Decentralized Autonomous Organizations (DAOs) - Legal Implications and Risks

Decentralized autonomous organizations (DAOs) are a new form of governance that use blockchain technology and smart contracts to automate decision-making and coordination among a group of participants. DAOs have been gaining popularity as a way to create innovative and democratic communities, projects, and businesses. However, DAOs also pose significant legal challenges and risks that need to be carefully considered before joining or creating one. This article explores some of the main legal implications and risks relating to DAOs, based on the current state of the law and practice.

Formation and Contract Law

One of the first questions that arises when dealing with DAOs is whether they are legal entities or not. Currently, most DAOs are not registered or recognized as legal entities in any jurisdiction, which means that they lack legal personality and capacity. This can create several problems for DAOs and their members, such as:

• Difficulty in entering contracts with third parties, such as service providers, vendors, or customers. Without a legal entity to represent the DAO, it is unclear who has the authority to bind the DAO and who is liable for breach of contract.
• Difficulty in enforcing contracts among DAO members, such as agreements on governance rules, dispute resolution mechanisms, or profit-sharing arrangements. Without a legal entity to enforce the contracts, DAO members may have to rely on trust or reputation to ensure compliance, which can be fragile and unreliable.
• Difficulty in accessing legal remedies in case of disputes or harms caused by or to the DAO. Without a legal entity to sue or be sued, DAO members may have no recourse to courts or arbitration tribunals to resolve conflicts or seek compensation.
• DAO members may face direct personal liability (including being treated as a general partner) with respect to the liabilities of the DAO.

Some possible solutions to these problems include:

• Creating a legal wrapper for the DAO, such as a corporation, a limited liability company (LLC), a cooperative, or a trust. This would provide the DAO with a legal entity that can enter contracts and access legal remedies on behalf of the DAO. This could also mitigate direct liability for DAO participants. However, this would also entail additional costs and complexities for setting up and maintaining the legal wrapper, as well as potential conflicts between the legal rules and the DAO's own governance rules.
• Using a hybrid model that combines a legal entity with a smart contract. This would allow the DAO to delegate some functions and decisions to the smart contract, while retaining some control and oversight by the legal entity. For example, the legal entity could act as a custodian of the DAO's funds and assets, while the smart contract could execute transactions and distribute rewards according to the DAO's rules.
• Relying on existing or emerging legal frameworks that recognize DAOs as legal entities or grant them some legal rights and obligations. For example, Wyoming recently enacted a law that allows DAOs to register as LLCs under certain conditions. Other jurisdictions may follow suit or develop alternative approaches to regulate DAOs.

Securities Regulations

Another major legal issue that affects DAOs is whether their tokens are considered securities or not. Securities are subject to strict regulations in most large jurisdictions. Securities regulations typically require issuers of securities to register with regulators, disclose relevant information to investors, and comply with various rules on trading and reporting.

Many DAOs issue tokens to their members or investors as a way to raise funds, distribute profits, incentivize participation, or grant voting rights. Depending on how these tokens are designed and marketed, they may fall under the definition of securities in some jurisdictions. For example, if the tokens promise future returns based on the performance of the DAO or its underlying assets, they may be considered investment contracts, which are a type of security. Similarly, if the tokens are traded on secondary markets where buyers expect to profit from price appreciation, they may be considered securities.

If DAO tokens are deemed securities, then DAOs and their members may face significant legal risks and obligations, such as:

• Liability for issuing unregistered securities or engaging in unlicensed securities activities. This could result in civil penalties, criminal prosecution, or cease-and-desist orders from regulators.
• Liability for making false or misleading statements or omitting material information about the DAO or its tokens. This could result in lawsuits from investors or regulators for fraud or misrepresentation.
• Liability for violating insider trading or market manipulation rules. This could result in fines, sanctions, or criminal charges from regulators or law enforcement agencies.
• Compliance with ongoing reporting and disclosure requirements. This could entail additional costs and burdens for providing accurate and timely information about the DAO's operations, finances, governance, risks, and token transactions.

Practical solutions to securities-related risks may currently be limited and impractical, particularly in the context of the current U.S. Securities and Exchange Commission's approach to the application of securities laws. Available securities registration and exemption options are likely incompatible or impractical with the effective operation of the DAO itself. There is also generally a lack of clarity on how a DAO token might be offered and structured to fall outside of the scope of applicable securities laws.

While DAOs present a novel and interesting form of structuring organizations and corresponding governance, there is generally a lack of clarity and certainty on how DAOs may fall within existing legal and regulatory frameworks and what the implications may be for the DAOs and their participants. Creators and participants should be aware of these uncertainties and take them into consideration in connection with their DAO-related activities.