Decentralized autonomous organizations (DAOs) are increasingly popular as the organizational structure of choice for many individuals, groups, and companies pursuing NFT-based projects and businesses. In this article, we delve into the legal considerations that NFT ventures should keep in mind while setting up their own DAOs.
What Are DAOs and Why Are They Important for 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 power, as decided by the size of each member’s investment or work performed to further its development or objectives. DAOs use smart contracts to automatically execute commands whenever a set of conditions are met. For instance, these contracts may trigger payments, authorize transactions, or initiate a course of action when a majority of the voting stock is cast in favor of a particular action.
The rules of a DAO are stored on an open-source blockchain, so anyone can look into the code and view the transaction records, but they cannot alter the code unless conditions are met that instruct the smart contract to do so. Since there is no central authority that can direct decisions in a DAO, members can share proposals and potential projects within the community where they may be adopted according to the vote. DAOs function similarly to corporations, but without the hierarchical structure. Their primary advantage is in promoting 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 goal or a joint purpose written into rules. There are many different types of DAOs.
Legal Considerations for DAOs
Any project or business utilizing a DAO should perform due diligence and seek the advice of an attorney experienced in the digital space to ensure compliance and protections afforded 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 registration provisions in these states. Only Wyoming and Vermont extend DAOs corporate privileges such as limited liability that are usually available to traditionally incorporated entities. The other 48 states and the District of Columbia may even exclude DAOs from entering certain commercial contracts with other entities or the government, due to their lack of legal status.
- Asset Protection – Unlike corporate shareholders, DAO members do not generally enjoy financial protections 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, bylaws, and contracts. Instead, they are treated as partnerships in which each member assumes joint and several liability. Therefore, if the DAO is hacked, declares bankruptcy, or owes money it cannot repay, each member is responsible for making creditors whole, exposing their personal assets. To address this weakness, a DAO would have to 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 created as well. For example, regulatory inconsistencies may 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 may violate multiple federal laws.
- AML/KYC policies – Many traditional corporate entities are subject to anti-money laundering and know your customer (AML/KYC) policies that prescribe safeguards organizations must implement to ensure they deal only with legitimate partners, customers, and token holders. The rules also require verification of members’ identities and reporting of certain financial transactions. DAOs often are formed precisely to allow their members to remain anonymous; reconciling this advantage with AML/KYC policies becomes complicated, considering DAO memberships can include individuals from around the world. Deciding which country’s laws apply can be difficult and is likely to result in protracted legal battles if a dispute arises.
- Decision Making and Dispute Resolution – Decision-making in a DAO is carried out by voting by its 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 corporations where decision-making is centralized and the final authority to make decisions rests solely with the senior management, shareholders, or a board. The aforementioned jurisdictional issues can make resolving disputes a tricky proposition.
From the above, it is clear that there are a number of legal risks and considerations involved in creating a DAO in the US. There are jurisdictions friendlier than the US for DAOs such as the Cayman Islands, 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 correct legal structure for your organization.
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. Nonetheless, they pose many legal risks as they are not generally recognized as legal entities in the US. Further, DAOs that involve multiple jurisdictions may complicate compliance for parties using NFTs. It is best to consult a law firm specializing in legal structures for emerging technologies organizations to reap the benefits of a DAO without falling foul of potential legal risks and pitfalls.
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