What the DAO? Why Everyone Is Talking About Decentralized Autonomous Organizations
April 11, 2022
Last month, Ukrainian President Volodymyr Zelenskyy legalized cryptocurrency in the country to address the deluge of digital assets that people wanted to donate to support humanitarian aid and Ukraine’s defense. Much of that cryptocurrency came from Ukraine DAO. The DAO raised funds by selling an NFT (more on that later) of the Ukrainian flag.
This would have been unheard of a few years ago—because DAOs were literally unheard of—and people then would have swarmed NGOs and charities in an effort to help Ukraine. We still do that today, of course, but DAOs have arrived as potentially powerful entities, and they are here to stay.
We introduced our series of client alerts about DAOs a few weeks ago. This edition will define DAOs and it will be followed in coming weeks by alerts about liabilities and legal entities, tax considerations, securities and regulatory concerns, and bankruptcy-related issues.
Let’s start here (those of you who know the basics can skip ahead):
A DAO is…
A DAO is a software-enabled organization built and governed by smart contracts on a blockchain network (like Ethereum). A smart contract could resemble a legal contract if it meets common legal requirements, but generally a smart contract is a set of rules written in computer code on a blockchain network that enables a network of computers to communicate and execute pre-programmed transactions once certain conditions are met. Smart contracts can have infinite configurations. For example, Alice writes a smart contract that calls for Bob to send her an umbrella when it rains in exchange for $20 worth of Bitcoin. As soon as a computer in the network detects that it is raining, the contract self-executes, sending Bob $20 of cryptocurrency and Alice an umbrella.
Sometimes the sums are much more than $20. Much more. Sometimes the amount is enough to buy a copy of the U.S. Constitution or enough to bid on the Denver Broncos (the BuyTheBroncos DAO is trying to raise $4 billion to do exactly that). Some people have called DAOs “digital flashmobs with money” and others have referred to them as “group chats with a bank account.”
DAOs are organized by real people who share a common goal, pooling their money to accomplish that goal. They may want to meet or socialize, talk about a common interest, or create, buy, or fund something. Instead of a CEO or a board calling the shots, the members make the decisions and good decisions lead to the creation of value, and, in turn, more users.
Because smart contracts are verifiable by anyone who views the blockchain, they are transparent. A DAO can execute transactions without third-party intermediaries, while still retaining the security and encryption that underpin blockchain technology. Once members of a DAO collectively decide on a course of action, the DAO’s smart contract automatically executes the decision. And no one can change a smart contract unless the members of the DAO vote to change it.
Members acquire rights in a DAO by purchasing the DAO’s native token, which confers voting rights in the DAO’s governance. Token holders propose and vote on initiatives to advance the DAO’s founding purpose—like donating to Ukraine, or raising $45 million to bid on a copy of the Constitution that Sotheby’s was auctioning off (ConstitutionDAO disbanded after losing the auction), or buying the Wu-Tang Clan album Once Upon a Time in Shaolin for $4 million, as PleasrDAO did.
There are different types of DAOs, which are usually categorized by their purpose. Compound, Aave, and MakerDAO are Protocol DAOs, which issue tokens and allow users to participate in decentralized finance (DeFi). PleasrDAO and Flamingo DAO are Collector DAOs, which, among other things, acquire collectibles. Friends with Benefits and Bored Ape Yacht Club are Social DAOs, which allow people to meet other like-minded people and chat about crypto or about nothing to do with crypto (sometimes they actually meet in person!).
ElektraDAO and ObscuraDAO are Creator DAOs, where owners create (hence the name) the content, distribute it, consume it, and value it. The content—usually non-fungible tokens (aka NFTs)—is the product of a collaboration of the whole community and the whole community shares in its value. It’s not hard to see the transformative implications of Creator DAOs for the entertainment industry.
A DAO is not…
A DAO is not a traditional legal entity, and to explain why, here’s some history. In the 19th century, corporate law helped build a structure that made pooling capital easier, while also limiting liability for owners of corporations. This innovation revolutionized the world of business. DAOs may be the next evolution of corporate organization. Many in the crypto space already view DAOs as a viable alternative to traditional legal entities because they enable a more transparent and efficient corporate governance structure than highly centralized systems.
Unlike a traditional legal entity, a DAO functions in a trustless environment. Members of a DAO are unknown to one another, and they can raise money efficiently to achieve the DAO’s founding purpose. This is what members of the Ethereum blockchain community did in April 2016 when they created the first DAO (called, of course, The DAO). The DAO resembled a traditional venture capital fund, except the fund was directed by its members—not by a central authority. It raised $150 million in Ether or “ETH” (the digital asset or “token” that facilitates transactions on the Ethereum blockchain) from more than 11,000 participants, the largest crowdfund ever. But then a hacker ruined things (don’t they always?) by exploiting a vulnerability in The DAO’s code and stealing $70 million in ETH. The community recovered the assets, but it decided to dissolve The DAO. Despite its collapse, The DAO paved the way for the proliferation of the current generation of DAOs.
Because it lacks a distinct legal personality—unlike corporations or limited-liability companies—a DAO can be seen as simply an amorphous organization built on computer code and existing on a blockchain. This lack of formal legal recognition could make it difficult for DAOs to:
- interact and form contracts with third parties outside the DAO,
- file or pay taxes,
- open bank accounts or make cash transactions,
- hold or protect off-chain assets,
- protect its intellectual property, or
- limit the liabilities of its members.
If a DAO is not a traditional legal entity, what kind of legal entity is it?
The legal limitations have so far prevented DAOs from gaining wider adoption. It’s all a work in progress, and it’s up to regulators and legislators to address these limitations. The prevailing view in the legal community today is that a DAO, on its own, would likely be treated as a general partnership, which means its members do not have limited-liability protection. A central tenet of corporate law is that equity holders of a corporation (and an LLC) are not personally liable for the debts and obligations of the corporation or the LLC as long as certain corporate formalities are maintained. And investors or other businesses may be reluctant to participate in DAOs for fear of exposing themselves to personal liability.
For this reason, some practitioners have proposed “wrapping” a legal entity around a DAO to give it the legal recognition it needs to conduct business and to protect its members from personal liability. Legal wrappers might include a foundation company formed in the Cayman Islands, Singapore, Switzerland, or other jurisdictions; a Wyoming DAO LLC; a Vermont blockchain-based LLC; or an Unincorporated Nonprofit Association (UNA).
We will explore these “legal wrappers” in greater detail later in our What the DAO series, but for now, let’s look briefly at the Cayman Foundation idea. Unlike most traditional corporate entities, a Cayman Foundation company has no shareholders, but it can have beneficiaries and purposes, and the bylaws of a Cayman Foundation can be set up to mirror the governance model of a DAO.
So, Cayman Foundations might work for DAOs seeking legal recognition while offering members limited-liability protection. But there are important issues to consider before creating a Cayman Foundation company, and we’ll discuss those in the coming alert.
Also, a philosophical question remains with any decision about reorganizing (or just plain organizing) a DAO’s corporate structure: Does placing a DAO in a corporate structure dilute its decentralized purpose?
You know who else really wants to know what kind of legal entity a DAO is? Regulators
Government will surely be directly involved in devising (and policing) whatever new corporate ecosystem will allow DAOs to pay taxes and protect their members while ensuring that they can still be innovative and collaborative. The Biden administration, in an Executive Order issued a few weeks ago, has signaled that it is willing, seeking a coherent, coordinated, and deliberate approach to regulating the digital asset economy.
This is a rapidly evolving area of law, and we will do our best to keep you informed. Stay tuned for the rest of our DAO series (coming soon to an in-box near you):
- Liabilities and legal entities
- Securities law
In the meantime, you will probably have questions. Contact professionals at O’Melveny for answers.
Each client alert in this series includes some crypto-lingo at the end to help you converse with other cryptophiles. Here are some terms:
- Nocoiner (or Normie): A skeptic who has stayed out of the crypto market for whatever reason.
- Proof of Work: The way transactions were confirmed on the early blockchain networks (such as bitcoin), requiring substantial amounts of energy.
- Proof of Stake: The way transactions are confirmed on the newer blockchain networks, requiring less energy.
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 Illinois, Wenting Yu, an O’Melveny partner licensed to practice law in California and New York, Damilola G. Arowolaju, an O’Melveny associate licensed to practice law in the District of Columbia, and Keith Guo, an O’Melveny associate, licensed to practice law in California and Massachusetts 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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