Uncertainty about the Legal Status of DAOs
Posted on Nov 11, 2022Yucheng Weng
I. What are DAOs?
Decentralized autonomous organizations (DAOs) are software-enabled organizations built and governed by smart contracts and blockchain technology.[1] Generally, a smart contract is a set of rules written in computer program on a blockchain that enables a network of computers to communicate and execute pre-programmed transactions once certain conditions are met.[2] DAOs are often used by individuals who share a common goal, like investing in start-ups, buying collectibles, or purchasing cryptocurrencies, to participate in decentralized financing. A recent article in the New York Times described DAOs as a “group chat with a bank account.”[3]
Unlike conventional corporations that vest power in boards of directors to determine what is in the best interest of their shareholders, DAOs are intended to be bottom-up organizations where members make decisions for the organization. Governance is conducted through a series of proposals that members vote on using smart contracts to suggest and approve actions for DAOs to take.[4] Essentially, all of the DAO members are the decision makers, decentralizing power and authority. Because memberships are determined by ownership of exchangeable DAO tokens, and tokens regularly change hands, the voting cohort is also dynamic.[5]
In addition, DAOs are theoretically more transparent than traditional organizations. Once members of a DAO collectively decide on a course of action, the votes will appear on the permanent block chain ledger[6], and the smart contract will automatically execute the decision.[7] Smart contracts are visible, verifiable, and auditable by anyone who views the blockchain.
II. Legal Status of DAOs and Implications
Proponents of DAOs often find the concept of decentralization and transparency behind DAOs appealing. Some view DAOs as a popular, viable alternative to traditional legal entities, claiming that DAOs could potentially change the way people work.[8] However, with their rising popularity, DAOs have also been under increasing scrutiny. Their use has raised some fundamental questions about their legal status.
First of all, it is unclear who is liable in a DAO’s governance. DAOs do not have a recognized corporate form under the existing legal structure.[9] The prevailing view in the legal community today is that the law would assume that individuals working together in a common enterprise have formed a general partnership, and thus, DAOs would likely be treated as general partnerships.[10] This may expose DAO members to personal liability for any of the DAO’s actions and obligations.[11] By contrast, in corporations or limited liability companies, the shareholders typically are shielded from personal liability.
The risk of operating DAOs without any formal legal structure is highlighted in a recent class action suit filed in the District Court for the Southern District of California, in which the plaintiffs allege that bZx DAO, its co-founders, and its members are jointly and severally liable for negligence that resulted in the theft of $55 million from its organizational fund.[12] The complaint alleges that because the bZx DAO lacks any legal recognition, it is a general partnership which subjects its members to joint and several liability.[13]
The Commodity Future Trading Commission’s (CFTC’s) first-ever lawsuit against a DAO filed this September also features the issue of liability The complaint alleges that Ooki DAO is an unincorporate association and seeks to hold individual members of the DAO personally liable for purported violations of the Commodity Exchange Act.[14] Relying on state common law, the CFTC proposed a novel theory that all of Ooki DAO’s token-holders who voted for the operation of the software protocol should be held liable.[15] If the court accepts the CFTC’s theory of liability, the decision could have a chilling effect on DAOs, discouraging people from participating in DAO’s decision makings.
Second, the lack of legal structures raises procedural issues about litigation. For instance, there is rarely any real-life interaction among DAO members, or the sharing of identifying information, which makes it difficult to sue members when issues arise.[16] In the Ooki DAO case, the CFTC attempted to serve unidentified DAO participants via a chat box on a website and an online forum, claiming that this was an appropriate method of service, given these are the sole mechanisms the Ooki DAO has chosen for the public to contact it directly.[17] A hearing will be held this November to determine whether the CFTC’s approach falls short of providing reasonable notice of the suit.[18]
Last but not least, the absence of legal recognition also flags unresolved questions regarding the application of equitable principles, such as the law of fiduciary obligations, to DAOs. It is unclear whether there is sufficient trust and confidence in relationships between DAO members, or between members and managers.[19] Lack of fiduciary duties may give rise to self-dealings and other conflicts of interest.
To get around the legal status problem, a number of DAOs have now formed new legal entities under limited liability company (LLC) laws. Wyoming, Tennessee, and Vermont have specifically enacted legislation permitting DAOs to obtain LLC status.[20] However, this is not a perfect solution: any statutory requirement for the formation of LLCs unavoidably takes away some of the decentralization element of DAOs. Therefore, the proper legal classification of DAOs will likely continue to be the subject of future litigation and legislation. The future of DAOs depends substantially on whether they can obtain legal recognition while preserving their transparency and decentralization.
[1] William K. Pao et al., What the DAO? Why Everyone Is Talking About Decentralized Autonomous Organizations, O’Melveny & Myers (Apr. 11, 2022), https://www.omm.com/resources/alerts-and-publications/alerts/what-the-dao-why-everyone-is-talking-about-decentralized-autonomous-organizations/.
[2] Id.
[3] Kevin Roose, What are DAOs?, N.Y. Times (Mar. 18, 2022), https://www.nytimes.com/interactive/2022/03/18/technology/what-are-daos.html.
[4] Andrew Gilbert, Decentralized Autonomous Organizations: The New LLCs?, Bloomberg Law (Aug. 2, 2022), https://news.bloomberglaw.com/securities-law/decentralized-autonomous-organizations-the-new-llcs
[5] See id.
[6] See Roose, supra note 3.
[7] See Pao, supra note 1.
[8] Steve Glaveski, How DAOs Could Change the Way We Work, Harv. Bus. Rev. (Apr. 7, 2022), https://hbr.org/2022/04/how-daos-could-change-the-way-we-work.
[9] See Gilbert, supra note 4.
[10] Laila Metjahic, Deconstructing the Dao: The Need for Legal Recognition and the Application of Securities Laws to Decentralized Organizations, 39 Cardozo L. Rev. 1553, 1547 (2018).
[11] See id. at 1547–48.
[12] Complaint at 2, Sarcuni v. bZx DAO, No. 22-cv-618 (S.D. Cal. May 2, 2022).
[13] Id. at 15–16.
[14] Complaint at 2, CFTC v. Ooki DAO, No. 22-cv-5416 (N.D. Cal. Sept 22, 2022).
[15] Id. at 19.
[16] Robert deBrauwere & Nicholas Saady, Breaking It DAOn: What You Need to Know About Current DAO Laws, Law.com, https://www.law.com/legaltechnews/2022/05/09/breaking-it-daon-what-you-need-to-know-about-current-dao-legislation/.
[17] Matthew Bultman, Where’s Ooki? CFTC’s Lawsuit Delivery Via Chatbox Raises Eyebrows, Bloomberg Law (Oct. 24, 2022), https://news.bloomberglaw.com/securities-law/wheres-ooki-cftcs-lawsuit-delivery-via-chatbox-raises-eyebrows.
[18] Id.
[19] See deBrauwere, supra note 16.
[20] See Gilbert, supra note 4.