DAOs and the law: Legal Wrappers

Decentralised Autonomous Organisations (DAOs) are an emerging method for organising community based activities using blockchain technology. In the first of our series of articles (available here), we looked at the legal nature of a DAO and some legal issues that can arise. In this article, Pádraig Walsh and Shirley Kong from the Digital Services and Fintech practice of Tanner De Witt explain the use of legal structures as a means of mitigating some of those legal risks.

Legal wrappers

A legal wrapper is a term used to describe the conduct of all or some of the activities of a DAO through an incorporated or registered legal entity. A legal entity is “wrapped” around the designated activities of the DAO. In most cases, liability incurred by the legal entity will be separate from the individual DAO participants engaged in DAO activities, and the legal entity (not the DAO participants) will be responsible and liable for legal consequences arising from those activities.

The primary need to use legal wrappers for DAOs arises because in the absence of a legal wrapper, DAOs are unincorporated organisations. This gives rise to a risk that DAO members may face personal liability for activities of the DAO. As a secondary benefit, a DAO can conduct activities with the real world through a legal entity. This can facilitate the DAO to open bank accounts, enter contracts and deal formally with third parties.

The use of legal wrappers is contentious within DAO communities. There are three general points of contention:

Localisation: DAOs are intended to be global communities. Legal wrappers are necessarily linked to a specific jurisdiction.

Centralisation: The use of the legal wrapper will inevitably result in some degree of centralisation, as DAO activities are conducted through the legal entity.

Loss of privacy: The formation of legal wrappers will involve disclosure of identification details of the founder / promoters of the legal wrapper vehicle. Many participants in DAOs are privacy advocates, and may be reluctant to disclose their identity for the purpose of incorporation or formal of a legal wrapper entity.

These are points to consider when founders are considering the rules that will apply to a DAO. There may be limited or manageable contractual or cyber risk if a DAO is formed for social purposes only. Social DAOs may also have less need or less friction when interacting in real-world environments. In these circumstances, the operation of the DAO may not benefit materially from adopting and operating through a legal wrapper entity. It may be sufficient for the DAO to adopt clear rules in its constitution and smart contracts.

The position is different if the DAO is more complex, receives capital or contributions, or operates a treasury. Then, the need for a legal wrapper is greater. Founders or promoters of the DAO should take legal advice and give serious consideration to conducting some or all DAO activities through the medium of a legal entity.

There are limits to the legal protection that a legal wrapper can provide. Forming a legal entity to engage in unlawful, criminal or fraudulent acts will not protect the individuals involved from criminal enforcement. Also, securities regulation and other similar mandatory laws will frequently look through a legal entity and impose liability on relevant individuals. So, if a DAO is engaged in activities that require authorisation or a licence from a securities regulator, then the individuals engaged in the unauthorised and unlicensed activities (and not just the legal entity) will be responsible and liable.

Characteristics of legal entity wrappers

The assessment of the use of legal entities by DAOs will involve a search for legal entities with characteristics that align with the characteristics of the DAO. This usually involves assessing a number of features:

Flexibility: The legal entity should enable the constitution to have a form of high degree of flexibility and customisable features. For instance, the articles of association of a conventional private company limited by shares will have a number of features that are too rigid for DAO operation.

No ownership: A DAO is intended to operate on the basis of egalitarian community principles. This includes a principle that the community as a whole (rather than specific persons or participants) owns the DAO. This is sometimes reflected in a legal structure for which there are no owners or shareholders.

Separation: The legal entity will be directly linked to a specific jurisdiction, and will have a degree of centralisation. The DAO founders may wish to minimise these consequences by separating governance of the legal entity from DAO governance or participation, but without sacrificing appropriate governance of the legal entity’s operation.

These particular requirements have led to the use of a variety of legal entities in various jurisdictions, and to the introduction of new legal entities that have customised features suitable for adoption by DAOs.

LLCs

LLC stands for limited liability company, and is a type of legal entity that is common in the US. An LLC will have limited liability protection for its members, and owners are typically not liable for the debts and liabilities of the LLC. An LLC can be member-managed, or the members can appoint a board of directors. The operating agreement for an LLC is highly customisable.

Some states in the US have adopted state legislation that has features designed to enable DAOs to form as an LLC. Common features of these laws include:

(a) The LLC must state in its articles of organisation that it is a DAO.

(b) The LLC must include in its operating agreement a summary of its purpose.

(c) The LLC will be considered to be member-managed unless its articles state that it is algorithmically or smart-contract-managed.

(d) The operating agreement must include prescribed information about the DAO, which can include details of the smart contract, the blockchain technology used, voting procedures, protocols for responding to security breaches, procedures for becoming a member, and the rights and obligations of each group of participants.

(e) The LLC will automatically dissolve if it does not approve any proposals or take any actions for one year.

(f) The LLC members have no fiduciary duties to the DAO unless specified in the operating agreement.

(g) There is no express obligation to provide inspection rights to members, except for what is available on-chain.

The particular requirements will vary according to the state chosen for formation of the DAO. Wyoming, Vermont, Tennessee and Utah are some of the states that have adopted specific DAO LLC laws.

Another alternative chosen by some DAOs is to simply use a Delaware LLC. Delaware is a well-established jurisdiction for LLCs. The LLC operating agreement can specify restriction of fiduciary duties and limitation of liabilities. However, this legal structure does not accommodate certain features of a DAO such as preserving the anonymity of the members in certain circumstances.

Jurisdictions elsewhere have also adopted DAO LLC laws. In February 2022, the Marshall Islands amended its Non-Profit LLC Statute to officially recognise DAOs. Under this law, token holders of DAOs can be LLC members and the LLC’s bye-laws can be encoded into the blockchain.

Foundations

A foundation is a business structure that originally developed in civil law jurisdictions. A foundation can be structured without members. This has appeals to DAO developers as a foundation appears ownerless, and this has an alignment with decentralisation. However, the operation of a foundation is not decentralised. A foundation is a separate entity, and hence can hold assets in the name of the foundation. This is different to a trust, in which assets are held in the name of the trustee.

The key features of foundations include:

(a) A foundation can be formed for any lawful purpose, including non-profit or charitable.

(b) The foundation offers legal personality and limited liability for the members.

(c) The foundation is not required to have members. Even if the foundation has members, those members may not be entitled to participate in financial returns of the foundation.

(d) The foundation can choose to have beneficiaries (for example, a DAO’s token holders), but beneficiaries will not have rights and powers unless specified in the bye-laws. Generally, beneficiaries will not have personal liability for the foundation’s debts or financial losses.

(e) The foundation can provide for liability protection for founders and directors (or council) who manage the foundation to protect them from personal liability. 

(f) The foundation may also appoint a supervisor or guardian to safeguard the purposes of the foundation.

Foundations are now common entities available in a number of jurisdictions, including Gibraltar, Switzerland and Cayman Islands. Hong Kong does not have a foundation as part of its available business entity suite.

Company limited by guarantee

The closest entity available in Hong Kong that can suit certain DAO requirements is the company limited by guarantee. A company limited by guarantee does not have shareholders, and the role of its members is quite different to shareholders in a private company limited by shares.

The key features of a company limited by guarantee are:

(a) The members do not have a claim on the assets of the company.

(b) The company is prohibited from paying dividends or profits to members.

(c) The members of the company will appoint directors, and directors owe a fiduciary duty to the company to act in its best interests.

Conclusion

The specific legal risks of operating DAOs has given rise to the legal community seeking appropriate measures to minimise and mitigate the risk of personal liability of DAO participants. Some risks can be addressed by careful consideration of the scope of operation of the DAO, and implementing rules in the DAO constitution and measures in smart contracts to manage certain legal risks. However, frequently the best approach is to consider conducting some or all DAO activities in DAO legal wrappers. This issue is often a complex assessment, requiring an understanding of the ethos of the DAO and aligning that ethos with available business entity structures.

Pádraig Walsh and Shirley Kong

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Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication. This article was last updated on 17 April 2024.