The law is coming for DAOs

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The United Kingdom Law Commission announced on November 16 it’s seeking views on how decentralized autonomous organizations (DAOs) can be characterized and fully incorporated into the laws of England and Wales.

The difficult-to-define entity that U.K. lawmakers are trying to get to grips with is a blockchain-based (usually) form of organization, often governed by a native digital token that participants can use to vote on the organization’s actions. They are often defined by open access, democracy, and decentralization.

This all sounds very utopian in theory, but because a DAO is a decentralized mass of users, not necessarily an incorporated entity, lawmakers are beginning to concern themselves with working out where it fits into, or outside of, existing ideas of a company or financial organization.

“The main idea behind the DAO was to create this decentralized entity, independent from anyone, but everything that is called the DAO is not decentralized because you will always have a connection to someone deploying it or benefiting from it with a location,” explains Marcin Zarakowski, Managing Director and former General Counsel of the Bitcoin Association, speaking with CoinGeek.

This supposed decentralization (or lack thereof) is part of the issue currently being addressed by lawmakers. The decentralized philosophy behind DAOs often conflicts with the reality that complete decentralization is nigh on impossible when real-world actors are involved. As Zarakowski states, “good luck in being able to prove that they are really 100% decentralized. If something is really decentralized, it means that no one really has control over it.”

Under this description, DAOs fall short of the decentralized ideal, as they are still controlled by a core team of committee members who often design the proposals that make it to vote and who set the terms by which the vote is passed and implemented.

With that in mind, the logical first step for the Law Commission on its journey to find a home for DAOs would be to see if these blockchain-spawned entities can be slotted into an existing category of organization.

A distributed General Partnership

“It’s impossible to have a legal entity that is not defined in the law,” says Zarakowski. “What usually happens with organizations considered or called by their founders’ DAO’ is they form the most basic type of a partnership, which is usually called a ‘general partnership.’ In most continental law, it’s the most basic form of engagement, but it’s still a contract.”

A general partnership is a business arrangement between two or more individuals who agree to share assets, profits, and the financial and legal liabilities of a jointly owned business. In Germany, this is known as a civil law partnership (Gesellschaft bürgerlichen Rechts) and is defined as an association of individuals or enterprises with a common goal and contractual purpose.

This is one possible existing definition that the law already accounts for and for which DAOs meet the basic criteria for. However, under a general partnership, all partners share 100% liability, which means that any and all partners can be sued for the actions of the collective. As Zarakowski explains, “it’s a contract, it doesn’t have a legal personality, so it cannot be sued. You will always need to sue all the partners of the general partnership, and this is how DAOs would most likely become qualified.”

While fitting DAOs into this category of organization might seem the simplest way to account for a decentralized network of individuals under current laws, it’s unlikely a classification that makes all network’ partners’ fully liable would be a popular one in the digital asset space. This itself would invite more questions: would every member of a DAO be liable for its actions, or only those who voted in their favor? Does it matter if a member, despite having voting rights, never cast a vote?

One alternative would be to introduce an entirely new legal structure that could provide added clarity to people wanting to found DAOs.

“Any new legislation would need to define that the DAO is decentralized in a way that allows for certain elements of centralization,” says Zarakowski.

These elements of centralization are things like the location of the DAO’s members and domains, as well as the authors of a smart contract and where it’s being deployed. But whether an organization can have some or all of these characteristics and still be properly said to be decentralized is a question the Commission will no doubt be addressing. It’s worth noting that after the collapse of the banks in 2008, Occupy Wall Street sought to create a small society based on complete equality in voting. No decision was made without the entire community. The problem with this is that nothing occurred. You can’t have a society without leadership. So, any DAO will always either have a leader or fail.

The DAO meets the SEC

Despite what former I.P. attorney ZeMing Gao describes as the delusion of “an invisibility cloak,” DAOs have bumped up against existing laws and regulations right from their inception, not least the very first DAO.

Aptly named ‘The DAO,’ the original decentralized autonomous organization was launched in 2016 on Ethereum. It was a smart contract where people could contribute Ethereum tokens in exchange for participation in a venture fund that was directed in the market to accumulate Ether, which would then be used for investing in other Ethereum-based projects.

The participants, people that contributed Ether, would vote on which projects should be chosen for investment. Unfortunately, the DAO did not have a charmed life.

“From the very beginning, the smart contract had a backdoor that was exploited by some hackers,” says Zarakowski, “people could observe how the donated funds were leaking from the DAO, and no one could stop it because it was a smart contract.”

However, the disaster did put the idea of decentralization to the test: faced with the theft of $150 million worth of Ether, drastic action needed to be taken, and it was. The developers in control of Ethereum, led by Vitalik Buterin, decided to fork the network to recover the lost Ethereum and render the stolen funds unusable. Though Buterin put this course of action to a vote, less than 6% of all Ethereum token holders participated, with more than 25% of the votes coming from a single address. Despite the absence of any real consensus, the decision was made to push ahead with the fork.

Even ignoring the lack of engagement from the DAO, the solution was designed, proposed, and ultimately implemented by a core of Ethereum developers. On that basis, can The DAO really be said to be decentralized?

In addition to the internal fallout, in 2017, the U.S. Securities and Exchange Commission (SEC) published a report examining whether The DAO and its associated entities and individuals violated federal securities laws “with unregistered offers and sales of DAO Tokens in exchange for ‘Ether,’ a virtual currency.” The SEC concluded that DAO Tokens were securities and, therefore, possible violations of U.S. securities law could have taken place.

Here we see an example of an enforcement body examining the workings of a DAO and the assets it’s trading in and determining that the activity fits within an existing framework, in this case, securities law. At the same time, it illustrates the need for deliberate action by lawmakers to clarify the legal status of DAOs: if the question is only being asked after a disaster has struck, then that leaves the creators, constituents, and those affected by the activities of any given DAO in an unsatisfactory grey area.

The Ooki DAO case

The elusive nature of the DAO was put before the U.S. courts directly earlier this year after the Commodity Futures Trading Commission (CFTC) took enforcement action against Ooki DAO for offering illegal digital asset trading and lending services.

Since the legal character of any DAO is uncertain, there was naturally a question over how exactly an agency like the CFTC would take action against what amounts to a loosely connected network of users spread across the globe. CFTC opted to sue the DAO directly, defining it as an entity comprised of all those individuals who hold the OokiDAO tokens and use them to cast votes over the organization’s governance.

Interestingly, the court granted the CFTC permission to serve the lawsuit via the OokiDAO’s online chatbox and a post on its online forum, a move the court accepted was necessary owing to the intangible nature of the DAO.

Such a move seems like a practical necessity if DAOs are to have a place within the law, but the court’s decision to allow service in this way inspired consternation from some corners of the crypto industry, with DeFi interest groups complaining that it would “chill novel and innovate forms of software development in the United States” and “obscure the fact that the CFTC seeks judgments against unknown individual token holders, as voting members of Ooki.”

But in the absence of clear and dedicated rules governing DAOs, the only alternative to this kind of CFTC enforcement would be for the government to admit defeat and decide that DAOs uniquely and inexplicably fall outside the ambit of the law. The futility of that position is illustrated by the fact that in Ooki DAO’s case, the DAO appears to have been chosen as a vehicle for the express reason of providing a smokescreen from regulators, according to statements made by Ooki DAO’s founder and cited by the CFTC’s complaint:

“So many people across the industry right now are getting legal notices, and lawmakers are trying to decide whether they want DeFi companies to register as virtual asset service providers or not – and really, what we’re going to do is take all the steps possible to make sure that when regulators ask us to comply, that we have nothing we can really do because we’ve given it all to the community.”

This is almost certainly the kind of bad take on regulation that encouraged the CTFC to state, when it brought an action against Ooki DAO, “DAOs are not immune from enforcement and may not violate the law with impunity.” Something the regulator no doubt intended to prove by debunking the myth of decentralization and serving the summons through a help chat box.

Despite the CFTC’s perceived enthusiasm to hold Ooki DAO to the law, the success of this action is still being determined, and questions remain about how to define the inheritor of the bZx protocol within regulations designed for centralized entities. Perhaps then, another solution lies in new laws, not existing ones.

Wyoming setting trends

Looking to the U.S. again, in March 2021, the State of Wyoming passed legislation recognizing DAOs as legitimate enterprises, making registering a DAO in Wyoming the same way an LLC or traditional corporation would register. Crucially, it prevents DAOs from being treated as general partnerships and thus prevents individual members from being personally liable for actions taken by the DAO by virtue solely of their membership.

It didn’t take long for this to draw DAOs into the regulatory fold, as on July 1, America CryptoFed DAO became the first DAO recognized under U.S. law.

In September this year, the SEC announced it had dug up anomalies in the Form S-1 registration statement of America CryptoFed DAO–an SEC filing used by companies planning on going public that contains basic business and financial information on an issuer–putting its registration in jeopardy.

This was swiftly followed by a second administrative action from the SEC, stating that the company’s attempt to register its two tokens, Ducat and Locke, was missing several basic financial details and contains “misleading statements and omissions.”

This is the attention to detail and micro-scrutiny that comes with being a registered organization, and once the Law Commission has decided how to integrate DAOs into the legal order, for better or worse, it should increase the need for due diligence across their activities.

The Law Commissions’ goal

“Proponents of crypto would like to go outside of the legal order to create this decentralized world, to bypass existing regulations, and to escape from the legislators,” suggests Zarakowski.

This existence outside the legal order and regulation is certainly true in the U.K., where according to the Law Commission, “many thousands of DAOs exist today, but few appear to be structured using the law of England and Wales.”

The Commission’s goal, therefore, is to clarify their legal status as well as the liabilities, rules, and regulations that apply to those who participate in DAOs.

Commenting on the call for evidence, Professor Sarah Green, the Law Commissioner for Commercial and Common Law, stated: “DAOs are said to offer multiple benefits to market participants, incentivizing cooperation and innovation, leveling playing fields, reducing the scope for human error, lowering costs, and increasing transparency. Yet their legal and regulatory status is unclear.”

Green went on to explain how the Commission hopes to address this uncertainty by building “consensus on the best ways of describing the constituent elements of DAOs and to highlight ways in which the law of England and Wales might foster their development.”

Consensus in the digital asset space might be a tall order, but the suggestion here is that the call for clarity on how to define DAOs within the law is not some sinister Orwellian attempt to stifle them but rather to ‘foster’ and encourage their development.

While the outcome of this quest to define DAOs remains uncertain, Zarakowski suggests that the wisest approach for the Law Commission would be the one that causes the least disruption to existing laws:

“Legislators must be cautious and not prone, because of how innovative and cutting edge the technology is, to create something that can disrupt the order. The goal should always be to create technology-agnostic legislation because technology always develops faster than the law. The idea is to create such general constructs and concepts that they can be applicable to anything, no matter what happens in the future.”

The suggestion being that showing favoritism to blockchain technologies when it comes to tailor-making rules and regulations, rather than fitting them into existing ones that other entities must abide by, may disrupt the whole system, causing a cascading demand for unique laws.

Fortunately, perhaps the general construct that Zarakowski speaks of already exists in the form of a General Partnership model, if not, we can only hope the Law Commission listens hard to the views its receiving and a logical consensus can be found for the DAO dilemma. 

Watch: The BSV Global Blockchain Convention panel, Law & Order: Regulatory Compliance for Blockchain & Digital Assets