Decentralized Autonomous Organizations (DAOs) are becoming increasingly popular as the organizational structure of choice for many individuals, groups and companies engaged in NFT-based projects and businesses. In this article, we delve into the legal considerations that NFT firms should keep in mind when setting up their own DAOs.
What are DAOs and why are they important to NFTs?
DAOs are organizations governed by rules encoded as computer algorithms to ensure transparent operations and transactions controlled by the organization’s members rather than an elevated group such as a board of directors or C-level executives. These community coalitions use tokens to represent voting rights, as determined by the size of each member’s investment or work done to further its development or goals. DAOs use smart contracts to automatically execute commands when a set of conditions are met. For example, these contracts can trigger payments, authorize transactions, or initiate a course of action when a majority of the voting shares are submitted in favor of a particular action.
The rules of a DAO are stored on an open source blockchain, so anyone can look at the code and see the transaction records, but they cannot change the code unless conditions are met that instruct the smart contract to do so. Since there is no central authority that can govern decisions in a DAO, members can share proposals and potential projects in the community where they can be adopted according to the vote. DAOs work similarly to corporations, but without the hierarchical structure. Their primary advantage is to promote a flat, democratic process through decentralized governance. Unlike a traditional corporation or similar organization, members of a DAO are not bound by any formal contract. Instead, they share a common goal or purpose written into rules. There are many different types of DAOs.
Legal considerations for DAOs
Any project or business using a DAO should perform due diligence and seek the advice of a lawyer experienced in the digital space to ensure compliance and protection provided by law. There are several variables to consider.
- Legal Status – DAOs are not recognized as legal entities in the vast majority of US states and are not expected to comply with the registration regulations of those states. Only Wyoming and Vermont extend DAO corporate privileges such as limited liability typically available to traditionally incorporated entities. The other 48 states and the District of Columbia may even exclude DAOs from entering into certain commercial contracts with other entities or the government due to their lack of legal status.
- Asset Protection – Unlike corporate shareholders, DAO members generally do not enjoy financial protection if their organization is sued. This is because DAOs are unincorporated entities and are not subject to the legal formalities of incorporation such as registration, articles of association and contracts. Instead, they are treated as partnerships where each member assumes joint and several liability. Therefore, if the DAO is hacked, declares bankruptcy, or owes money it cannot pay back, each member is responsible for making creditors whole, and disclosing their personal assets. To address this weakness, a DAO must register and be recognized as an LLC or LLP.
- Regulatory framework – Because many states treat DAOs as partnerships, not only are their members exposed to personal liability, but other legal risks are also created. For example, regulatory inconsistencies can lead to investigations into financial and asset trading violations. A report issued by the Securities Exchange Commission (SEC) in 2017 concluded that a DAO that sells tokens without properly registering them could violate several federal laws.
- AML/KYC Guidelines – Many traditional corporate entities are subject to the Anti-Money Laundering Know Your Customer (AML/KYC) policy which prescribes safeguards that organizations must implement to ensure that they only deal with legitimate partners, customers and token holders. The rules also require verification of members’ identities and reporting of certain financial transactions. DAOs are often formed precisely to allow their members to remain anonymous; Reconciling this benefit with AML/KYC policies becomes complicated, considering that DAO membership can include individuals from all over the world. Determining which country’s laws apply can be difficult and is likely to lead to protracted legal battles if a dispute arises.
- Decision making and dispute resolution –Decision making in a DAO is carried out by voting by the members. This means that each member of the DAO can influence its actions or future by initiating a new governance or management proposal themselves. This is in sharp contrast to traditional companies where decision-making is centralized and the final authority to make decisions rests exclusively with top management, shareholders or a board. The aforementioned jurisdictional issues can make it difficult to resolve disputes.
From the above, it is clear that there are a number of legal risks and considerations involved in setting up a DAO in the US. There are jurisdictions that are friendlier than the US to DAOs such as the Cayman Islands, the British Virgin Islands, El Salvador, Singapore and Gibraltar. It is best to consult a corporate attorney with a current understanding of DAOs and related developments to check whether a DAO is the right legal structure for your organization.
Conclusion
DAOs are taking the NFT world by storm as the next generation of financial and business innovation. They offer many advantages over traditional corporations, including decentralization, member-driven voting and decision-making, and pooling of funds. Nevertheless, they pose many legal risks since they are not generally recognized as legal entities in the United States. Furthermore, DAOs involving multiple jurisdictions can complicate compliance for parties using NFTs. It is best to consult a law firm that specializes in legal structures for new technology organizations to reap the benefits of a DAO without falling into potential legal risks and pitfalls.
The content of this article is intended to provide a general guide to the subject. You should seek specialist advice about your specific circumstances.
