DAO and the Law: The Future

Decentralised Autonomous Organisations (DAOs) are an emerging method for organising community based activities using blockchain technology. In the final article in this series exploring legal issues related to DAOs in Hong Kong, Pádraig Walsh from the Digital Services and Fintech practice of Tanner De Witt look to the future and considers best practices for DAO governance going forward.

Education

DAO developers typically come from a technology background, and frequently do not have a good understanding of legal and regulatory requirements. It is a common fallacy of tech developers to believe that if innovation makes a course of action possible, then so it shall be done. This is not the case, however, in respect of DAO activities that give rise to legal risks or breach mandatory laws such as securities laws.

Education driven by the financial services sector has achieved a degree of success in respect of certain aspects of daily life. For instance, it is rarely challenged now when personal identification information is requested for know your customer (KYC) reasons in many walks of life. It is simply considered a fact of life. It would be a success if the myth could be dispelled in DeFi circles that decentralisation and smart contracts mean regulation does not apply.

When founders establish and incorporate a business in the real world, there is a basic understanding that incorporation is a significant event with legal consequences. A DAO is not just an IT project. It is also a significant event with legal consequences. DAO founders and developers should understand those legal consequences, and address risks in the design and implementation of their work.

Adoption of DAO constitutions

Efforts should continue to outline best practices for DAOs and to promote initiatives that provide greater clarity to DAO participation, and how governance and decision processes should be conducted. Very few DAOs presently prepare a constitution that outlines this. The attempt to consider, craft and then code governance processes is a better approach than not actively considering this at all.

A DAO constitution is a core foundational document that sets out the purpose and guiding principles of the DAO. It will address topics such as membership and participation, transparency, governance and decision-making, technical features of on-chain operations and smart contracts deployed, and dispute resolution. It is the DNA of the DAO.

Industry experts can provide guidance on aligning DAO constitutions to best practice standards and achieve a degree of convergence among the models that are presently being used. This could be done either through voluntary contributions, or by specific advice to specific projects. This is an area in which lawyers, in particular, can play a helpful and supporting role.

Adoption of legal wrappers

The use of legal wrappers for DAOs has gained traction. However, the available choices are frequently confusing, and generally are not designed to align with the requirements for DAOs.

There are signs of progress. The Coalition of Automated Legal Applications (COALA) published a DAO Model Law with a number of interesting features. This initiative was a specific attempt to design a model law that takes account of the technical features of DAOs, and to address questions that merit treatment arising from those technical features. The Model Law includes specific provisions that deal with contentious forks, modifications, upgrades and migrations on the legal personality of a DAO (as well as its claims and assets), and the limited liability of its members. On the subject of member liability, the model law proposes that members may be liable for failure events arising from gross negligence or acting in bad faith, but will not attach to those not involved in the relevant decisions or conduct.

The COALA DAO Model Law is not a perfect solution to all legal issues DAOs raise. It is, however, a genuine industry attempt to outline a set of legal principles that provide clarity to the legal status, responsibility and liability of participants in DAOs. This is a better outcome than organising a DAO without any recognised legal structure, and leaving the possibility open that the DAO may be construed as a partnership. It is also a better outcome than using obscure or ill-suited existing structures as legal wrappers for DAOs.

Disclosure of basic personal information

Privacy is a laudable principle. It is not, however, an absolute human right. The right to privacy has always been balanced by other competing rights according to public policy and community standards. It is not tenable to have DAOs engaging in unlawful practices, and using anonymity and pseudonymity as shields from following the same laws and regulations that apply to others. It is reasonable to require that some basic personal information is gathered in respect of DAO participants who exercise a degree of influence or control over DAO operations. This could be imposed as a requirement for adoption of DAO legal wrappers. It is a legitimate trade off to achieve limitation of liability arising from using a legal wrapper.

Clarity in regulation

The laws and regulation in Hong Kong in respect of virtual assets are prescriptive but clear. This is the benchmark that other jurisdictions are moving to. Clarity in regulatory expectation and requirements is especially beneficial when the market includes a significant number who do not have a traditional finance background with the compliance culture that traditional finance inculcates.

Effective enforcement

Enforcement against DAOs is inherently challenging. Enforcement assessment should have a degree of pragmatism. Egregiously bad actors should be pursued vigorously, particularly where there is evidence of significant investor loss (and particularly retail investor loss). Technological advances are making it possible to identify the genuine identity of persons acting pseudonymously on-chain. It may not be as worthy of time, effort and resources to pursue participants in ill-conceived DAO projects where there is no fraudulent intent or significant investor loss.

Promote innovation

Law and regulation are often perceived as dragging and holding back innovation. It need not be so. Innovation is not an end in itself. Rather, innovation must serve a purpose that improves the world we live in. Law and regulation serve the same purpose – improving or maintaining the quality of the world we live in.

Government, policy makers and regulators can help to provide an environment in which legal and regulatory assessment is factored into the incubation and development of innovative projects. It may be possible to bring projects into a regulatory sandbox, or to collaborate in incubation centres in universities or government bodies. The goal then becomes not just innovation, but the right innovation.

Promote real world integration

DAOs still have the ring of remoteness. The possibilities inherent in galvanising communities in projects at a grassroots level are still largely unexplored. This is an area that traditional companies should actively explore. Likewise, it would be beneficial to promote more examples of the positive impact DAOs have had on communities, particularly in the sphere of sustainability and social causes.

Conclusion

We are at the start of the journey in respect of DAOs. There are good reasons to believe that projects will organise themselves as DAOs more frequently in future. The community ethos at the heart of blockchain aligns to how many people organise activities in physical life. Building best practice playbooks is a critical step in DAO development. This will help to minimise risks inherent in DAO operations, and bring the potential benefits of this innovative form of organisation and endeavour to fruition.

Pádraig Walsh

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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 08 May 2024.