Legal and other issues with Decentralized Autonomous Organizations or DAOs
In this article, I highlight a few problems with DAOs. The laws make it such that DAOs render members to unlimited liability arising from other members’ actions, DAOs cannot hold property in its own name, DAOs create tax problems for members, DAOs’ voted resolutions may not have legal force, and DAOs may be regulated by investment laws. I consider legal issues with setting up, formation or running of DAOs in Singapore.
I’ve suggested two variations of a CLG model to address some of the legal issues.
Conceptually, DAOs run into the trust problem and the skill problem.
Decentralised Autonomous Organisations (DAOs) are groups of people who engage in a common endeavour and collectively make decision, having the right to do so by virtue of their possession and control of certain digital tokens. (Read more at this great article by Antler.)
DAOs are effectively unincorporated associations. The law holds every person in the group to liability for everything the group does (through any of its members). This means that if one member purports to act for the group and gets into trouble, everyone else will be responsible and have to bear the debts.
It is not a separate legal entity and cannot sue or be sued in its own name. It would be a nightmare to have to administratively maintain a collective legal action represented by certain representative members.
It cannot own property (including intellectual property) or enter into contracts in its own name but only do so through certain of its members as trustees—meaning there’s a risk that such trustees could take off with assets and the other members have little practical recourse.
It probably would have difficulty maintaining a bank account for fiat money.
If the group receives income, each member would probably be taxed on income each receives.
The group exists by contract. So, the contract terms, whatever they may be, govern the relationships between the members. Depending on the terms of the constitution contract, decisions of the group recorded as resolutions may not even have binding contractual force. The mechanisms for decision making must be clearly spelt out in the constitutional contract.
Another potential legal issue with DAOs is that once some property or assets are involved and there are potential or actual returns, the enterprise may become deemed to be a collective investment scheme under applicable investment regulations eg under the Securities and Futures Act in Singapore. The offer or trading of the digital tokens relating to the DAO may then become an offer of units in CIS which is unlawful unless the relevant requirements under the law have been met. In 2017, the US SEC famously declared that “the DAO”’s offer of tokens is an unauthorised offer of securities (under the US Howey test). Similar issues have been considered in the US context.
Suffice to say, given all the above limitations, it is preferable to have an alternative structure to an unincorporated association with loose constitutional contractual terms.
One option is to incorporate a company limited by guarantee (CLG). CLGs afford separate legal liability benefits, and can thus hold property or maintain bank accounts on its own and sue and be sued in its own name. Considered a public company, it can have more than 50 members and because it has no share capital, it must simply maintain a register of members. The practical challenge would be to administratively update the register of members (which must contain the name, address and date of obtaining membership of members) since most DAOs confer membership based on possession and control of governance tokens simplicities. Share-based membership is possible and would address this issue since people who want to be members must submit a proposal to be a member.
Alternatively, the CLG can comprise only certain key founding members of the DAO as members and directors of the CLG; and to constitutionally provide expressly that the CLG’s members and directors must take into consideration the decisions of the DAO made in voted resolutions from time to time. Perhaps other rules could be spelt out in the constitution concerning the DAO membership.
The other challenge however is that such administration of the CLG would require certain DAO members to do so on behalf of the whole DAO. This erodes the pure vision and purpose of having a DAO, which is a decentralised system that is not supposed to work based on trust in any individual but the smart contracts and protocols.
Yet, taking a step back from technical legal and regulatory issues, the thing about DAOs is that their effectiveness in pursuing any enterprise which has impact on the real world (not only on the blockchain or any applications relating to the protocol) would be limited by the quality of its members and their behaviour regarding the DAO. In a traditional company structure, ownership and management are separated. Capital owners may not have time, or even skills, to do everything required of management. That’s why management can be different from capital owners, but are chosen by the owners and empowered and incentivised to pursue the owners’ interests by pursuing the company’s best interests. In most cases, there is such an alignment. The owners’ control over who comprises management would suffice for owners to protect their interests.
In DAOs, there’s no inherent structure. It’s an open book. Members may vote one day on something as inane as the colour of a banner, or as complex as the appropriate capacitance for a capacitor on an integrated circuit. One would think that the latter question should be decided by a technical expert. But DAOs would allow members to propose it to be voted on by all members. And then a whole motley crew of non-experts would get to determine this question.
And then, who’s going to actually produce the banner or integrated circuit board? Who’s going to register the integrated circuit design?
Thus, there would be a trust problem (which DAOs were meant to solve) and a skill problem.
On the skill problem, an idealised view would be that skilled members can persuade others on appropriate matters. That, after all, is the nature of democracy. In reality, that probably wouldn’t work. Ask anyone who has tried to persuade a spouse or friend about how best to carve the turkey. Indeed, from experience, many companies fail when owners intervene significantly in management’s decisions.
In summary, I’ve highlighted a few problems with DAOs. The laws make it such that DAOs render members to unlimited liability arising from other members’ actions, DAOs cannot hold property in its own name, DAOs create tax problems for members, DAOs’ voted resolutions may not have legal force, and DAOs may be regulated by investment laws.
I’ve suggested two variations of a CLG model to address some of the legal issues.
Conceptually, DAOs run into the trust problem and the skill problem.
Nonetheless, it would be good for stakeholders to continue to think about developing and evolving structures and systems which enable DAOs to flourish for good. The idealised potential of DAOs is great and offers a vision of globalised democratic enterprises for good. The question is how to get there.
#techlaw #technologylaw #singaporelaw #crypto #virtualassets #digitaltokens #DAO #decentralized #blockchain