DAOs and the law: Key Characteristics and Legal Issues

Decentralised Autonomous Organisations (DAOs) are an emerging method for organising community based activities using blockchain technology. Novel uses of technology give rise to novel legal issues, particularly when they intersect with capital and commerce. In the first of a series of articles, Pádraig Walsh and Shirley Kong from the Digital Services and Fintech practice of Tanner De Witt explain the legal nature of a DAO and some legal issues that follow.

Key characteristics

DAOs are a community of persons that organise themselves according to rules and conduct activities that are automated and operate without central management or control and mostly without human intervention.

Autonomous means acting independently without direct control of humans. DAOs aspire to performing all functions, activities and decisions without human intervention, by automatically executing rules that are encoded in smart contracts.

Transparency is a key tenet of DAOs. DAOs deploy blockchain technology. To the extent DAOs transact and operate on-chain, there will be a high degree of transparency in DAO activities. Third parties and members can view and verify on-chain transactions. DAOs are open source. This again supports the objective of transparency as a means of building trust without the need of a central authority.

DAOs are not fixed to jurisdictions. Any potential participant around the world could vote, purchase tokens and make decisions regarding the DAO.

Legal nature

DAOs are a novel form of organisation, and do not fall squarely within the common forms of business entities.

Looking at each of the common business forms in turn:

Companies limited by shares: DAOs are not companies limited by shares. Companies issue shares. The board of directors of a company acts as a centralised decision-making body. Companies are formally incorporated in a specific jurisdiction, and are registered with a central registration authority, such as the Companies Registry in Hong Kong. A DAO does not have these characteristics.

Partnerships: A partnership is the relationship that subsists between persons carrying on a business in common with a view of profit. The sharing of profits of a business is often evidence that the person is a partner of the business. The legal consequence of a partnership is that each partner is liable for all the debts of the partnership. General partnerships (as opposed to limited liability partnerships) arise by operation of law; there is no formal incorporation or registration process.

There are similarities between partnerships and DAOs. This has been reviewed and confirmed in the recent bZx DAO case in the US. However, if a DAO is not carrying on a business with a view of profit, then it will not be considered a partnership. DAOs that operate as non-profit-making, or for charitable purposes, will not be considered general partnerships.

LLCs: An LLC is a hybrid corporate structure with features of a company and a partnership. An LLC will separate the liability of members of the LLCs from debts and liabilities of the LLC itself (like a company). However, the LLC can be taxed as a pass-through entity like a partnership. This form of corporate structure is quite popular in United States and Cayman Islands, but is not available in Hong Kong.

DAOs often conduct activities through legal entities and are often closely associated with a variety of legal structures. This is a natural consequence of needing to engage at times in the real world, or with real-world institutions, organisations or businesses. Also, the use of legal entities can mitigate some legal risks.

Legal risks

Contract

Most DAOs are not incorporated or registered legal entities. Consequently, they lack legal personality and capacity. This causes issues when a DAO seeks to enter into a contract with service providers, vendors, customers or employees. Counterparties will doubt whether a DAO has legal capacity and authority to enter into and perform a contract. If there is a breach of contract, can a counterparty sue a DAO? There is a risk that a DAO could be considered to be a general partnership. If so, then each DAO participant may face personal unlimited liability as a general partner for all the liabilities of the DAO.

Member disputes

The rules between DAO members are often documented in a constitution, and encoded in a smart contract. Those rules may deal with resolution of certain disputes between DAO members. However, it is hard to encode resolutions to all kinds of disputes that could arise. Can DAO members sue the DAO just like shareholders suing the company and its directors? Can DAO members sue each other in respect of operations of the DAO? How can responsibility (and hence liability) be attributed in an organisation that has no central decision-making body to be responsible?

Governance

In practice, the voting power of some DAOs can be concentrated in a small group of token holders. That group frequently has the influence and power to pass proposals that serve their best interests at the expense of the minority token holders. The aggrieved minority token holders may have no recourse against the controlling group, because the true identity of the majority token holders may not be known.

Cybersecurity

DAOs are built on blockchain technology. DAOs deploy smart contracts so that transactions can be executed automatically with no third-party intervention. This is relatively new, advanced and sophisticated technology. The code may have bugs and vulnerabilities. There have been a significant number of security incidents involving DAOs, including substantial losses.

Intermediary liability

DAOs typically outsource part of their functions to intermediaries. The outsourced service provider is sometimes anonymous. This may lead to risk of human error or misconduct. This risk is particularly high if code development or treasury functions are outsourced. Can the DAO or aggrieved DAO members bring a claim against anonymous outsourced service providers?

Tax

There are commercially-focused DAOs. Investment DAOs may see gains or losses on their portfolio. Collector DAOs may see the value of their art or NFT holdings appreciate. DAOs are likely to be treated as business entities for tax purposes, meaning that they may be subject to profits tax.

DAO members may also have tax reporting or payment obligations. However, it may be difficult to determine their reportable income. DAO members may also be subject to tax if they engage in taxable transactions such as staking, lending or mining and other types of disposition of tokens.

Conclusion

Innovation is at the heart of technology. Innovation in technology gives rise to new ways for people and communities to interact and transact. However, law, legal issues and legal consequences follow. Those forming DAOs should take care at the outset to identify the purpose for the DAO, be aware of legal issues that can arise, and take steps to minimise and manage those risks.

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 10 April 2024.