Get to Know This Acronym for a Crypto Regulatory Alternative: DAOs

Governmental authorities are moving toward tighter regulation on cryptocurrency projects. Decentralized autonomous organizations (DAOs) present a potential alternative, with many cryptocurrency projects planning to launch as, or convert into, DAOs.

At the most basic level, DAOs are organizations moderated by self-enforced rules encoded by software on behalf of their members—in many instances, the governance token holders. In theory, no single person or team manages the DAO; rather, this function is decentralized and conducted privately through various democratic on-chain voting mechanisms.

In practice, of course, different DAOs are at varying stages of decentralization from the team that created the DAO.

Where Do DAOs Fit in the Regulatory Scheme?

Given the novelty of this governance structure, at least from a legal perspective, it is not surprising that the regulatory response to date has largely been to try to fit DAOs within traditional corporate structures.

For example, Wyoming’s recent DAO law is designed to allow DAOs to fit within an LLC structure. This bill is designed with several benefits in mind, including protecting DAO participants from theories of liability based on general partnerships and giving a corporate form for recently passed legislation that allows DAOs to register as LLCs.

At first blush, this might appear to be a step in the right direction. However, structuring DAOs within this traditional corporate framework is in some ways counter to the original vision of DAOs as decentralized and democratic entities. Such LLCs may inevitably require managers to exercise a significant level of discretion while carrying out the voting of the members, akin to how traditional LLCs would function in a central manner.

Then how can a DAO—which may only exist in the ether—thrive in today’s society and regulatory frameworks? Key to answering this is to examine what off-chain (i.e., real world) functions DAOs can or cannot perform. We explore two examples.

Can a DAO Enter Into a Contract?

Generally, a DAO cannot enter into a traditional contract. However, a DAO can operate by using so-called “smart contracts,” which execute based on an internal, automated trigger—following rules that resemble basic “if then” statements. The “ifs” can be straightforward, objective benchmarks: if a stock achieves a certain threshold, then a payment corresponding to a fixed fee will be issued.

But when the “ifs” are more subjective and require nuanced judgments (e.g., achievement of a service provider milestone), these simple contracts face limitations. Moreover, an entity-less DAO is limited to cryptocurrency transactions, as it is not able to open a traditional bank account in its own name.

Solving these limitations of a DAO will be critical to presenting DAO as a true corporation alternative. For instance, with respect to the subjective evaluation that a DAO may perform, there is building acceptance of committee-based review and approval as a means to provide the if in a smart contract. The committee’s affirmative vote can trigger the execution of contract provisions whether directly or through a transfer of a token to signify the approval.

Regarding the fiat limitation of a DAO, continued proliferation of decentralized exchanges and increased adoption of stablecoins may provide a functional alternative.

Can a DAO Have Legal Rights?

DAOs may also struggle at enforcing their legal rights, as there is no entity to be a plaintiff in litigation. A key function of traditional contracts is enforceability. If a counterparty breaches, one can sue in court for damages.

Smart contracts, however, lack legal enforceability. This creates risk for parties relying on smart contracts, as legal recourse is unavailable if the counterparty breaches. Without traditional enforcement mechanisms, in the smart contract sphere, participants are primarily driven by reputational risk and financial incentive.

This structural distinction may also lead to DAOs and their counterparties utilizing structures designed to mitigate these risks, including extra-contractual forms of incentives to encourage desired performance by a counterparty (e.g., a carrot) and escrows for proof of payment (e.g., a stick).

Another important consideration is whether a DAO can legally own an asset that requires a corporate structure. For instance, can a DAO own intellectual property? Generally, no.

IP and other property must be owned by a legal entity or individual. Nonetheless, DAOs can look to some open source software communities to provide potential road maps for distributed ownership under a common framework.

While none of these provides the traditional legal framework of an enforceable contract, careful smart contract structuring could form the basis for approximating some key contract characteristics in a manner sufficient for many purposes.

The stronger the push to fit cryptocurrency projects into the existing corporate structure, the stronger the pushback will be from the cryptocurrency community. Rather than focusing solely on how to fit a DAO into the existing regulatory frameworks, sophisticated projects can identify and address legal and operational limitations of entity-less DAOs to achieve permissionless access, decentralization, and democratic governance.

Previously published by Bloomberg, September 24, 2021 with co-author Joon Kim (Mina Foundation)
Get to Know This Acronym for a Crypto Regulatory Alternative: DAOs (