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What the DAO? Breaking Down the Latest Blockchain Craze

March 8, 2022

DAOs, or decentralized autonomous organizations, are the latest trend in the crypto community. Surging in popularity among technology entrepreneurs and investors, DAOs have the potential to disrupt the traditional economic system as they become active investors and lenders. But, they also raise significant issues of securities, tax, and corporate law. Here, partners William K. Pao (Chair, Fintech Group), Scott Sugino (Partner, Fintech Group), and Wenting Yu (Partner, Fintech Group) discuss the basic structure of DAOs and the legal issues they raise.

In the simplest terms, what is a DAO?

Pao: A DAO is essentially what the name suggests: an entity that is decentralized and autonomous. Unlike a company, which has a central authority—whether that is a CEO or board or senior management—and is run from the top down, a DAO is intended to be a bottom-up organization where members of the DAO make decisions for the organization.

How does that work? How does a group of people make decisions for the DAO?

Sugino: To understand DAOs, you need to understand their underlying technology. DAOs rely on smart contracts—software code that runs on a blockchain. Each DAO’s rules of governance are coded in these smart contracts and cannot be changed unless voted on by a majority of the DAO token holders. Thus, all of the DAO members are the decision makers, which accounts for the “D” in DAO: decentralization.

When you start a DAO, a core team of community members builds the smart contracts that provide the framework from which the DAO will operate. These smart contracts are visible, verifiable, and publicly auditable—and when you join a DAO, you agree to these smart contracts. Changing a smart contract isn’t easy and typically requires the votes of all of the DAO members.

How do you become one of these DAO community members?

Yu: To obtain voting power in the DAO, you typically need to hold governance tokens, which are cryptocurrencies tied to a certain project. You can think of these tokens as voting chips that authorize you to vote on key decisions. What’s interesting is, oftentimes these digital tokens are held by many people who have no connection to, and do not know, one another—yet are able to organize around a specific purpose.

You’ve described the D in DAO. But what about the A? What does “Autonomous” mean for purposes of a DAO?

Pao: It is the smart contracts that allow the DAO to be run autonomously. One analogy that has been used is that of a vending machine. You put in a quarter and you get a soda immediately as opposed to ordering the soda and having a server get it for you. DAO token holders commonly vote on, among other things, the adoption of a particular smart contract, which is basically code that self-executes once the vote is tabulated. These smart contracts offer speed, efficiency, accuracy, transparency, and security, because they occur on the blockchain.

What’s an example of a use case for a DAO?

Sugino: A lot of DAOs are in the DeFi—or decentralized finance—space. And, in many ways, they aim to supplant traditional banks and cut out intermediaries. For example, there is a DAO that a borrowing and lending platform where community members can lend and borrow various cryptocurrencies through smart contracts and algorithms. If I wanted to borrow crypto, I could put up as collateral some form of crypto that I already have, and then, through the protocol, borrow another type of crypto without having to interact with a bank, get approval based on credit scores, or use any sort of third party.

So, if a DAO is an alternative to a traditional company, do DAOs and companies take the same corporate form?

Yu: Not quite. Remember, the corporate form was established many years ago to create an independent legal entity with limited liability for its investors who appoint a board of directors to manage the company’s affairs. But with a DAO, there is typically no legal entity, no CEO, no board, and no other management.

There is some uncertainty as to the kind of legal entity a DAO can take. One of the most popular and flexible structures for a DAO is a Cayman foundation, which operates as a hybrid between a company and a trust. It’s an ownerless organization that mimics the structure of a DAO, and there is no centralized governance body. A Cayman foundation can act as a DAO’s service arm, which enters into contracts and interacts with service providers. But, this is still unfolding and an example of where the technology rushed ahead of the law, with many DAOs figuring out their legal structure after they form.

There have been ongoing questions about whether cryptocurrency and tokens are securities. What about these DAO tokens?

Pao: Given how active the SEC has been, we should expect the same level of scrutiny around DAO tokens as we have around the entire cryptocurrency ecosystem. In addition to making the numerous arguments that have been made as to why certain digital assets are not securities, truly decentralized DAOs will likely take the position that, even if token holders expect to make profits, such profits would be through their own offers and not “the efforts of others.”

What about taxes? Do DAOs pay them?

Sugino: Tax authorities have not much provided guidance on this question, but I think it’s safe to say they will not allow an entire part of the economy to escape taxation, and DAO token holders should factor taxes into their DAO-related transactions.

All of this sounds exciting. What is your favorite part of working with DAOs?

Pao: This idea of decentralization, giving the community decision-making power, is really resonating with our clients. Our challenge as lawyers is to help the first movers navigate an uncertain legal framework, which requires creative thinking, and that’s what I love about it.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. William K. Pao, an O’Melveny partner licensed to practice law in California, Scott Sugino, an O’Melveny partner licensed to practice law in California, and Wenting Yu, an O’Melveny partner licensed to practice law in California and New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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