Long reads

Demystifying DAOs

Arvin Abraham

Arvin Abraham

UK Fintech Lead Attorney, McDermott Will & Emery

Decentralised Autonomous Organisations (DAOs) are organisations whose rules and governance (the parameters by which they operate and stakeholders interact) are encoded in a blockchain (i.e., in a computer program rather than set out in a typical paper based governance document such as a shareholder’s agreement).

As these rules are set out in a blockchain they are transparent to the DAOs members and not subject to the same level of interpretation as in a typical organisational construct. Decision making by the DAO and certain changes in the operating framework would operate according to that pre-built framework, either happening automatically upon the occurrence of trigger events or for certain decisions upon the approval by holders of a sufficient number of the DAO’s tokens who would vote electronically.

One of the major benefits of a DAO is to reduce organisational friction and make governance fully democratic by removing the need for a board of directors, management team or other intermediaries between the members of the DAO and decision making.

However, DAOs are also subject to significant disadvantages, notably their lack of legal personhood which prevents them from owning property or entering into contracts in most jurisdictions, limiting their use for typical corporate purposes. These disadvantages can be overcome, but generally require the reintroduction of some aspects of traditional governance structures.

How They Work

DAOs can theoretically operate on any blockchain although given the popularity of Ethereum for decentralised finance transactions, Ether-based DAOs remain the most ubiquitous. A DAO operates via smart contracts that function autonomously without the layers of management bureaucracy found in a typical organisation. The smart contracts underpinning a DAO would automatically execute certain commands or take actions upon the affirmative vote of holders of a certain amount of the DAOs tokens.

Smart contracts are computer programs running on a blockchain that automatically execute or run commands when predetermined conditions are met. This promotes certainty of outcomes as there is normally no intermediary involved in the execution of the command. A DAOs members will have complete certainty in knowing that once trigger conditions occur the DAO program will take the actions that it has been pre-programmed to take.

It is apparent that a computer program which is acting based on pre-programmed instructions will promote transparency in organisational decision making. This also reduces the friction and red-tape found in a typical organisational construct where actors who are independent of the organisation’s members (e.g., management, employees or a board of directors) must be relied on to effect the will of the members.

Those third party actors may not have the same view on what actions to take as the organisations members or how to take those actions. Where their wills diverge from the members, they can be forced to act, usually by relying on cumbersome governance processes such as a shareholder vote in an annual meeting.

The perception of shareholders in many modern corporations of being dis-enfranchised lowers their propensity to participate in organisational decision making and the time and economic cost of participating in such decision making processes serves as a further barrier. DAOs solve this problem. Many decisions of the DAO require no further member action, depending on just the computer code to execute the instructions.

For example a DAO can be programmed to buy or sell securities upon the occurrence of certain market conditions. No management decisions or stock traders need to be involved. Where decisions are subject to the instructions of members, it is simple and easy to access the DAO by logging on to a computer and voting on the step to take. This process is also remarkably frictionless – computer based voting can occur in a pre-determined window which can be as long or short as set in computer program code; once the vote occurs the resulting action can be taken by the DAO instantaneously.

Legal Framework and Regulatory Status in the UK

DAOs are still a relatively novel concept and their formal legal status in the UK is not yet defined. This is also the case globally, although the acceptance of DAOs as being true legal entities is starting to happen. A notable example is the state of Wyoming in the US, which allows DAOs to have limited liability company status.

Without status as a formal legal entity, DAOs currently do not have legal personhood. This means that a DAO in the UK cannot own property or enter into a contract for itself, which is a major limitation versus standard organisational constructs such as corporations or partnerships.

The regulatory status of DAOs is currently based on the framework governing their underlying tokens. Generally speaking, Ethereum based tokens are classified as exchange tokens or utility tokens in the UK and are viewed as falling outside of the Financial Conduct Authority’s regulatory perimeter and thus not regulated.

Although Ethereum based tokens are currently viewed as unregulated, it would not be inconceivable to see this status change if regulators were to accept that DAOs have formal legal status. In that eventuality, the tokens, which represent the formal membership and voting interests in a DAO, would effectively be securities and likely subject to characterisation as a security token, which would fall squarely within the FCA’s regulatory perimeter. DAOs may also find themselves subject to requirements on collective investment schemes, which arguably could apply to some DAOs operating in the UK today.

Solving the Agency Problem

While the wait continues for regulators to determine whether DAOs can benefit from legal personhood, there are some strategies that can be employed to give DAOs real world agency today. However, these solutions are all currently imperfect and require the reintroduction of elements of the governance found in a typical corporation or partnership.

Solving the agency problem involves introducing additional legal entities to serve as middle men between the DAO and the real world. These middle men entities can take a variety of legal forms and be located in different jurisdictions, with the choice dependant in part on tax and bankruptcy proofing considerations. Example middle men entities include the introduction of a Cayman Charitable Trust combined with a Cayman Company or separately a Cayman Foundation Company, in each case that would transact on behalf of the DAO in the real world.

The decision making powers of the trustee or directors of the Foundation Company can be circumscribed to minimise the governance rights that are transferred from the DAO’s members, but would clearly require some loss of authority by the DAO.

The additional structures required to give real world effect to a DAO can be a complex web and the above is a very simplistic view of how real world agency can be conveyed. This clearly cuts against one of the main benefits of a DAO which is to simplify organisational decision making. Furthermore, depending on the legal entity chosen to act on behalf of the DAO in the real world, that entity’s directors or management may have conflicting duties to that entity and not to the DAO itself.

The Future

DAOs currently operate in a halfway house where they have clear governance benefits but at the same time are subject to severe limitations from their lack of legal personhood. The necessary maturation of DAOs as a legal construct will likely bring with it increased regulation as they become more accepted as a standard organisational form and regulated like one – e.g., with DAO tokens being treated like securities. Although the red-tape associated with this may be cumbersome, it would be more than compensated for if DAOs would then enjoy the benefits of legal personhood, allowing them to own property and enter into contracts directly without the complex legal gymnastics required to given them real world efficacy today.

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