Legal Issues Confronting Formation and Operation of a Decentralized Autonomous Organization (DAO)

By James Holbein, Of Counsel, Braumiller Law Group, and Justin Holbein¹

Introduction to DAOs

“A decentralized autonomous organization (DAO), is an organization represented by rules encoded as a computer program that is transparent, controlled by the organization members and not influenced by a central government.”² DAOs are an emerging new type of organization particularly prevalent in the Ethereum blockchain ecosystem. Combining ideas about organizational forms, coordination, network effects, blockchain, and smart contract technology, DAOs allow a group to organize around a mission or goal and coordinate through smart contracts, enforced immutably and autonomously on the blockchain. DAOs represent an evolution in how people coordinate with one another, as the organization itself is autonomous from a 3rd party intermediary’s influence and goals.

In essence, DAOs allow groups of participants to create organizational forms beyond the hierarchical, top-down corporate firm, which must be responsive to the needs of a board and shareholders. DAOs essentially eliminate or minimize the roles of executives and managers in the organization, relying instead on transparent rules that apply to all members and participants. Being an emergent technology, DAOs are rapidly expanding in the Ethereum blockchain ecosystem, and are being experimented with, used, built, and iterated on in real time. There are many unsolved problems with DAOs, particularly around issues involving legal compliance, benefits, recruiting, talent retainment, income volatility, and governance. Regardless of the current problems, DAOs have the potential to empower groups to solve problems, coordinate, and execute ideas in a way that may be increasingly necessary to solve entrenched 21st century problems. Before getting into the technical aspects and legal requirements, let’s start by discussing how DAOs represent a new type of organization.

DAOs represent a unique opportunity and challenge today as they are rapidly evolving into a new class of organization. DAOs are reminiscent of cooperatives (co-ops) in many ways, albeit with an expanded set of abilities enabled by the decentralized and transparent nature of the blockchain combined with automatically executing smart contract logic. The transparency of DAOs is one of their main benefits, “since all of the actions and funding in DAOs are viewable by anyone. This significantly reduces the risk of corruption and censorship.³ The transactions undergone by a DAO are individually visible at any time, while also protecting the anonymity of their members through cryptography. DAOs also have low barriers of entry and exist in contrast to traditional hierarchical firms. While this can be a definite plus for fluidity and flexibility of DAO organization, it can also represent a unique challenge as successful DAOs need to have attractive incentivization structures and keep rent-seeking activities low to retain membership.

DAOs have a key differential in their structure from the hierarchical firm in that they are decentralized, consisting of many autonomous individuals and small teams that take responsibility for their own goals and determine their own forms of governance. Static job descriptions are replaced by a fluidity of roles, where members are allowed to opt in or out as they see fit. The fluidity of roles and ease of entering and exiting DAOs can be a large boon as well as a challenge. Without the same structure as a firm locking people into certain roles, the game theoretic incentives that keep members participating become increasingly important. A DAO that does not end up structuring its smart contracts and coordination mechanisms in a way that incentivizes and benefits the members faces challenges from a DAO that has a more positive benefit structure for all of its members. A crucial part of the structure within DAOs that helps with this issue are the autonomous groups that often form within it, to pursue objectives tangential and related to the overarching mission of the DAO.

In current DAOs, these small teams are often called “guilds,” reminiscent not only of medieval crafting associations, but from the squad-like entities born of modern massively multiplayer online games (MMOGs). The gamification of interaction in DAOs is an important part of how DAOs function, as game theoretic incentives allow DAOs to build inner structures that reward members and encourage positive participation. These incentives also foster a sense of individual and cooperative ownership in the efforts that fulfill the objectives of the DAO. These incentives are not only in the positive feeling members get for participating and furthering the goals of an organization they participate and believe in, but there can also be direct financial incentives through ERC-20 tokens, or non-fungible tokens (NFTs). The renumeration isn’t always financial though, as the NFTs a DAO generates for its activities or to reward members are often a key piece in establishing a communal identity within the overarching DAO itself.

The ability of members to decentralize and formulate rapidly executing autonomous groups within DAOs, while also adhering to the central mission of the DAO, allow powerful network effects to begin to accumulate, as a DAO itself becomes an organization of organizations. This is where DAOs begin to separate from traditional co-ops in definition (although not entirely), and the organization itself begins to become an aggregate entity that members not only participate it, but actively vote on and govern to create maximally beneficial rules for the participants.

Crucial to how DAOs function are smart contracts, which we will be focusing on here within the context of the Ethereum Ecosystem. A smart contract is a directly executing computer program on a blockchain that can represent many different things, from agreements between two persons, to guaranteed execution of funding proposals, to even complex governing structures that cannot be censored. In the context of DAOs, smart contracts enable the rules of how a DAO functions to be executed without interference, and without the necessity of including a trusted third party to make sure that agreements are carried out. DAOs take advantage of this in many ways, including how members are automatically paid for their efforts, how proposals are voted on and enacted, and even how the agreements of the DAO are audited. All smart contracts will execute and are all available openly to be viewed on the blockchain. This powerful transparency takes us to a point where you simply cannot structure a DAO that has perverse incentives going against the best interests of the members, as they can simply view it in real time, and due to low switching costs, leave the DAO for more appealing opportunities.

What are some current examples of DAOs? DAOs currently active include MakerDAO, MolochDAO, BanklessDAO, Raid Guild, and MetaFactory. These DAOs all have different purposes, from governing the issuance of funds against crypto collateral, funding grant proposals for different projects (MolochDAO), being a collective of guilds that members vote on to decide different objectives (BanklessDAO), undergoing collective development projects (RaidGuild), and organizing around fashion and culture that creator members produce (MetaFactory). This is only a small snapshot of DAOs, and many more are being created by the day. Another important point is that while many DAO’s are for-profit organizations, they also can be set up as non-profit organizations to aggregate capital and fund specific projects (environmental, charitable, housing, social, etc.) based on the votes of the members.

An example of a successful DAO is action is MakerDAO. MakerDAO is the governance structure of the Maker protocol. The Maker protocol “allows anyone, anywhere to generate the Dai stable going against crypto collateral assets.”⁴ The Maker DAO employs a two-token system, one being the Dai stablecoin, and MKR, the governance token used by stakeholders to vote on proposals and manage the Dai stablecoin and how it is implemented. MKR token holders are the decision makers of the Maker protocol. Token holders vote to decide on different policies governing the DAI stablecoin, including the “stability, transparency, and efficiency” of the stablecoin.⁵ The DAO governs the protocol, and the incentives of the token holders ensure that policies benefit all who use MakerDAO, as there is an incentive to coordinate the best policies for all token holders.

Another example of a rapidly evolving DAO is Bankless DAO, formed as a decentralized community to “help the world go bankless.” The DAO aims to accomplish this by forming a decentralized community to coordinate together and “propagate bankless media, culture and education. Its goal is to drive adoption and awareness of truly bankless money systems like Ethereum, DeFi, and Bitcoin. It achieves this through the collective participation of its community.”⁶ A native governance token allows members voting rights in proposals for the DAO and funds a community treasury for the pursuance of the goals of the Bankless DAO. Members are free to organize into guilds and pursue whatever sub-goals they see fit in accomplishing the main mission of the DAO. These autonomous groups within the overarching group are a key aspect of the organizational strength and evolving coordination abilities of how DAOs seek the accomplishment of their objectives.

Kinship groups, tribes, armies, churches, and modern firms (profit and non-profit) are all types of organizations that have evolved legally and in business to coordinate increasingly complex human interactions, goals, and projects. DAOs are what is referred to in the book “Reinventing Organizations” as a “Teal Organization,” or an “organization as an independent force with its own purpose, and not merely as a vehicle for achieving management’s objectives. Teal organizations are characterized by self-organization and self-management.”⁷ DAOs are autonomous in the sense that they are autonomous from an outside groups objective, as the coordination and incentivization layer is the blockchain the DAO uses for coordinating its objectives. This is a critically important piece in the evolution of coordination, as third-party influences do not end up co-opting the goals of the DAO, and it remains “autonomous” in the sense that the DAO fulfills the accomplishment of whatever goals the members select without third party input or influence.

While DAOs at a high level represent an evolution in how human beings organize and coordinate, at a lower level they are simply an extension of many related web3 and blockchain technologies. Digital assets allow ownership of fungible and non-fungible goods to be tokenized. Besides the many cryptocurrencies we have seen rise over the past decade, lately there has been an explosion in Non-Fungible Tokens (NFT)s, simply meaning that each token is not a 1 to 1 exchange for another. Importantly, participation in a DAO can be tokenized, and members granted voting rights and incentives based on what tokens they hold. As tokens are all smart contracts, the way DAOs are governed can be programmed and voted on by their participants. Smart contracts run immutably on the blockchain and are censorship resistant. This means that 3rd parties can’t arbitrarily change the rules to their benefit, and members can know that voting proposals within a DAO will execute autonomously of human intervention.

As an extension of the many different technologies humanity has been building for many decades, DAOs represent an evolution in coordination, and not a revolution. They represent simply an interesting and powerful new way for human beings to coordinate, and with that, a way to help solve many formerly intractable problems. Many of the large-scale problems affecting humanity today are rooted in an inability for people interested in solving these problems to develop a proper way to coordinate effectively. By the time interested people and parties are at a scale to effect change, many third parties have established themselves along the coordination layer and inserted their own needs (openly or not) that may come at the expense of the overall mission. DAOs offer an opportunity to change that dynamic and offer a chance at re-imagining how we group together with one another to solve problems. This isn’t to say there aren’t problems facing DAOs, as in any emergent technology. Issues with long term member retention, gamified participation that can itself be gamed by bots, benefits for members, governance structures, and voting are all open issues DAOs and their members are actively experimenting and attempting to solve. Beyond the issues, the creation of DAOs as a coordination structure represent an important evolution in how people can democratically coordinate on their own terms to achieve objectives they choose. This in of itself represents an important piece of humanity’s own evolution and may indeed play a part in resolving many of the current challenges we face today.

Federal Regulation of the Crypto Sector

The legal environment for federal governance and regulation in the United States is clearly wary of cryptocurrency and DAOs, focusing on protection of consumers and existing regulated entities. Regulating entities include the Securities and Exchange Commission (SEC), the Commodities Futures Trading Corporation (CFTC), the Federal Reserve, the Department of Treasury, the Office of the Comptroller of the Currency, and other members of the President’s Working Group on Financial Markets. Activities that will draw SEC scrutiny include:

• The offer and sale of crypto tokens
• Crypto trading and lending platforms
• Stable value coins (Stablecoins)
• Investment vehicles involving crypto assets or crypto synthetics and derivatives
• Custody of crypto assets

The Chairman of the SEC stated recently, “I’ve suggested that platforms and projects come in and talk to us. Many platforms have dozens or hundreds of tokens on them. While each token’s legal status depends on its own facts and circumstances, the probability is quite remote that, with 50, 100, or 1,000 tokens, any given platform has zero securities. Make no mistake: To the extent that there are securities on these trading platforms, under our laws they have to register with the Commission unless they qualify for an exemption.”⁸

This approach could be helpful to some DAOs. With the focus on creating exchanges for cryptocurrency, and investment vehicles for trading tokens, the SEC will continue to exercise its jurisdiction to bring some regulatory coherence to the sector. The regulators are all struggling to apply well-honed rules for the existing types of hierarchical centralized organizations (banks, stock exchanges, brokers, etc.) to this upstart, decentralized, autonomous, cryptographically-protected new sector that does not fit the current model at all.

What will be the federal approach to regulating DAOs? On the one hand, if a DAO is about trading different types of cryptocurrencies, it will be federally regulated because of the close similarities to equity investment vehicles or exchanges. On the other, many DAOs will not necessarily be about the value of the tokens used to transact business of the DAO, but more about how to deploy resources to more efficiently work cooperatively to achieve a goal that the members of the DAO agree is something they want accomplished. For instance, an environmental DAO that allows members to deposit a certain amount of cryptocurrency to obtain governance rights and another amount to contribute to attainment of projects that the DAO agrees to pursue, may or may not be characterized as an investment that would trigger SEC or CFTC jurisdiction. It may be that for some DAOs, regulation as cooperative associations is more appropriate than are financial exchanges or similar heavily regulated organizations, as we discuss later in the article.

What Does Compliance Look Like?

The regulatory authorities have identified the key characteristics of anti-money laundering (AML) programs that will be acceptable. “An AML Program must include, at a minimum:

(a) policies, procedures, and internal controls reasonably designed to achieve compliance with the provisions of the BSA and its implementing regulations;
(b) independent testing for compliance;
(c) designation of an individual or individuals responsible for implementing and monitoring the operations and internal controls; and
(d) ongoing training for appropriate persons.

Rules for some financial institutions refer to additional elements of an AML Program, such as appropriate risk-based procedures for conducting ongoing customer due diligence.”⁹

At a minimum, smart contracts will probably have to bake into the code some aspects of this list in order to become more widely acceptable and useful to businesses and individuals seeking to employ these new technologies seamlessly. It is important for the regulators to protect investors and consumers, but it is also important to enfranchise small business, the poor, individuals without access to banking services, and anyone who simply cannot comply with existing centralized system requirements. Striking a balance between these competing values will be the real challenge to realizing the promise of DeFi and the crypto sector.¹⁰ One of the most promising benefits of DAOs is the low barrier to entry for individuals and small businesses who otherwise are not participating in the stock market, banking, and lending, or making their services or goods available to broader markets. The possibility of greater inclusion and grouping of like-minded individuals to undertake projects for the common good of the group is something new and inherently more democratic than most existing organizations.

U.S. Legislation – Wyoming DAO Supplement to the LLC Law

In July 2021, Wyoming became the first state to promulgate legislation to specifically permit the formation of DAOs.¹¹ The law is a supplement to the existing LLC Law, which was notably the first in the nation. The law allows the creation of DAOs as limited liability companies, conferring legal status and identity on such entities for the first time in the United States.

As a supplement to the LLC Law, the DAO Supplement is viewed as providing exceptional coverage for DAOs, but the rest of the LLC Law applies to them, where not specifically carved out. The technical requirements include using DAO, LAO, or DAO LLC in the name of the organization to distinguish it from current LLC usages. The Article of Organization must include a specific notice to alert all potential members that the DAO may eliminate fiduciary duties and restrict transfers of ownership interests, withdrawal, or resignation from the DAO, return of capital contributions and dissolution of the DAO.¹²

The Articles of Organization, or alternatively, the Operating Agreement of the DAO, must indicate whether it will be member-managed, with at least one person who is a member in order to conduct the business of the DAO LLC, because management shall be vested in its members.¹³ The Articles of Organization will govern a range of activities generally undertaken by corporations, including: members’ rights, duties, relations, voting rights, DAO activities and how they will be conducted, means of amending the articles or operating agreement, distributions to members, transferability of membership interests, withdrawals of members and their contributions, dissolution and distribution to members upon dissolution, procedures for amending, updating, editing or changing applicable smart contracts, and a publicly available identifier for any smart contact used to manage, facilitate or operate the DAO. Much of the information necessary to operate the DAO will be available in the white paper of the entity creating the DAO and publicizing its advantages to potential members.¹⁴

Alternatively, the DAO may be “algorithmically-managed”, by the underlying smart contract without human intervention.¹⁵ It is not necessary for the DAO to reveal the workings of the smart contract(s) used for transacting the business of the DAO, but the law requires that the underlying smart contracts must be “able to be updated, modified or otherwise upgraded.”¹⁶ This requirement can work a hardship on many DAOs, because one of the main attractions of using blockchain and smart contracts is that the record is immutable, so having the contracts readily modified is not really possible without an entirely new contract to replace the prior version.

Potential members should be aware that the law specifically precludes rights of inspection of records because transactions will be transparent on the blockchain and therefore there is no need for additional documentary transparency. “Open blockchain” means a blockchain as defined in W.S. 34-29-106(g)(i) that is publicly accessible, and its ledger of transactions is transparent;”¹⁷

The DAO Supplement anticipates that DAOs will be used to transact business using digital assets, which are defined as “a representation of economic, proprietary or access rights that is stored in a computer readable format and is either a digital consumer asset, digital security or virtual currency;”¹⁸ or digital consumer security, defined as “a digital asset that is used or bought primarily for consumptive, personal or household purposes and includes:(A) An open blockchain token constituting intangible personal property as otherwise provided by law;(B) Any other digital asset which does not fall within paragraphs (iii) and (iv) of this subsection.¹⁹ Wyoming has enacted a Digital Identity statute that provides some additional support for the use of DAOs under the DAO Supplement.²⁰ The state legislation can be used in a complementary manner to enable the creation of a DAO with members using digital identities and even to undertake limited in-state crowdfunding efforts to create the treasury needed to support the projects the DAO undertakes. No other jurisdiction in the U.S. has combined these approaches in such a complementary fashion.

Can DAOs Be Regulated as Cooperative Associations?

Given the turmoil concerning regulation of the crypto sector at the federal level, there may be another legal alternative available for regulating DAOs. The principles at the heart of cooperative associations are very much at the core of many, if not all, DAOs. The Rochdale Principles, first set out in 1844, are a set of ideals for the operation of cooperatives that could be applied to DAOs.²¹ A brief analysis of the goals demonstrates that DAOs can readily be structured as cooperative associations, especially member-managed DAOs that have somewhat more interaction among the members than purely algorithmically-managed DAOs. To demonstrate the commonality of principles between DAOs and cooperative associations, the International Co-operative Alliance list of principles that were published in 1995²² provides an excellent analytical structure:

1. Voluntary and open membership (DAOs qualify)

• Anti-discrimination (Digital identity essentially eliminates the ability to discriminate)
• Motivations and Rewards (Not all of these motivations and rewards are required for every coop or DAO, and other motivations and rewards may be available)

• Financial
• Quality of Life (service to community or society)
• Giving Back (volunteering)
• Altruism (benefiting others)
• Sense of Duty (community, causes, societal goals can all come into play)
• Career Experience (volunteering, training, and related activities)

2. Democratic Member Control (membership in DAOs generally requires equitable contributions to the treasury with control of project selection and accomplishment exercised by the members)

3. Member Economic Participation (this is essential to DAO smart contracts and project work)

• Limitations on Member Compensation and Appropriate Use of Surpluses (DAOs are not hierarchal, and all financial incentives are transparent in the operation of the smart contracts and Articles of Organization)

• Members receive limited compensation on capital subscribed for joining
• Surpluses can be reinvested in the organization and its projects
• Members determine whether to pay dividends or other compensation
• Members vote on projects of the DAO, exactly as co-operatives are designed to do

4. Autonomy and Independence (These principles are inherent in DAOs)

5. Education, Training and Information (DAOs may provide this type of service, but such activities would require enumeration in the Articles of Organization or Operating Agreement)

6. Cooperation Among Cooperatives (DAOs easily work together as described earlier in the article)

7. Concern for Community (Unless provided for in the Articles of Organization or Operating Agreement, this principle is not inherent in DAOs).

Given the close alignment with cooperative association principles, regulatory authorities and legislatures should explore legal and regulatory mechanisms that facilitate the formation of DAO cooperatives that provide democratic, autonomous, and beneficial social and community benefits by the very nature of their formation and operation.

How to Make DAOs Work

“Being internet-native organizations, DAOs have several advantages over traditional organizations. One significant advantage of DAOs is the lack of trust needed between two parties. While a traditional organization requires a lot of trust in the people behind it — especially on behalf of investors — with DAOs, only the code needs to be trusted. Trusting that code is easier to do as it’s publicly available and can be extensively tested before launch. Every action a DAO takes after being launched has to be approved by the community and is completely transparent and verifiable. Such an organization has no hierarchical structure. Yet, it can still accomplish tasks and grow while being controlled by stakeholders via its native token. The lack of a hierarchy means any stakeholder can put forward an innovative idea that the entire group will consider and improve upon. Internal disputes are often easily solved through the voting system, in line with the pre-written rules in the smart contract. By allowing investors to pool funds, DAOs also give them a chance to invest in early-stage startups and decentralized projects while sharing the risk or any profits that may come out of them.”²³

“DAOs solve the principal-agent dilemma through community governance. Stakeholders aren’t forced to join a DAO and only do so after understanding the rules that govern it. They don’t need to trust any agent acting on their behalf and instead work as part of a group whose incentives are aligned. Token holders’ interests align as the nature of a DAO incentivizes them not to be malicious. Since they have a stake in the network, they will want to see it succeed. Acting against it would be acting against their self-interests.”²⁴

In summary, DAOs provide an inherently evolutionary means to create organizations on a cooperative, democratic, and unbiased basis to accomplish goals held in common by the members and displayed transparently in the smart contracts underlying the operation of the DAO. While some DAOs may be engaged in investment activities that warrant supervision by the SEC and CFTC, many will certainly have other goals that could well permit regulation as cooperative associations in which the members manage and control the organization in a non-hierarchical manner and the sharing of profits or dividends is equitable and democratically governed.

Authors

James R. Holbein is Counsel to the Braumiller Law Group PLLC. He practices in the area of international trade and customs law and has written several articles exploring the potential for new digital technologies to reshape supply chains and improve access to financial services.

Justin Holbein has been active in the blockchain space in many capacities since 2014. He is certified in data analytics, Python programming and is actively building smart contracts and Web3 Dapps. He is an active participant is several Ethereum-based decentralized autonomous organizations (DAOs). He contributes analysis and uses smart contracts to develop solutions to coordination problems in the DeFi and DAO space. 

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