By: Salomé Bernhart
Reviewed by: Nathan Vandy
The field of cryptocurrencies is still relatively new. There were no decentralized digital currency assets before 2009 and no general smart contract platforms before 2015. Web3 has grown quickly and it is therefore important to consider potential and unpredictable developments in a rapidly evolving field when making recommendations on the proper legal treatment of Web3. DeFi faced a sudden upsurge of activity in 2020 and gained importance in the blockchain landscape but also managed to bridge TradFi financial services. For the private and public sectors, Web3 offers a multitude of opportunities and challenges. It is therefore important to provide an overview of the regulatory landscape, recognize points of interaction, and situations where tension can present itself, and assess the costs and benefits of different courses of action.
Thank you to @PrimeDAO_ and @Prime Rating for supporting this work and sponsoring this research in support of every DAO on this important topic and creating more value to Web3 by pushing the conversation further and expanding boundaries of what is legally possible in the absence of clear regulation.
In this article, Web3 and policymaking will be discussed in an attempt to help clarify where protocols/DAOs sit from a legal perspective, in the world outside of the crypto space.
This report will help companies, policymakers, regulators and institutions who would like to interact with DAOs better understand where they’re legally positioned, in practical terms. Jurisdictional nuances and tax optimization strategies will not be specifically considered in this research.
To better assess Decentralized Autonomous Organizations (DAOs), we can classify them into Registered DAOs, that are organized according to the laws of a country and that are recorded in a government registry, and unregistered DAOs that exist outside of the legal frameworks defined by national laws and are not registered in a government registry. The advantage of incorporating DAOs into a regulatory framework would facilitate and increase legal certainty from the perspective of the DAO's participating members and parties, as well as from the perspective of regulators, including the general public. In order to evaluate if a DAO could fit into any existing law a first step would also be to identify if a DAO has any elements of a legal personality.
Before a DAO chooses how it wants to be structured and where it wants to position itself, from a legal point of view, it's important that the following terms should be understood: Functional equivalence and Regulatory equivalence.
While applying existing corporate laws to DAOs has been proven to be very difficult because they are based on an intrinsic operation nature, it is possible to view “functional equivalence” from specific provisions. The concept of ‘functional equivalent’ appeared in UNCITRAL's study on electronic commerce in 1996, and has since been utilized by comparative law academics, especially in a number of European Union and European national literature. The idea is intrinsically tied to the notion of technical neutrality. As seen in the following two examples, electronic signatures vs handwritten signatures or tokenized shares vs shares.
If they are functionally equivalent and accepted by law, then there might not be the need to introduce new specific corporate rules, just because they are not yet encompassed. On this subject, Twitter user @CryptoLawRev pointed out that functional equivalence “is a term of Art in comparative law” and more can be found about this topic in @coalaglobal’s Model DAO Law paper.
Equivalence can also be seen in a regulatory manner as the establishment of functions of a legal rule and the function of technology. Granting DAOs regulatory equivalence would mean that they try to achieve traditional corporate law objectives by relying on innovative technologies like blockchains. An example of regulatory equivalence is the relationship between registration requirements for corporations and the deployment of a DAO on a certain blockchain. As already pointed out, unregistered DAOs will not comply with most existing legal standards, but the features of their technology may meet some of these requirements through a different process or procedure.
A crucial element that should be taken into account when choosing (if any) a legal entity for DAOs, is the distinction between permissionless and permissioned projects.In the case of permissioned blockchains and protocols, the software is deployed and controlled by certain identifiable participants and they maintain an access control layer to allow certain actions to be performed; they can therefore be considered centrally controlled/coordinated. By looking at the current laws, permissioned blockchains are more akin to a traditional private corporation or foundation as they both have centralized governance.
Permissionless blockchains and protocols, on the other hand, allow decentralized coordination among many participants. The control over the protocol is distributed among the actors, generally, via a token-based system and enables permissionless participation. Usually, permissionless DAOs also lack formal managers and all members stand on equal footing, at least in terms of the availability to join and gain access to pertinent information needed to contribute and govern the DAO.
Also, blockchain development introduces situations that have no equivalent IRL. Consider, for example, that the legal status of a protocol would have to be reevaluated in the event of a hard fork of the underlying permissionless blockchain or the restructuring of a whole protocol itself. Moreover, the nature of DAOs and on-chain protocols opens the doors for exceptional events such as governance hacking that have no equivalence in the real world. An example of such events is to use flash loans to vote on governance decisions, instead of using them for their intended purpose which is typically to take advantage of price arbitrage opportunities.
Because they operate exclusively in a digital world, DAOs can effectively exercise self-regulation and introduce dispute resolution frameworks that can be handled on-chain by on-chain litigation resolution protocols. DAOs open the doors to both old and new ways of regulation and dispute and in the recently approved DAO law in Wyoming it is mentioned that it’s the DAO’s choice to either handle disputes on the blockchain or in a court of law.
A decentralized judicial platform is a type of blockchain-powered "digital court" that provides fair decisions by crowdsourcing jurors to resolve disputes with an economic incentive (examples are Jur, Kleros & Aragon).
It sometimes seems difficult to evaluate who are the “stakeholders” of Web3 projects. Therefore, first, we have to map users, using relevant information about their nature. In general, it’s possible to group stakeholders into four categories, though in some cases stakeholders may span multiple categories. The following classification seems to have generated a consensus through multiple research papers:
– Builders: They create, implement and support protocols, infrequent business and technical development contributions.
– Suppliers: Provide capital, high impact (business and technical) contributions to the functioning of protocols.
– Users: They use the protocol's functionality for intended use cases.
– Governance: They make decisions on the development of the protocol.
One of the more difficult words to define in an industry full of confusing neologisms is decentralization. The word describes a simple concept: activity that isn't controlled by a central authority. How to define it, why it matters, and how to regulate it, isn't so straightforward. The digital assets economy's future will be shaped by the answers to these questions. It is imperative that lawyers, judges, regulators, and others involved in the legal industry develop a common understanding of what "decentralization" means, since we can assume that the law applies differently in a "sufficiently decentralized" system than in a centralized system. The law cannot be applied if this is not clearly defined. The best way to create a consistent understanding is to test if a DAO is decentralized.
It is possible to have more or less decentralized aspects of protocols. Decentralization can occur at the asset level, at the smart contract level, and at the governance level, to varying degrees. While looking at Governance it’s important to understand who decides which aspects of the system can be altered by token holders and if there is a threshold to propose governance changes. Custody is another key point of decentralization, and it's important to understand who oversees safely (if any) storing assets. Users should know if their funds are under their custody or not. Also important is that every user understands if their funds are under their control and accessible at all times, and if there are multi-signature wallets involved in the control of the protocol then the parties should be known. Optimally, the admin keys of a decentralized project should either be destroyed or be controlled by a DAO, and the keys held in cold storage. The rationale for this is that a decentralized project should not be able to make any protocol modification unilaterally by a single party once a smart contract is deployed. It is therefore essential to understand which parties can make changes to the protocol. Another measure of decentralization is having public bug bounty programs where protocols expand their breach prevention capabilities beyond their internal teams or hires. Bounties, and also professional peer and publicly available audits of the deployed on-chain code, are indicators of a more, verifiable and secure protocol.
Insurance coverage is less mentioned in research but in my opinion, is part of the spectrum of the level of decentralization of a protocol. DAOs that pursue insurance go a step further on the path of self-regulation and the best-case scenario is when funds are covered in case of any negative event to avoid losses for their users. If a protocol provides insurance, it needs to be clear which form of risk is covered, to what amount, and if the insurer is able to withstand substantial coverage claims from different users simultaneously.
A Nakomoto coefficient can also be used to test decentralization. Essentially, it represents how many validators (nodes) would have to collude together to successfully slow down or block a blockchain.
Another test is the Howey test, which refers to the famous Supreme Court case for determining whether a transaction qualifies as an "investment contract," which would be subject to Securities Act and Securities Exchange Act disclosure requirements. It's also sometimes called the "Bahamas test” to simplify. One version of the Bahamas test asks: "Would the project still exist if the sellers/workers fled to the Bahamas?” A “yes” answer means that the risk of fraud is sufficiently low so that the instrument is not considered a security.
After all, it is the degree of decentralization of a DAO that determines how it is perceived by regulators but as of today, there is no clear guidance on this from law/policymakers.
Lawmakers and legal scholars have yet to show a broad interest in DAOs. Although DAOs offer economic benefits, they are excluded from the regulatory framework even in crypto-friendly jurisdictions, affecting the effectiveness of their newly developed legislation. To date, only a few lawmakers have introduced legislation incorporating new forms of blockchain-based structures. The legal implications of DAOs are still not fully understood, even though they are gaining rapid attention. The purpose of this section should be to provide a general overview of common DAO legal structures.
The majority of DAOs today are unregistered DAOs and their legal status is currently uncertain because either they are not (yet) encompassed by the law, or because they stand outside of the reach of regulators. DAOs and blockchain enthusiasts have been waiting for legal certainty for years and hope that new rules remain flexible to innovation. On one hand, legal recognition, as well as protections must be offered and on the other hand, crypto projects and their involved members/parties need to have the freedom to evolve technologically and experiment with new coordination frameworks.
Because they have no legal structure, their ability to engage and interact with more traditional enterprises is limited at best and impossible most of the time.
DAOs that invest solely in non-securitized assets, like NFTs, Governance tokens, or Staking tokens, are not necessarily in need of a legal wrapper and there are other use cases that don't require a legal wrapper. However, a DAO may need a legal wrapper for other reasons, and providing limited liability to contributors can be one of these reasons. Another reason is if, for example, they start buying, trading, and interacting with tokens that could be deemed securities.
If a DAO decides to remain unregistered, it's important to understand the downsides of that decision. Although this legal theory has not been proved in court yet, unregistered DAOs are viewed as general partnerships or an unincorporated association of persons from a legal standpoint where:
General Partnerships are formed when two or more persons form an agreement for the purpose of co-owning a business. General partnerships do not have a corporate form and do not have liability limitations for partners. A lawsuit can therefore attempt to hold all or any members of a DAO liable. There are certain types of activities for which a government may impose direct liability on its members.
Deciding not to have a legal structure means that DAO members stay jointly liable for anything that goes wrong. In spite of incredibly innovative and creative work, we should not simply ignore the existing rule of law.
It is imprudent and unnecessary to make protocol members liable for their innovative work as entrepreneurs. Any person contributing to a DAO should be aware of that risk.
DAOs don't always have members and applying limited liability for the actual DAO does not seem reasonable since the DAO is not understood as a legal entity that has the right to interact in the world and engage in formal contracts with others. Some DAOs are actually just multisigs, so the signers of the multisig of unregistered DAOs expose themselves to additional risks since they are executing all of the DAO's actions. The holders of keys in a multi-sig are generally exposed to certain levels of private litigation and regulatory risk, especially as their names are usually transparent and exposed. Moreover, the tax consequences related to their activity are unclear, and multi-sig holders are limited in their ability to act. As far as regulatory and private litigation risk is concerned, multi-sig key holders do not have limited liability protection, meaning that they may each be liable for actions they take or, potentially, for actions taken by other multi-sig key holders.
In short, in an unregistered DAO, developers, contributors & members are at risk of being liable for any harm caused by the DAO's operations.
Another downside is that the DAO cannot conduct operations off-chain which limits its economic operability. In the absence of a legal entity, the DAO cannot sign legal contracts, conduct off-chain operations, own IP, hold assets, open a corporate bank account, pay taxes, and, most importantly, limit the liability of its members.
A growing number of DAOs are operating under offshore foundation structures (e.g., Cayman Islands, Panama, Singapore, British Virgin Islands, Switzerland). In this section, the two most common offshore jurisdictions Cayman and Switzerland are looked at in more detail.
Offshore foundations are often chosen because of their more favourable tax regime. A DAO should be considered as part of this Foundation set-up provided that the Foundation is decentralized in its governance, either from the beginning or as it matures. This can be accomplished by making the Foundation founderless and memberless, with a Nominee Director who will act upon and execute all on-chain and off-chain decisions made by the token holders. Members of the DAO and its core contributors can be supervisors of the Foundation, without taking on direct executive responsibilities.
The Nominee Director will only act as the DAO's echo, which means he has no executive power at his disposal: no access to the Treasury Funds, and no ability to create or vote on Governance proposals (both on and off-chain).
Grants can be provided to a US operational entity, as well as to any other entities the community chooses to fund. This structure offers a good degree of flexibility in funding distribution. DAO members won't own the foundation or be "wrapped" by it. This means that the relationship between the offshore Foundation and the DAO can never be completely trustless. Offshore Foundations provide an extremely flexible framework for executing proposals passed through a DAO's governance process, while favourable tax provisions allow DAOs to optimize their Treasury tax obligations. Several practitioners recommend that the contributors that are more involved in managing the DAO still “dock” themselves and exercise their activities via a legal structure that limits their personal liability.
The Cayman Foundation has proven to be a particularly popular vehicle for use by crypto projects and DAOs. One reason is that the Caymanian corporate legislation is largely based on American and English law, which makes it quite universal in its application and operation around the world. Also, the favourable tax regime offers DAOs potential tax savings regarding their treasuries. However, an offshore structure like the Cayman also brings Increased regulatory scrutiny and therefore stricter local AML, KYC and Data protection laws to deal with.
A number of crypto projects have established foundations in Switzerland, and a canton in Switzerland named Zug has been nicknamed “Crypto Valley”, due to the large number of projects that have their headquarters there like Ethereum, Cardano, Polkadot, Aave, Cosmos, Solana, Tezos, Dfinity, Near, Nexo and Diem (formerly Libra). Switzerland is also known for its crypto-friendly banks and it is possible to pay for goods and services, and even taxes, with cryptocurrencies.
The prestige may not outweigh the extra burden of owning a foundation in Switzerland. Foundations in Switzerland must be registered at a public registry, supervised by a federal authority, and have a deed that cannot be altered. Foundations basically work like non-upgradable smart contracts because a foundation cannot be changed once it is established (deployed). The deed can contain code, for those that need more flexibility in their operations. Swiss foundations have their own legal personality, no beneficial owners, and are public. Swiss foundations serve the purpose defined at their formation, so blockchain developers can use them to ensure that their projects reflect their core values, such as decentralization and inclusivity. It is difficult to make changes to foundations and for decentralized organizations with evolving activities that change over time, this structure is not very attractive. Swiss foundations of blockchain DAOs are “permanent” and even after leaders decide to leave, the foundation will still exist because the code is being committed. Swiss foundations are represented by their foundation council members who must act within the purpose of the foundation. Since the board members are personally liable for their actions, the decision making power or control over a foundation cannot be transferred to external stakeholders (such as DAO members). As a result, the foundation is an interesting legal form for long-term infrastructure projects, such as protocol development (Like the Ethereum Foundation). If/When this is not the case, Swiss foundations can be perceived to be more administratively burdensome.
A Swiss association is a legal structure similar to a voluntary association under U.S. law - also known as a club. Swiss associations are well-established legal entities for non-profit activities and limit the liability of their members. As defined by Swiss law, an association is a group of natural persons and/or legal entities formed and structured in accordance with a written agreement, with the aim of pursuing a non-economic purpose. Setting up the articles of association is a fundamental part of the process as it contains all rules, obligations, and their purpose. Swiss civil law is liberal and flexible when it comes to the formation and governance of associations. An association becomes a legal entity as soon as its constitution reflects that intention. While associations cannot have a commercial purpose, they are allowed to conduct commercial activity. In this case, the association must register with the Registrar of Commerce (Associations that do not conduct commercial activity and are not subject to audit do not need to register). The taxation of charitable or public non-profit associations may also be exempt under certain circumstances. The main bodies that govern associations are:
An association is governed by its general assembly. Its responsibilities include naming the board of directors, accepting and rejecting members, and handling all other corporate matters not assigned to another body. It is the association's general meeting that amends its articles, decides on its dissolution, and supervises its subsidiaries. In Switzerland, General Assemblies must meet physically, but digital meetings may be acceptable if a proper democratic process is followed and the articles of association specify exactly how the meeting will take place. According to the articles of association, the board of directors has the responsibility and authority to manage the affairs of the association and to represent it.
As soon as you form a Swiss association, a legal persona is created and you can open a Swiss bank account (registration is required). On a practical note, a Swiss bank will most likely be more sceptical, or the process will be harder if no Swiss individual is part of the association and no association board member is domiciled in Switzerland. If this happens, there is always the possibility to use a local third-party service or hire a local member for the board of directors. In terms of liability, the Swiss association structure has advantages, since as long as the organization and its members adhere to the statutes, members cannot be held liable for their actions as they act in the interests of the association, and it is important to have a harmless abstention article included.
The less known Decentralized Autonomous Association (DAA) is modelled after the Swiss Association's structure. This template was designed by @MME_Switzerland, a legal and tax consulting firm based in Switzerland to establish an association in the most decentralized way possible. The goal is to reduce the centralization points as much as legally possible. The DAA template proposes the following bodies governing the association.
Its powers are limited to the basic competencies that, according to Swiss law, must be handled by the general assembly (such as the change of statutes, the liquidation of the association, etc.).
Delegates of the DAA are only equipped with those competency skills which require the action of a human, e.g. keeping the books or representing the DAA.
The core of the DAA structure is the Member Community which is decentralized and blockchain-governed. All relevant business matters of the DAA are decided by the Member Community. This may include decisions on proposals, support of new projects, or allocation of DAA funding. The Member Community provides and sets up the infrastructure to enable on and off-chain voting to transparently propose and vote.
Member applicants are reviewed by the DAA Whitelister group to verify member eligibility for the Association. The DAA Withelister is a smart contract that approves token gated membership of the association.
To better understand why the UNA structure is a viable option for DAOs, it's important to recognize two types of legal structures:
DAOs generally lack a shared business or for-profit purpose, so they fit more neatly into the unincorporated bucket. But because most DAOs have Governance tokens with a market value, the situation gets a bit more complicated. However, if a DAO’s primary purpose is to develop and share an innovative technology (that creates a more efficient and transparent financial system), it can be argued that any increase in value to the governance tokens is incidental and, given the highly volatile digital asset market, not necessarily directly tied to their efforts. There are other characteristics that will impact the categorization of DAOs as a for-profit or not, such as: how was the initial token distribution made, limits of token distributions, revenue, and revenue distributions. Only after a DAO is analyzed across these factors it can be determined its for-profit or not-for-profit status.
Uniform Unincorporated Nonprofit Association Act (UUNAA) is a relatively new legal structure. Under common law, nonprofit associates were not legal entities, so states created statuses to give these associations legal entities. This led to a wide variety of treatment of non-profit entities on a state-by-state basis, and a fair amount of contention about it. UUNAA was endorsed by the National Conference of Commissioners on Uniform State Laws in 1996, updated in 2008, and last revised in 2011. Andreessen Horowitz (@A16z) first introduced the UNA structure for DAOs with a comprehensive overview of tax, liability, and UNA entity strategies. @David_M_Kerr has shaped the UNA conversation in a lot of DAOs and provided extensive insight into the legal landscape available for DAOs.
In some states, UNA’s can provide limited liability to their members and be taxed as corporations. They are the non-profit equivalent of “unincorporated general partnerships”. Groups/DAOs form unincorporated associations when they agree together to undertake a task, even without any paperwork or formalities. Unincorporated associations with the intention of making a profit are considered general partnerships.
If the UNA's purpose is simply to accomplish tasks without a profit motive, it can also register at the state level as a separate legal entity from its members, thereby avoiding the classification of a general partnership.
As a result of this structure, it has different ways to be set up.
One possibility is to "wrap" an entire DAO into one UNA (electing federal taxation as a C-Corp), whereby it's a straightforward path to becoming a UUNAA through a governance proposal. Another option is to "silo" the DAO activity between the treasury and the protocol, with the treasury wrapped in a UNA and the protocol remaining regimeless or "wrapped" in a variety of possible entities, depending on the facts and circumstances of a particular DAO. In this case, all activities related to the Treasury (e.g., grant programs, DAO development work, staking/liquidity mining programs, treasury diversification, etc.) would fall under the Treasury’s UNA, but separate activities relating to the Protocol (e.g., changes to protocol smart contracts, decisions regarding protocol fees, etc.) would fall under the separate and distinct Protocol. A “siloed” treasury and protocol entities can give better independence between use cases and allow to respond to changes more flexibly. A UNA generally also allows for the creation of an enforceable US contract with membership liability that is assigned to the DAO. Any proposals that violate the non-profit function of the UNA would also lead to a security violation, so by having a UNA structure the security violation is basically avoided due to clarifications that must happen through a legal review of the proposal. This also means that a DAO needs to ensure that certain executions are compliant before executing new ideas or ways to operate in the crypto world, which can potentially slow down operations in a fast-moving environment.
Limited liability companies, or LLCs, are legal U.S entities used to own, operate, and protect businesses. A Limited Liability Company provides the same legal and financial protection as a corporation but can be easier to operate. LLCs are widely used and offer more structural flexibility than corporations in terms of their governance. LLCs can be member-managed and allow members to waive their fiduciary duties to each other, making them more adept at decentralized governance. Something often forgotten when talking about LLCs, is that there are equivalent legal structures in almost every country of the world (for example Canada LLP, and the UK LLP).
What is interesting with an LLC is that the member's liability is limited to the extent that the LLC's members have invested capital in the business. When considering LLCs this is a crucial point because when an LLC effectively does incur damages then, whatever the amount of damage, the member’s personal liability will always be limited to how much a member has invested into the LLC. If there's a lawsuit it will only ever be up to the capital of the LLC and if you want to show fraudulent play you've got to really show that there's been an intention of fraud on behalf of the managers of that entity, irrespective of whether that entity is controlled by a physical person by another corporate or by a DAO.
Some LLCs are created by multisig managers for the sole purpose of protecting them as holders of the token so that the LLC, and not the individual, is the multisig holder. This could be a way for members to avoid the risk of direct liability on everything they are worth.
In the United States, some states have even passed laws intended to facilitate the operations of DAOs (such as Wyoming or Tennessee). According to many practitioners, the newly passed laws allowing DAO LLCs make little difference and do not allow anything that would not have been possible with an LLC before the law was passed. While the statutes mention things like that these jurisdictions can be managed by its members or by smart contracts or algorithms, they do not explain what they mean in detail. Therefore, although these statutes appear crypto-friendly, they do not seem to be a clear solution at this point since they do not provide any guidance. Due to the lack of federal recognition and the lack of clarity about the various forms of DAOs, many DAOs choose to incorporate under the Delaware LLC Act rather than the Wyoming DAO LLC.
A final note is that although the LLC structure is very popular, and having states recognize the economic and cultural value of DAOs is generally a positive development, unfortunately, the LLC is not a suitable legal structure for all DAOs. DAOs with large or fluid memberships may have difficulty using LLCs, and they still have certain points of centralization (e.g., a tax representative).
According to the American Bar Association, Delaware became the first state in the U.S. to permit series LLCs in 1996. Since series LLCs are a relatively novel business structure and their state recognition differs, the legal ramifications aren't always clear, and that imparts legal uncertainty. What distinguishes a series LLC from a traditional LLC is that a regular LLC is one separate business entity, while a series LLC is a group of separate legal entities under one parent LLC.
Every Series has a Master LLC and individual Series. Essentially, each Series is an LLC on its own, with its own name and Members that are independent of the Members of the Master LLC and other Series. It is crucial to note that assets and liabilities between the Series amongst themselves as well as between the Series and the Master are entirely firewalled (though there is not yet sufficient case law to confirm this firewall is 100% secure in all states). The Master spawns all individual Series without requiring extra filings with State Registry: the Series' first Member simply signs an Operating Agreement and the Master only needs to keep track of the series' chosen name and initial Member. Under this legal construct, the time it takes to spin up a new entity can be reduced to the speed at which a Series signs a contract with its Master. An individual Series needs a first Member, in the analog world, this Member would either be a physical person or a representative of a company that contracts with the Master LLCs by signing the Series Operating Agreement. Series LLCs have the advantage of being easy to form.Series LLCs pay only one formation filing fee regardless of how many series they will have. In the event of a lawsuit against one series, the others are not liable. position
@otoco_io realized that the first Member of a Series LLC can be a smart contract address to increase the speed of formation of these series LLCs. And because this on-chain Series LLC has the same legal validity as any other LLC, a new Series LLC can be established by signing a cryptographic transaction on the blockchain between the owner of a wallet and a Master smart contract that enables the Series Operating Agreement.
According to this setup, the first Member of the Series LLC is whoever controls the wallet that sends funds to the Master LLC smart contract address that spins up the Series LLC.
It is possible to instantly spin up a legal wrapper on-chain using Otoco's service to create series LLCs in a few transactions. Multisig wallets replace physical members as the company's first shareholders. In essence, the DAO is the first member of the LLC. The LLC controlled by the DAO is not a wrapper, but rather an extension of the DAO. This is also interesting from a Governance point of view as the DAO basically controls this LLC and acts as an agent in the real world. This started as a legal experiment by Otonoco but found quite some traction as there is a demand for fast legal solutions. More about it can be read here.
Trusts have a long history and the law of trusts was developed during the crusades under the authority of the king of England in the 12th century. In the 21st century trusts are a mature and well-established structure.
Trusts are legally binding arrangements in which, normally, a person (known as the settlor) transfers assets (or for another purpose) to another person (known as a trustee) for the benefit of other persons (known as beneficiaries). Depending on the circumstances of the case, trusts can be adapted to the settlor's needs. It is possible for the settlor to be one of the beneficiaries or even a trustee. Typically trusts don't need to be registered (e.g. Guernsey and Jersey). It is important to be familiar with the following roles in a trust structure in order to better understand it.
The settlor is the person who creates the trust by transferring certain assets to the trustees for a specific purpose. This is not as easy to identify in DAOs because they often compile of a decentralized member base. Thus, a solution is to use the technology development company to create the trust in order to advance the goals of the DAO community.
The trustees of a trust will hold the settled property on trust subject to the powers and duties specified in the trust instrument and the law. The DAO can choose whoever it deems the most suitable trustees regardless of where they are resident.
In order to advance the purposes of the trust and ultimately the community, the DAO can instruct the trustees to exercise certain powers (e.g. grants, specific transactions, acquisition). Trustees have limited liability for their actions as Trustees, except for fraud, willful misconduct or gross negligence on the part of the Trustee.
It is necessary to appoint an enforcer to ensure that the trust assets are used in accordance with the objectives and rules outlined in the trust documents. In addition to enforcing the terms of the trust, the enforcer has the power to appoint and remove trustees with the consent of the DAO community.
Purpose Trusts, Guernsey,Any purpose whatsoever, whether or not involving the conferral of any benefit on any person, and includes, without limitation, the holding or ownership of property and the exercise of functions.
Purpose Trusts, Jersey:
Any purpose whatsoever whether or not (a) involving the conferral of any benefit on any person; or (b) consuming or capable of consuming the income or capital of the trust, including without limitation the acquisition, holding, ownership, management or disposal of property and the exercise of functions.
Although DAOs are bringing us together to set up new systems and new ways of doing things, in the excitement of building these blockchain protocols, products, and services, it seems that most DAOs are missing the opportunity to incorporate the real world into their roadmap. It can be argued that because there is no need for registration and reporting with financial supervisors, a Trust is the legal structure that most closely matches DAO’s promise of decentralization. DAOs can use a purpose trust in which no individual members have a beneficial interest, but the trust instruments can articulate the community’s purposes and set its mission, management, and governance.
Trusts are available in certain offshore jurisdictions and are created by transferring assets to a set of Trustees, who can act according to the instructions of the token holders. The Trustees are overseen by an Enforcer who can bring legal action if they do not act properly. Ownerless foundations are similar to this in the sense that they can be used as a vehicle to handle assets and distribute them, as well as enter into legal agreements.
Introducing a legal structure into a DAO has been proven to be problematic because corporate formalities, designed for centralized and in-person organizations, may compromise the benefits of decentralization. Having no reliance on a government, the absence of a central point of failure, efficient cooperation among participants, and active participation from a broader group can easily be lost when complying with obligations that have kept pace with the advancement of technology. Additionally, in a trust, not only the trustees, but also other prominent stakeholders in the DAO may hold fiduciary obligations. A possible fiduciary duty arises because there is a relationship of trust and confidence. If there is a fiduciary relationship then one should subordinate their own interest to another person. This includes the duty of care, transprency and good faith.
Recently, @dydxfoundation has used a non-charitable purpose trust formed on Guernsey as part of its legal structure. Both Jersey and Guernsey laws also permit the establishment of hybrid trusts which have both charitable and/or non-charitable purposes. With hybrid trusts it is possible to have both purposes and beneficiaries or, if desired, the option to add beneficiaries at a later date if needed.
Guernsey trusts separate a person's ownership rights from their right to benefit from their property. It involves one party (settlor/grantor) transferring property to another party (trustee), who is then responsible for holding it for a specific purpose. Therefore, they are useful for DAO community treasuries that are designated for growth and development (like grants) and clarify the existence, or lack thereof, of any tax payment and reporting obligations. Guernsey's non-charitable Purpose Trust eliminates certain challenges associated with other proposed entity structures. The need for an administrative body, such as a state government, to authorize the existence of the entity has been a key issue but Guernsey law does not require such approval for a Purpose Trust. Instead, the Purpose Trust becomes effective when assets are transferred to it, and Trustees and Enforcer sign the Trust Agreement. Guernsey law only allows government involvement for the Purpose Trust if there is a Guernsey court ruling on a matter that is applicable to it. Basically, only a court can end the existence of a DAO, just as it may end the existence of the Purpose Trust.Under a Trust structure, token holders retain the legal right to name Trustees, remove Trustees, add Trustees, remove and add an Enforcer, or terminate the Trust and transfer funds wherever the token holders decide (except to the DAO or the DAO token holders).The Purpose Trust solves the risks and limitations of multi-sig key holders by limiting liability for Trustees, ensuring they are tax compliant, and enabling them to perform off-chain activities more effectively. In comparison with all the other legal wrappers in this document, trusts are evidently the most aligned in purpose with the nature of what a DAO is because they let a grantor entrust someone/something to steward an asset on its behalf.
While interviewing practitioners for this paper two ideas repeatedly stood out: first, creating a legal structure is optional, and second, when choosing a legal structure there is not a “best” one. The key is choosing a structure in which the DAO and its participants feel as compliant or risk-free as they want to be. Currently, there is a tremendous amount of DAOs and most of them choose to be regime-less. If this is a prudent decision for the future, is an open question.In summary, there are a lot of different options, and every DAO has to decide how compliant it wishes to be and how strong it wishes to be in protecting its participants. A recent paper published by @paradigm written by Rodrigo @RSSH273 & @ChrisBrummerDr provides an extensive overview of possible legal structures.
With so many decisions, what kind of compliance do DAOs want to achieve today? This is THE question DAOs should ask their token holders. @A16z proposes a method here for deciding which structure will be most suitable for a particular DAO.
Several DAOs will remain 100% regime-less, meaning contributors and multisig signers ignore possible regulatory requirements and accept the risks that come with this decision. On the other hand, DAOs that can bridge IRL can sign contracts, hire people (when an employment relationship is required), make fiat payments, enable social security and benefits, and bring clarity to tax obligations. What seems to be fundamental is that any legal structure does not change the current relationship between the governance framework and its existing ecosystem. Legal structures do not necessarily slow down a protocol’s ability to adapt and grow, but instead, open the door to further innovation. It is important not to impair privacy, DAO-2-DAO integrations, growth, and innovation by adding legal friction points or bottlenecks. The challenge, of course, is not letting this bridge create any impediments to the evolution of the protocol or add stress to the current governance model.
It is fair to assume that in order to start a collaboration with high-level institutions, DAOs would probably be best advised to choose the most legally compliant structure. On this topic, DAOs have to also consider the comfort level of the institution they wish to approach and the level of risk these potential partners are willing to take.
Disclaimer: This research paper does not constitute professional, legal, tax, or financial advice. All content is provided solely for informational and educational purposes. Consider seeking independent professional advice on financial, tax, legal, and other matters. The information collected in this document was sourced from online resources, meetings with lawyers, and advisors, conversations with companies that already have set up legal wrappers for DAOs, and might not reflect the most recent laws. Salomé Bernhart declines any obligation to update this document.
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