Legal Risks and Potential of DAOs

The goal of this article is a dedicated analysis of the law and regulations surrounding Distributed Autonomous Organizations (“DAO” or “DAOs”). I want to be clear that we are big fans of these structures and believe that they will have a major impact on our society because they can fundamentally alter how businesses are formed and run.

With that, there are many risks and pitfalls associated with DAOs as they are currently conceptualized and utilized. Identified below will be some of these issues and a little insight into how they might be dealt with. Accordingly, this article may seem bearish on DAOs, but that is simply because of the size of the risks involved. Also please note that this article does not address any of the issues associated with raising capital, either traditionally or in the crypto space.

A Brief Background

DAOs go far beyond any traditional definition of a company in that they allow groups of people of virtually any size to come together for a unified purpose with little friction (other than the frictions that are currently endemic to the blockchain space).

Such purposes can, and do, include business, charity, and community organizations. These structures allow people who have never met and may never meet, people who are domiciled all over the world, to organize effectively and act collectively.

So, what’s the catch? This all sounds very cool and very tech-forward, but as with many fringe industries, people/groups/companies utilizing DAOs run into several legal issues very quickly. These issues all stem from the fact that the existing laws around business, corporate structure, securities, and liability do not contemplate this sort of organization because until recently they didn’t exist.

DAOs in their current iteration could not exist prior to the blockchain era. Subsequently, because the blockchain era is so nascent, the law is struggling to catch up to the innovation. Laws and regulations catching up in some fashion are an eventuality, but until they do, early pioneers face huge risks as regulators, legislatures, and plaintiffs’ attorneys inevitably try to shoehorn these new creations into existing legal frameworks.

Operational Risks and Limitations

If an organization has elected to go “DAO first,” i.e. has not wrapped a corporate form around the DAO, the members of that DAO are not protected from liability the same way they would be in a company, an LLC, or a limited liability partnership, where liability is limited to the entity itself.

Simply put, the shareholders of a corporation, the members of an LLC, and the partners in an LLP are only “risking” what they have contributed to said entity and the percentage of the entity’s assets that their ownership stake entitles them to.¹ Instead, existing corporate law dictates that what the members of said DAO have formed is a general partnership.

A general partnership has some notable operational hitches – as a general partnership has no corporate form, its members are 100% personally liable for all actions of the partnership and of the other general partners. They are also jointly and severally liable resulting in several serious implications.

If a plaintiff sues a partnership and is successful in such suit and there aren’t enough assets in the partnership to make the plaintiff whole, such plaintiff can recover against the assets of the partnership and of all of the assets of each partner because there is no firewall between the partners’ assets and the partnership’s assets.

Furthermore, in such a scenario, if the plaintiff isn’t able to equally recover from all of the partners, a court can allow the plaintiff to recover against one or some of the partners for the entire amount and leave it up to the individual partners to compensate each other proportionately internally.

To illustrate this further, say for example a group of American citizens form a DAO with some Japanese citizens and then an aggrieved third party who is an American citizen sues this DAO. The plaintiff would sue the DAO in an American court and since the court would deem the DAO a general partnership, the plaintiff would not be burdened by having to recover against the Japanese partners.

Instead, this plaintiff would be able to recover against the American partners, and it would be the American partners’ responsibility to chase down the Japanese partners for their share of the damages. Given the size of DAOs and the inherent anonymity in their formation, such recovery could prove impossible for the members who were forced to pay out by a court.

The current remedy to this problem of general partnerships is to wrap the DAO in a corporate form, whether that is an LLC or a C-Corp. MetaCartel, Flamingo DAO, and The LAO are good examples of this.

That said, these DAOs have other limitations placed on them that also tend to frustrate the purpose and the promise of DAOs. More specifically, these organizations are limited to 99 stakeholders and have strict rules around the nature of their members.

This is due to specific US laws concerning the number of stakeholders a company can have. In the case of the organizations just mentioned, since they all have a financial or investment component to their stated business operations, i.e. managing assets or making investments, they are limited to 99 stakeholders. This is done so that they can take advantage of the 3(c)(1) exemption to the Investment Companies Act of 1940 so that they aren’t deemed to be “inadvertent investment companies.”²

Should a company be deemed an inadvertent investment company, all of its contracts can be voided, and it is restricted from engaging in interstate commerce among other significant penalties. Additionally, in order to fall under this exemption, all members/shareholders must be accredited investors.

If the purpose of the company is not financial in nature, and the risk of becoming an inadvertent investment company is not prohibitive, there are other limitations that must be considered. Notably, if the company has more than $10 million in assets the entity-wrapped DAO cannot have more than 500 non-accredited investors as stakeholders.³ If the company exceeds that amount, it is subject to the reporting requirements of the Exchange Act of 1934 and is more or less treated like a public company, something that none of these organizations are set up to deal with.

$10 million might seem like a high bar to clear, but many crypto native companies are hitting numbers of that size and far larger in a very short amount of time, so dealing with the stakeholder limit before reaching that threshold is essential (because forcing stakeholders out of a company about to clear the $10 million threshold generally presents a whole host of other legal issues).

If all of the stakeholders of a company are accredited, the limit on the number of stakeholders is raised to 2000 (the dollar value remains $10 million), but as soon as the number of stakeholders rises above 2000, such entity would still be treated like a public company that is subject to the same reporting requirements.⁴

These reporting requirements are incredibly expensive and are difficult for “traditional” companies to comply with. Considering the fact that most DAO members are basically anonymous, the AML/KYC requirements alone would be prohibitive.

Note: Even if a project isn’t specifically named a DAO, this analysis can still apply. Many projects are in the process of, plan to, or have already issued, governance tokens to decentralize their operations. It is highly likely that regulatory bodies will look at these organizations/companies/projects and apply the same rules regarding the number of participants.

Potential Mitigation

Unfortunately as of yet, there are no clear solutions to these issues. Corporate entities are creatures of state law, but all of the issues related to the number of stakeholders I just identified are federal in nature, so while forward-thinking states like Wyoming are creating DAO-native entities the participant limits absolutely still apply unless and until there is a change to federal law.

Given how novel DAOs are, it will probably be a long time before such changes are made so how can projects protect themselves? There is no clear-cut answer to this problem at the moment, however, there are certain steps that can be taken that may minimize most of these risks and potentially even eliminate some of them.

For projects with the financial means, off-shoring the entity that issues a governance token or that wraps a DAO, seems to be a viable option for now, although all offshore jurisdictions are currently looking at these issues too and may enact rules around them. But, for the moment at least, organizations like MakerDAO have made use of foundations in places like the Cayman Islands and Switzerland as a way to try to sidestep some of these issues.

Of course, offshoring is not cheap, so bootstrapped projects may not be able to avail themselves of this, so what can they do?

One unique option that our firm has been toying with is to attempt to turn some of the previously mentioned weaknesses into strengths, specifically leaning into the idea of a general partnership but requiring that all the individual partners join the partnership through a single-member LLC because general partnership interests are presumed not to be investment contracts, and therefore not “securities” under federal law.⁵ Additionally, the general partners of an issuer and general partners of the general partners of an issuer are deemed to be accredited investors.⁶

This does not negate the joint and severable liability or the responsibility of the individual partners for the actions of the partnership and the other partners, but because these individuals’ LLCs are the actual partners, such liability does not extend to the personal assets of the humans involved in the project. It would extend to whatever assets each natural person decided to keep in their LLC. The project still functions without a corporate firewall, but the participants have erected many personal firewalls between themselves and the project.

This specific structure for these specific purposes has not been utilized by any project that we know of, much less tested in any court, but given existing SEC rules and guidance, the safe bet would be to ensure that no partner would own more than 10% of the total partnership interest. Such restrictions obviously limit the utility of this approach, but we believe that this method has real potential here for certain projects in that almost all of the issues identified above can be sidestepped.

The firm is also working on another novel approach that we believe has never been tried but offers great promise for projects in this space and could in fact become a standard for DAOs and governance tokens. For more information on this structure, please contact the firm and we can see if it would be applicable to your project.

Please note that all existing and proposed solutions to the issues described in this article are by definition not court-tested and could fail. But we believe that any option is better than being DAO-first or entity-less due to significant liability issues and regulatory concerns.

Ultimately other states will follow Wyoming’s example and create DAO-native entities and we believe that at some point the federal government will get on board and provide proper exemptions, but until that time projects are at risk.

In the short term, we expect warnings like this to largely fall on deaf ears in the industry, and in the long term we feel there will be a regulatory standard, but in the midterm, there is going to be a lot of pain for projects that have opted to be DAO-first and haven’t properly addressed these risks.

If your project is a DAO or if you are considering issuing a governance token, please contact us. We can discuss ways to mitigate and deal with some of these issues.

1. The concept of piercing the corporate veil is outside the scope of this article.
2. 15 U.S.C.A. § 80a-3(c)(1)
3. 17 CFR § 240.12g-1
4. 17 CFR § 240.12g-1
5. S.E.C. v. Schooler, 902 F. Supp. 2d 1341 (S.D. Cal. 2012)
6. 17 CFR § 230.501(4)

Author: David Rodman

The information in this blog post (the “Blog” or “Post”) is provided as news and/or commentary for general informational purposes only. The information herein does not, and shall never, constitute legal advice and therefore cannot be relied upon as a legal opinion. Nothing in this Blog constitutes attorney communication and is not privileged information. Nothing in the Post or on this website creates any kind of attorney-client relationship or privilege of any kind.

Originally published at https://therodmanlawgroup.com on March 29, 2021.