Introduction

Centuries ago, joint stock corporations were prevalent, followed by modern-day corporations and limited liability companies (LLCs). Now, there’s a new breed of entities — decentralized autonomous organizations (DAOs) — whose supporters deem them not as “companies,” but rather as assemblies of individuals built on principles of decentralization, transparency, and bottom-up control that reflect the digital universe. But as the popularity of DAOs grows, the need for legal clarity becomes increasingly pressing. The law is far from settled, and the path to legal safety remains shrouded in mystery. Ignoring legal dangers of DAOs could be disastrous.

“Before jumping into the DAO fray, it is crucial to seek professional legal advice and navigate the legal labyrinth with caution. Crypto investors must be aware of the legal requirements when investing in DAOs to avoid enforcement actions that may arise due to the ambiguous nature of DAOs.”

What is the purpose of DAO?

The term “DAO” was coined in the 1990s by German computer scientist Werner Dilger. Two decades later, blockchain enthusiasts, notably Ethereum’s Vitalik Buterin, began theorizing about DAOs as entities with automation at the center and humans at the edges.

In its essence, DAO, or Decentralized Autonomous Organization, is a blockchain-based entity that operates directly by its contributors or members, without formal corporate structure. It’s a virtual community with a purpose, enabling people to fundraise for joint projects. DAOs have no physical offices, directors, or employees, and are governed by encoded rules within the blockchain software. This makes them self-executing, with all transactions immutably recorded on the blockchain, ensuring transparency. Only members can propose changes to the purpose or rules of the DAO. The voting procedures in a DAO are done through direct voting, with each member having equal voting rights, but without any legal status.

DAO Legal Showdowns

2016: The DAO

The legality of the concept “Code is Law”, which involves utilizing technology to enforce regulations, is not clear-cut. A prime example of this is the 2016 hack of “The DAO”. A vulnerability in its code allowed a hacker to steal 11,000 investors’ Ether, sparking the question of who the rightful owner was: the contributors or the hacker who interacted with the publicly available code? The “Code is Law” argument would support the latter, but without a legal personality, The DAO was unable to pursue the hacker. White hat hacker Griff Green stepped in and took the risk of retrieving some of the stolen Ether, but his actions resulted in a multitude of legal threats. This raises the question of what constitutes rightful ownership of funds in DAO, and underscores the legal gray area surrounding it.

2017: ConstitutionDAO

ConstitutionDAO raised $47 million in ether for the sole purpose of bidding on an original copy of the U.S. Constitution. A hybrid model featuring legal entities facilitated the DAO’s activities. However, ConstitutionDAO was outbid at the auction and refunded contributors, but most of the raised money was lost due to Ethereum fees. This highlights the legal and financial dangers of getting involved with DAOs, emphasizing the need for careful consideration before participating.

2022: ShapeShift — Making the private corporation public through DAO

ShapeShift, a cryptocurrency trading firm, transformed itself into DAO from a private corporation in July 2022. This move allows anyone to become a token holder, promoting a fluid market, and decentralization. Its CEO intends to reduce his ownership to just 5% of the DAO’s tokens while remaining involved in the company’s ventures. Despite the benefits of the DAO structure, a future investor could still purchase a majority of the tokens, effectively re-centralizing the company.

2022: Ooki DAO

The legal ambiguity surrounding DAOs was again in the spotlight, with Ooki DAO accused of facilitating illegal crypto derivatives trading, resulting in legal action by the Commodity Futures Trading Commission (CFTC) against the founders in September 2022. In an unprecedented move, the CFTC sought to sue the entire DAO, leading to a landmark ruling in January 2023 that recognized Ooki as an “unincorporated association” of Token Holders, enabling it to be sued like a person or corporation. Legal experts are questioning the CFTC’s approach, arguing that a DAO should not be considered a person and that individual token holders should be targeted instead.

2022: Avraham Eisenberg

The delicate balance between technology and the law was once again being put to the test with the case of Avraham Eisenberg. In December 2022, Eisenberg was taken into custody by US authorities on the grounds of having executed a highly lucrative trading scheme that leveraged a smart contract belonging to Mango Markets, a decentralized finance DAO, resulting in a $110 million loss. The FBI regards Eisenberg’s actions as illicit, yet it is ultimately up to the judiciary to decide the fate of his case and the viability of the “code is law” doctrine. These legal battles will prove to be decisive in determining the future course of the relationship between code and law within the DAO ecosystem.

Untangling the Legal Maze of DAOs: Navigating Liability and Corporate Chaos

The emergence of DAOs has been a watershed moment in the world of blockchain technology, with “The DAO” (2016) paving the way as a blueprint for a decentralized organization governed by smart contracts. However, the critical issue in DAO is the absence of legal status, which exposes members to personal liability in case of any legal disputes or breaches of legal requirements. Experts are warning that DAOs may be deemed “General Partnerships” by the courts, potentially exposing all participants to unlimited joint and several liability.

In theory, a DAO can function as a code-based entity, free from the constraints of a physical corporate structure. However, code-based entity still requires essential practical elements such as domain names, web hosting, banking services, and legal representation. For DAOs that seek to engage in contracts involving real estate, intellectual property, or other legalities, it is imperative to establish some form of legal personality.

Can DAOs Retain their Unique Edge with Legalization?

DAOs have been largely unrecognized in most jurisdictions, but some positive developments offer hope. American CryptoFed DAO has been recognized as a legal entity in Wyoming, while dOrg LLC has become the first entity that directly cites blockchain code as its source of governance in Vermont. Australia’s Senate committee has also recommended acknowledging DAOs in a legal capacity.

But some believe that the formal recognition of DAOs as legal entities threatens to undermine the very essence of what makes them special, which is their ability to operate entirely through smart contracts. These experts argue that defining how members will manage the DAO and how disputes will be resolved is antithetical to the core concept of a DAO, as these provisions cannot be fully managed through smart contracts.

Others see DAOs as a new and improved corporate structure, with alternatives such as “Wrapped DAOs” that offers semi-anonymous boards of directors in some jurisdictions, but this feature may not be possible in others.

On the other hand, there are those who view the traditional concept of a corporation as outdated, and believe that DAOs represent a new and improved form of corporate structure. These experts suggest alternatives like foundations in the Cayman Islands, which can act as the service provider for the DAO while retaining legal personality. However, this solution may not meet the standards of the Web3 community as it requires a centralized legal entity.

How Governance Tokens in DAOs Face Securities Law Challenges

The legal complexities surrounding DAOs are a source of concern for many in the crypto space. The fear that governance tokens issued by DAOs may be considered securities under securities legislation has created a legal quagmire, with highly regulated markets such as the U.S. imposing severe fines and jail terms for the sale of unregistered securities to unaccredited investors.

The Howey Test, which is used in the U.S. to determine whether a token is a security, considers factors such as an investment of money into a common enterprise with a reasonable expectation of profit derived from the efforts of others. However, the Howey Test is not universally accepted, with legal systems in the Cayman and British Virgin Islands taking a more favorable view of DAOs. In these jurisdictions, DAOs cannot be considered securities as they are decentralized and therefore not managed by others. With the legal landscape being so complex and costly to navigate, obtaining hundreds of legal opinions on securities law is not a practical solution.

But there is an alternative method of regulating DAOs. The Rochdale Principles, first established in 1844, align closely with the principles of DAOs and could serve as a framework for regulating them as “cooperative associations” as both share common principles such as voluntary and open membership and democratic member control.

Moreover, for DAOs that invest in “securities,” including digital assets, compliance with the Investment Company Act of 1940 may be necessary. As per the Act, DAOs could be categorized as “investment companies” and need SEC registration before publicly offering securities or if they exceed 100 holders, unless in certain circumstances.

Furthermore, antitrust implications surrounding DAOs remain uncertain, as the relevant agencies have yet to provide any guidance. Should a DAO be viewed as a collection of individual members acting together, rather than as a single entity, antitrust issues could arise. This could lead to issues with sharing competitive information and collaboration by individual members, some of whom may be competitors. Criminal liability could result from certain antitrust violations, and mergers involving blockchain-based service providers may undergo review for anti-competitive practices. Even a legally formed DAO must ensure compliance with antitrust and other legal regulations.

Conclusion

DAOs, traditionally focused on digital ventures, have transcended their boundaries in recent times, exemplified by the emergence of Special-purpose acquisition companies (SPACs) that specialize in acquiring physical companies. Such developments have fueled predictions of DAOs becoming a prominent business entity and being dubbed as “the new LLCs.” The recent surge in DAOs provides strong support for these forecasts.

The legal status of a DAO remains a crucial issue for market participants due to the lack of clarity on personal liability and enforcement actions. While DAOs and its members continue to face battle with regulations, crypto investors have also been facing a growing number of scams and rug pulls, making it increasingly difficult to know which projects to trust. During the last Bull Run, COMB was one of the first projects to register as Limited Liability Company (LLC) on 2.25.2022. By becoming an official registered entity, COMB has provided investors with greater confidence in their ethical behavior and commitment to transparency.

This Article was written by Raviyank Patel on behalf of COMB Finanical