuss the project and vote. Depending on the rules or protocol governing the DAO (and which are embedded into its code), once consensus is reached, meaning when sufficient members agree according to the rules of the DAO, a decision is made and smart contracts action it. By way of example, a DAO’s rules could be as simple as ensuring that its decisions are only made by majority vote. Essentially, once decisions are made, the DAO’s smart contracts are activated. These smart contracts hang off the DAO blockchain effecting its operations through algorithms (based on the DAO’s rules, the code of the DAO) that run when certain criteria are met – they are non-repudiable and enforced without discretion, making the DAO’s functions automated and self-executing.

Every decision made and transaction carried out by the DAO through its smart contracts is coded on its blockchain; is immutable, tamperproof and transparent. No member or administrator/project governor (if the DAO has one) can edit the rules of the DAO (its source code) without other members noticing it. Essentially, the rules and governance of each DAO are coded in smart contracts on the blockchain and cannot be changed unless voted upon by the DAO’s members.

The use cases for DAOs are endless. In 2021, the ConstitutionDAO, made up of 17,000 members put together $40 million to bid on an early copy of the US Constitution – they were ultimately outbid by a hedge fund billionaire. 7 Some of the more well-known DAOs that collect NFTs (Non-Fungible Tokens, which are a form of digital asset) include

FlamingoDAO (with a portfolio in early 2022 of over $1 billion, and members comprising traders, developers, artists and builders) 8 and PleasrDAO (notably the owners of Wu-Tang Clan’s one-of-akind unreleased album, “Once Upon a Time in Shaolin”). 9 DAOs are also making the purchase or renting of digital land in the various metaverse platforms more accessible, by pooling funds to invest in digital real estate, for example, Pangea DAO is a metaverse land investment cooperative with the “goal of creating more equitable virtual worlds”. 10 Then there are mission orientated DAOs, for example, the Komorebi Collective DAO, which invests in “exceptional female and non-binary founders” 11 and the Big Green DAO, “a USA 501c3 non-profit that believes growing food changes lives”. 12

Issues with DAOs and possible solutions

In 2016, the concept of DAOs ran into problems with the unfortunately named, “The DAO”. Initially extremely successful, The DAO raised $150 million, which at that time, was one of the largest crowdfunding efforts undertaken. A hacker (or hackers) exploiting an issue with The DAO’s code base, managed to draw $50 million worth of ether (ETH) from the DAO before it was stopped by Ethereum having to hard fork 13 its blockchain to restore the siphoned funds (by moving the funds raised to a recovery address where the DAO’s token holders could exchange their DAO tokens for ETH). 14 This created concerns around security and debate as to whether code should be the only law, meaning that if the algorithms of the smart contract (that formed part of the DAO’s code base) allowed the drawing of the $50 million, then it could not be illegal and should be allowed to stand. 15

Since then, with the gains made in DeFi, confidence in DAOs is again increasing rapidly. However, DAOs in most jurisdictions are still not supported by government oversight or any regulatory structures that address issues of taxation and other legal uncertainties, as to member responsibility and potential liabilities.

In order to truly flourish, establish on a large scale and give long term benefit to its members, DAOs need certainty through regulation, they need to be recognised as a legal personality. 16 Granting DAOs separate legal personality would mean that a DAO could own assets, sue and be sued and could also protect its members from personal liability.

The current situation (in Australia) is that DAOs are not established as legal entitles, and consequently, their decentralised governance structures do not fall readily within existing regulatory categories. At present, DAOs are likely to be considered common law partnerships or unincorporated associations, whose operations are run by smart contracts. These entities are not recognised as separate legal entities from their associated members/partners and consequently, this creates issues around the holding of assets, succession, the liquidation by members of their tokens, taxation and could potentially expose a DAO’s members to a number of risks and liabilities, including that they could be held liable for debts incurred by the DAO. To address these issues, hybrid structures have developed – DAOs are being wrapped in legal personality for example, through the creation of limited liability companies or trusts linked to DAOs, acting as service entities, giving DAOs the ability to enter into contracts, hold assets and ensure that their members are protected by limited liability. 17

Until we have regulations that deal with DAOs, these structures provide a bridge between the digital world of the DAOs and the real world of legal regulations and protections. As reported in the Australian Financial Review, in 2021, the Digital Law Association (the DLA) proposed “formal recognition of new, decentralised models for corporate governance where a board of directors is replaced with an internet community” and suggested that a DAO Limited structure could draw from the “DAO Model Law” proposed by the Coalition of Automated Legal Applications (COALA), but not to adopt it wholesale, 18 with a new “authorisation class” to be created in the Australian Financial Services Licence (AFSL) regime, for digital assets, the currency of DAOs. 19 The DLA argued that DAOs:

…will increasingly feature as a business model in the digital and decentralised economy and must be given legal recognition, the clear ability to hold property and contract, as well as limited liability. 20

The DLA also “called for a review of the impact of tax laws on DAOs to ensure technological neutrality happens in practice. It has also suggested that a multi-agency working group establish a

taxonomy for digital assets setting out the Australian legal and tax implications of digital asset businesses and transactions with input from multiple Australian regulators”. 21

Following the DLA’s submissions and those of other interested parties, in October 2021, Senator Andrew Bragg’s Select Committee made a number of recommendations on cryptocurrency and digital assets, de-banking and “that the Australian Government establish a new Decentralised Autonomous Organisation company structure”, 22 proposing that:

The government should examine the COALA model and other international examples in developing a DAO company structure that suits Australia’s specific corporate frameworks. 23

Apart from legal personality, the protocol (or rules) of the DAO must be considered carefully as code is the law of the DAO. Transparency through open source coding (available in a public forum) is of fundamental importance here as usually, during the DAO’s development phase (before its member base is assembled), its creators and designers decide a number of substantive aspects of the DAO’s protocol including its decision framework, financial incentives, voting structure and governance (unless they set these up provisionally and include as part of the DAO’s protocol, an approval mechanism to allow members to vote on the DAO’s protocol when launched). Other issues that need to be considered when setting up or joining a DAO include:

1. whether the DAO has administrators, and their role in the DAO, for example, do they act as the ‘post box’ of the DAO, a contact point for regulators and other third parties;

2. was an audit of the DAO’s code done prior to launch and whether the DAO undergoes regular audits to ensure that its code continues to match the objectives of its members and is not subject to major security risks;

3. the different classes of tokens the DAO offers and what rights and liabilities are attached to them, for example, whether there is protection of minority rights;

4. voting protocols – do they deal with voter indifference or voting fatigue and possible off-chain voter influence (to gain a majority to push a project through the DAO);

5. whether the DAO’s tokens are able

to be liquidated, transferred or bequeathed;

6. the DAO’s dispute resolution processes;

7. fiduciary or other equitable obligations that members of a DAO may owe to each other – and how to legislate or contract out of these obligations;

8. the anonymity of members which could make recovery against them difficult and costly;

9. security issues – it may take time to vote on changing defective code and in the meantime, hackers may make use of the identified shortcomings in the code;

10. when a hard fork will be initiated (and how the fallout of possibly having two DAOs in operation will be managed);

11. potential missing elements from smart contracts that could create disputes within the DAO or with third parties affected by the operation of a smart contract, including, representations made by the parties to a smart contract (for example, as to the scope of the contract or with regards to consumers of a DAO product), warranties, indemnities, force majeure provisions, governing law, notice provisions, human errors (for example, late payment even by mere hours may not result in the smart contract being triggered) and coding errors (for example, performance does not match the agreement between the parties); and

12. the massive energy consumption associated with running blockchains. In 2022, Forbes reported that Ethereum and Bitcoin mining operations together were responsible for “emitting more than 78 million tons of CO2 into the atmosphere, equal to the annual tailpipe emissions of more than 15.5 million cars”. 24

Conclusion

The potential of DAOs is enormous. It has the potential to democratise decision making, creating diverse opportunities for asset acquisition, ensuring that those who gather together to achieve a particular goal, will be able to do so transparently, quickly and efficiently. Vitalik Buterin, a co-founder of Ethereum noted that:

“One of the more interesting long-term practical benefits of the technology and concept behind decentralized

autonomous organizations is that DAOs allow us to very quickly prototype and experiment with an aspect of our social interactions that is so far arguably falling behind our rapid advancements in information and social technology elsewhere: organizational governance. … Now, it may be possible to create systems that are more fluid and generalized that take advantage of the full power law curve of people’s ability and desire to contribute.” 25

However, to truly take advantage of all that DAOs promise, we must have proper and adaptable legal guardrails in place to regulate and provide oversight. This is what we need to be working on now.

Angelina Gomez, counsel at Clifford Chance; Co-founder and director of the Digital Law Association, https://digitallawassociation.com/.

For Endnotes and complete article please view the full pages of the publication.