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DAOs — Understanding Legal Risks While Navigating Uncertain Waters

Ken Griffin, billionaire CEO of hedge fundCitadel, purchased a first-edition copy of the U.S. Constitution at a Sotheby’s auction for $43.2 million in November 2021. Although this purchase was a newsworthy feat in itself, what really caught the attention of the public at this auction was not the size of the winning bid, but rather who (or what) was outbid in the process. Over the span of a week, an internet collective calledConstitutionDAOcame together andreportedly raisedover $40 million in cryptocurrency in an effort to win the auction. Although crowdfunding over the internet is a pretty familiar idea, most of the crowdfunding we are used to happens through a central service likeKickstarterorGoFundMe. ConstitutionDAO was rather structured as a decentralized autonomous organization (or DAO). Although not the first of its kind, ConstitutionDAO showed the mainstream public a glimpse of the power that this new form of organizational structure can yield.

The rare first printing of the United States Constitution that ConstitutionDAO bid on. Image Credit: Yuki Iwamura/AFP/Getty Images

Today, DAOs come in all sizes and serve different purposes, and the influence and capital that some of them wield may surprise you. See, for example, Uniswap, which is one of the largest decentralized crypto exchanges (DEXs) in the world. In September 2020, Uniswap became a DAO which currently has about 300,000 members who govern and vote on matters regarding the exchange, including how to use its $1.6 billion community treasury. At the end of 2021, DAO treasuries cumulatively held more than $11 billion in cryptocurrency, and the 15 largest DAOs held $7 billion combined. Although treasury sizes have decreased significantly since then as result of the recent market downturn, these protocols are not to be underestimated. A current list of various DAOs and the sizes of their treasuries can be found here.

DAOs will likely continue to have a major impact on our society moving forward. However, all is not so simple. These structures are very novel and our legal system has yet to account for them. As a result, before deciding to create or even participate in a DAO, there are various risks to consider or at least be aware of. After providing a brief overview of some of the fundamentals, this piece will highlight a few of the legal uncertainties surrounding DAOs. As a former practicing lawyer, I’ll attempt to simplify certain issues surrounding organizational form, liability, and securities law that are often buried in legalese. The average investor has probably never considered these risks, which I hope to bring to light. I am a fan of these structures and think in the future they may fundamentally alter how businesses are formed and run. However, in the present while we wait for our legal system to catch up, more knowledge concerning how DAOs fit within our current legal system may be beneficial to those navigating these uncertain waters and assessing risk.

What are DAOs?

If you were to look up the definition of a DAO, the general answer you will receive is that DAOs are internet-based organizations, collectively owned and organized by their members. There is no centralized authority, no CEO, no board of directors, nor are there stockholders to obey or serve. Community members (who are often anonymous and either purchase or are allocated membership through tokens) submit proposals to the group, and proposals that are supported are adopted and enforced by the DAO. Not too complicated, right? Well, it gets a bit more complicated when we consider how DAOs are actually able to enforce proposals. How can an amorphous, internet-native organization comprised of various strangers scattered across the world actually get anything done? Enter smart contracts.

Without getting too technical, smart contracts are programs stored on a blockchain that run when predetermined conditions are met. For example, a smart contract might automatically move an amount of cryptocurrency from one party’s wallet to another when certain criteria are satisfied. If “x” occurs, a smart contract will then execute step “y.” A DAO’s rules of governance (think bylaws) are coded in smart contracts, which structure and help facilitate the operation of the organization. A core team of community members builds these smart contracts when a DAO is initially formed. Parties that join a DAO are therefore agreeing, in substance, to abide not just by the rule of law, but the rule of code, which is more deterministic than how traditional organizations are run.

For the Star Trek and sci-fi fans out there, an analogy that I like to use for DAOs is the Borg. The Borg are an alien species (cyborgs) that are linked as a collective hive mind. Any action that their spacecraft makes is decided on not by a captain but rather in unison (their brains are linked to a collective consciousness via bio-chips). DAOs are similarly not led by a CEO or centralized authority — actions are taken only when the majority (or other prescribed portion) of its members agree.

Image Credit: StarTrek.com (the Borg cube)

Given that smart contracts serve as the foundation for DAOs, they could not exist prior to the blockchain era. It is therefore not surprising that our existing laws around business and corporate structure do not contemplate this sort of organization and blockchain-based governance. However, as a result, until our laws and regulations catch up, early adopters creating and participating in DAOs face some risks to the extent regulators try to force these new creations into existing legal frameworks. Below are a few of those risks that are helpful to understand.

Liability / Business Form

If one has a serious business idea, one of the first to-dos is to legally form that business under state law. There are various entity types that one can choose from, including corporations and limited liability companies (LLCs). The appropriate entity type for a business will depend on a variety of factors, not least of which include business purpose and tax considerations. For our purposes, there is one primary benefit of creating a legal entity for a business that we will focus on — limited liability.

Limited liability is a longstanding benefit that applies to various legal entity forms and protects the personal assets of an organization’s owners from creditors. So, for example, if I form a business today as an LLC or corporation which proceeds to go bankrupt next year, my business’ creditors (the people the business owes money to) will not be able to come after my house, cars, or other personal assets for recovery unless I had pledged those personal assets to secure a loan for my business. It is only the business’ assets that are on the hook.

Image Credit: LegalZoom

Given the pace of the crypto and blockchain industry, it is not surprising that many DAOs are formed without any thought towards having a corporate identity. To do otherwise actually runs counter to the principles of decentralization that the industry stands for. However, if an organization has gone “DAO first” (i.e., has not wrapped a corporate form around the DAO), the members of that DAO are technically not insulated from liability the way they would be if they had formed a corporation, an LLC, or other entity type where liability is limited to the entity itself. Rather, existing corporate law likely deems any for-profit, “DAO first” entities a “general partnership,” which is formed when two or more persons engage in a business for the purpose of joint profit. Formal lawsuits have already been brought that allege certain DAOs should be characterized as general partnerships. There is no filing requirement to form a general partnership — it arises by default from the actions or activities of the partners, which can be implied. Not only are partners in general partnerships subject to unlimited liability, but they are also joint and severally liable. So, if a plaintiff successfully sues the general partnership and there are not enough assets in the partnership to make the plaintiff whole, that plaintiff can recover the full amount it is owed from the personal assets of any partner it wants (i.e., the plaintiff does not have to recover from each partner equally).

When investors purchase a DAO’s tokens they probably do not consider whether that DAO has a corporate form and the personal risks they might be subject to if it does not. In reality, the risk of being subject to unlimited liability in the way described here is probably very low if you were to join, for example, Uniswap’s DAO (even if it is not wrapped in a corporate form). It would be extremely hard for creditors to recover from any one of thousands of essentially anonymous individuals in countries all over the globe, particularly when participation in DAOs can be so temporary. For smaller DAOs with known membership, there could be more risk. However, if DAOs are characterized as general partnerships, then large businesses, institutional investors, and other regulated commercial entities may be reluctant to invest or otherwise support DAOs for fear that membership would put other assets at risk. In the long term, it is therefore clear that for DAOs to go mainstream, participants will need a clear and easy path to limited liability, which will require an evolution of our current business organization laws.

SEC Considerations

For those creating DAOs which make investments, there is also a potential risk that they fall under the purview of the U.S. Securities and Exchange Commission (SEC). For example, the Investment Company Act of 1940 regulates organizations that are primarily engaged in the investing and trading of securities. Although it is still very much a gray area as to whether and what type of cryptocurrencies are considered a security in the eyes of the SEC, if a DAO were to invest in assets that cross this line and be considered an “investment company,” it would fall under the Investment Company Act’s regulation and be subject to various registrations and ongoing disclosure requirements. A few exemptions exist which allow, for example, many hedge and private equity funds to avoid the obligations and requirements of the Investment Company Act. However, these exemptions require either a company have a limited number of beneficial owners (e.g., 100) or that its owners meet certain net worth requirements or have professional financial knowledge or experience. Many DAOs have thousands of members, and none that I am aware of require members to disclose their personal identities let alone facts such as net worth. As a result, these exemptions would not be available for most DAOs.

Image Credit: Reuters / Mike Segar

There is also the question as to whether DAO tokens are considered “equity securities” by the SEC. The debate as to whether a digital token is considered an equity security is a nuanced one. Jay Clayton, a past Chairman of the SEC, has indicated that in his view many are. DAO tokens are generally governance-related, so there are compelling reasons to not characterize these assets as securities. However, if they are ultimately classified as equity securities, many DAOs would be required to register under the Securities Exchange Act of 1934 and would become subject to various reporting requirements. Again, there are exemptions here, but given the ease with which we have seen many DAOs amass assets and members, most DAOs would have trouble fitting into these.

How to Mitigate Risk in the Future?

The legal risks highlighted in this piece hopefully provide others with a more complete picture of the current state of DAOs. For those thinking about creating their own DAOs, while it is impossible to mitigate every risk given the inherent uncertainty surrounding how the SEC will treat DAO tokens (among other risks), there are steps to take that may prevent against potential downside. For one, it would be forward-thinking to consider issues surrounding liability. This means consulting a lawyer as to the best way to structure and/or wrap a DAO in a corporate form to ensure limited liability for those involved. Strategies are constantly evolving here, so there is no one-size-fits-all solution, particularly as state laws as well as the laws in other countries and jurisdictions continue to develop.

For example, in the United States, each of Vermont, Wyoming, and Tennessee have recently passed legislation providing certain legal protections to DAOs, in effect allowing them to operate in the states as limited liability companies. However, the verdict is still out on how effective these current laws will be long term, as some believe they suffer from design flaws that stem from a fundamental misunderstanding of blockchain technology and how DAOs really function.

Others have made use of foundations and other types of structures in foreign jurisdictions such as the Cayman Islands. There are various options and strategies for structuring DAOs available, but the process will take some thought and vary depending on the type of each DAO involved.

Whether the SEC will ever broadly label DAO tokens equity securities is also an unknown and still developing, which is an unavoidable risk that should be on everyone’s radar. Although such a broad label is unlikely, for DAOs that have a for-profit or investing purpose, the risk of falling under the SEC’s purview becomes much more likely and needs to be considered and accounted for.

Over the course of the next decade, I anticipate our legal system to catch up to technology and explicitly accommodate DAOs and any other form of blockchain-based governance that may arise. In the present, DAOs do not fit cleanly within the confines of traditional business associations. For this governance structure to continue to burgeon it will therefore need its own legislation in place. American business history is littered with examples of rules evolving over time for the sake of innovation and progress — I anticipate the same to occur here.

This article is provided for informational purposes only and should not be construed as legal advice on any subject matter. You should contact your attorney to obtain advice with respect to any particular question, issue, or problem.

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