Decentralized Autonomous Organizations

Decentralized Autonomous Organizations are self-operating, transparent entities that leverage blockchain technology and smart contracts to make decisions and execute actions without the need for intermediaries or centralized control. In this episode, Zachary Pyers and Sabhi Syed will review this emerging technology and its place in the legal world.

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Transcript

ZBP     Zachary B. Pyers, Esq.

SS        Sabhi Syed, law clerk

ZBP

            Welcome to the, another episode of the Reminger Report Podcast on Emerging Technologies.  We are doing another special law clerk edition.  I have Sabhi, who is one of our law clerks in the Columbus office, joining us today.  Sabhi, would you just take a moment to introduce yourself to our listeners and viewers.

SS

            Sure, Zach.  So, my name is Sabhi.  I am in my third year of law school at Case Western.  I’m a law clerk here at Reminger, and we’re going to be discussing decentralized autonomous organizations today.

ZBP

            I, well so, I appreciate that you’re jumping in with the topic already.  Decentralized autonomous organizations, or DAOs as they’re sometimes called, are kind of a new thing.  If you could, I know that the DAOs, the decentralized autonomous organizations, kind of rely on the blockchain technology and that’s an important component of it.  Can you kind of explain to us how this all comes together, how the blockchain and these DAOs kind of tie together and kind of explain to us just kind of a little bit of background on it?

SS

            Yeah, for sure.  So, blockchain technology is essential to how DAOs operate, and a lot of people know blockchains and they’re commonly known for their crucial role in cryptocurrency systems and for maintaining secure and decentralized records of transactions.  So, blockchains, what they are, essentially a digital ledger or a database of transactions that are duplicated and distributed across an entire network of computer systems on the blockchain.  So what that means is when a transaction does occur, it’s validated by each user, and these users are known as “nodes.”  So now what happens is that every node in the shared network validates these transactions, making the system a shared ledger.  So another interesting note about the blockchain and the way that it applies in DAO is that it offers a platform that allows an unlimited number of users to access it.  It’s unique that it does limit those who can view information stored on it, so when it’s hosted by millions of computers at the same time, it creates a network accessible to anyone who can access the internet.  So all you need is an internet connection, and you can view information stored on a blockchain by downloading open-source software that is freely available.

ZBP

            So what exactly is a decentralized autonomous organization?

SS

            So a DAO is a computer program, and it has no single reader and it runs on a blockchain network.  It does so by allowing a set of users to interact with each other according to protocols which can be programmed in different code.  Now a decentralized organization will operate under the same basic concepts of a traditional corporation, but the distinction between the two is that DAOs have a decentralized management structure, so for example, a decentralized management structure does away with a board of directors that are so common to a traditional corporation.  Essentially DAOs do not have officers or even a separate corporate existence, but when we describe a DAO, it helps to view it in light of a simple corporation.  So the structure of a simple corporation has three classes of members.  We have shareholders, we have a board of directors and we have other members that are involved in the corporate hierarchy.  In order to become a member in the corporation, shareholders purchase shares of the company.  So investors follow a set of bylaws to determine how votes are cast and how to select a board of directors, among other things, but in addition, you have members of a corporation such as employees which are hired by directors or other employees in the hierarchy of the organization.  So when we contrast this and look at it in a DAO, it involves a set of users that interact with each other and make decisions according to protocol specified in code and that is enforced on the blockchain.  So this means that the decisions in a DAO are made collectively through the votes of these users, and the users I keep referring to, they’re known as token holders.  So what we have is unlike a traditional organization like a partnership where votes must be counted and followed by actions taken in furtherance of the group decision, the decision and execution process in a DAO occurs automatically, and it’s a single step so it’s simply a function of the blockchains and the actual software.  Now because DAOs don’t have officers or even a separate corporate existence, they instead merely consist of persons who by participating on a common blockchain have agreed to govern their venture through software protocols.

ZBP

            So how do decentralized autonomous organizations go about completing their transactions that you just described?

SS

            So the transactions are completed and a function of the smart contract, so the smart contract is vital to how DAOs complete transaction on the blockchain.  They do things like verify the transaction did, in fact, occur.  So the most simple example of a smart contract is a transaction between a consumer and a business at the point of sale.  So the smart contract will affect the customer’s payment and the business shipment or transfer of ownership, so smart contracts are essentially applications on a blockchain that ensure each party of a transaction meets its designated responsibility, so it holds everyone accountable in essence.  But the use of complex smart contracts allows organizations to establish rules of governance that are defined on a blockchain.  Because the rules of governance in a DAO promote transparency and the rules are distributed to every node in a network, therefore DAOs do not have a single owner who can force them to act in a specific way or construe them to be that way.  Smart contracts are computer programs that enable the terms of a contract to execute when a certain event occurs like I mentioned because they are triggered on the occurrence of an event such as a transaction with no external intervention.  So if you’ve noticed, this removes the need of a third party, and it prohibits human judgment from affecting certain processes, so it also allows parties who don’t know each other to enter into agreements without any sort of reluctance because there aren’t any doubts as to performance, and you can see how this may benefit DAOs that operate globally.  Now when developing a smart contract, the contract terms are translated into code and saved to a blockchain.  What this does is to create a decentralized smart contract that can be accessed by anyone on the blockchain, so once the program condition is satisfied, the clauses of the contract are automatically executed.  Now a simple example of putting this into action is a betting example.  So let’s say two parties enter a bet over which one of their sporting teams wins a sports game, so each party places tokens into their respective accounts that are controlled by the smart contract.  When the game is over, the smart contract will verify the winner through credible real world sources.  When the smart contract receives the relevant information about the winner of the game, the smart contract is autonomously executed, meaning tokens are immediately removed or delivered from their respective accounts.  If you note, if you made note of it, the key aspect of a smart contract is that there is literally no human intermediary required.

ZBP

            So how does the decentralized aspect of the DAO kind of play out in practice?

SS

            So the autonomous spectrum that DAOs operate under is the driving factor behind those who claim DAOs will usher in this next era of innovation.  So at the far end of the autonomous spectrum are DAOs which incorporate artificial intelligence to run it, to run entirely autonomously on a blockchain.  What this means is that a DAO can operate indefinitely without any sort of human control, but humans can still contribute funds to the DAO in return for digital tokens and a share in the DAO’s profits.  Another fundamental feature of a DAO like we discussed earlier is the involvement of many users in the network where, spread across several different jurisdictions, so it’s in the DAO’s interest that there many users as, as possible in the organization, but as great as it sounds, there are challenges of decentralization.  Based on theory, those who hold a traditional view will argue that delegation of decision-making to a board of directors or other centralized body overcomes coordination costs and promotes a more efficient organization, but for example, larger shareholders from a large list of companies may pay sizeable coordination costs which practically inhibit shareholder decision-making other than for significant decisions, so by reverting to the decision-making process among token holders, DAOs may create potential coordination issues that we see in traditional corporations.  Along with these coordination issues, we also have to consider the validation for certain DAOs.  As our listeners are aware now, DAOs abide by the technological and economical restrictions of the underlying blockchain they are founded upon.  For example, Ethereum, a notable blockchain requires a rigorous task of having every Ethereum node execute smart contract codes through the Ethereum virtual machine.  Basically, every DAO that operates within Ethereum would be subject to these strict regulations and requirements which again causes issues in the validation.

ZBP

            Now that we know a little bit about DAOs, decentralized autonomous organizations, how does, how does one go about setting one up?

SS

            That’s a great question.  So, what, the absence of a board of directors is one of the most cited differences between a DAO and a traditional limited liability corporation, and the reason behind this is the lack of a board of directors will eliminate managerial costs and agency costs while democratizing decision-making, but DAO enthusiasts fail to emphasize that in reality, DAOs will almost always require a development team to establish their initial framework.  The start-up development team are generally referred to as the initiators, so even though it isn’t essential for the development of a DAO because there are DAOs that are born global due to globally-distributed nature of the blockchain, the collective action required to instigate development of a DAO in a decentralized manner can be very difficult to, a feat to achieve in practice, so one consequence of this is the model that initiators are given a substantial amount of authority.  Because these teams make fundamental decisions including ones about governing structure and voting mechanisms, the initiators have the means to exclusively control the direction, scope and substance of the DAO.  This is something that DAO proponents may gloss over because it goes against the notion of the distributed power to DAO.  DAOs are considered to be trustless meaning that there is an elimination of trust.  Essentially there exists the replacement of trust in humans with the trust in the underlying code, but the underlying code of a DAO is written by the development team, so this trust placed in the underlying code is actually a trust in the competency of the development team eroded.  This means that DAO members must trust that the initiators have established adequate decentralized governance mechanisms, and it’s interesting because the level of control attributed to initiators resembles the control provided to the board of directors, so initiators of a DAO, like a board of directors, have the power to set the scope and strategy of the organization, but at the same time, they also possess the opportunity to make decisions that further their own interests which may be at the expense of others.  The paradox is that some say the development teams that intend to launch their business as a DAO are likely to be well intentioned and others claim that this notion fails to recognize the potential for ill-intentioned initiators to take advantage of DAO token holders through fraudulent initial coin offerings.  Even if initiators have the best intentions and are willing to forego future profits by relinquishing decision-making rights, DAO token holders still must have some form of trust in the initiators to be competent and unbiased.

ZBP

            Now, as we talk about this and we’ve talked about kind of contrasting the, the structure of a traditional corporation vs. that of a DAO, can you kind of walk us through, is the organizational structure similar to that of a traditional corporation?

SS

            Yes, and to build on what we discussed earlier, DAO tokens offer decision-making rights to token holders that are similar to the rights provided to shareholders.  The smart contracts code will determine whether DAO token holders will be able to vote on a multitude of decisions like appointing subcontractors to carry out work or deciding on the total compensation for completing projects, but granting rights isn’t the only role that tokens play.  The way a token is designed can have an effect on the conduct of token holders.  Basically tokens act as financial rewards for those who validate transactions in a correct manner.  The best interests of token holders are served if the value of tokens increased.  Therefore token holders will try to optimize the DAO with successful projects and accurate validations rather than undermine the DAO through fraud or non-performance, but even with the structure difference for a traditional corporation, DAOs still face similar challenges, one of them being is voter apathy.  So we know voter apathy, which can be defined as a lack of interest in voting, has been commonly referred to both, in both corporate and political contexts for quite some time.  For publicly listed companies, shareholder apathy is one of the main reasons why decisions are delegated to management in the first place.  Shareholder apathy inhibits shareholders from aggregating their votes in order to control a corporation.  Similarly, if changes to a DAO’s governance code requires a large quorum of the legible (sic) token holders to vote, then DAOs face the same risk of absenteeism in voter engagement that traditional corporations face, and in an attempt to resolve the issue of voter apathy among token holders, decentralized systems are adopting governance systems called “liquid democracy.”  So liquid democracy encompasses both representative democracy and direct democracy.  What this model allows is voters to be given the option to either delegate their vote to an expert to present their views or they can just vote themselves.  In a representative democracy, voters cannot withdraw their delegation whereas in a liquid democracy, voters can withdraw it at any time and can either vote themselves or delegate to someone else.  The purpose behind all that is to keep delegates accountable, and DAO enthusiasts believe liquid democracies can be viable solutions to the voter apathy problem.  The notion that voters have the option to make their vote more informed should result in better outcomes, but in application, liquid democracies also may create other issues.  The delegation from token holders arguably creates a new agency problem where DAO token holders risk being exploited by those who they delegate to, so proponents argue that delegates will be held accountable because of the liquidity of the vote and will be incentivized to act opportunistically, but this fails to realize that token holders who delegate their voting authority do so because they are not well-versed enough to provide an informed vote, and this means that token holders who delegate their vote because they don’t understand the complexities of the voting matter will also be unlikely to understand whether their delegate has misused their vote.  So these agency issues that exist among shareholders in traditional corporations are similar to the agency problems also between controlling and non-controlling token holders.  So in a traditional corporate governance, it's common that company owners with a controlling interest in a firm and those with non-controlling interests may hold conflicting interests.  This happens because the subset of owners may make decisions that will implicate all owners, and we see this often in the case of majority shareholders _____ decisions and using their authority over minority shareholders, so the implications of the governing mechanisms that involve majority and minority token holders are so similar in the way that minority and majority shareholders operate.  For example, some DAOs even employ a one token, one vote system, and in these systems, minority token holders face the same risks of exploitation as minority shareholders.  So the structure of these is very unique in that they both face these voter apathy problems and agency issues, and they do overlap in that sense in the organizational structure of both a DAO and a traditional corporation.

ZBP

            Now corporations have a long history in the United States as being legal entities and kind of the legal framework that surrounds them.  DAOs are kind of a newer thing that’s come on the scene within the last few years.  Where do we find DAOs kind of in the place of the legal world?

SS

            That’s a very great question.  So DAOs are in their earliest stages of their growth, and they’re becoming more popular.  The spotlight on them has illuminated the challenges they face, so for one, DAOs do not yet enjoy certain privileges which has created concerns because of this lack of legal protection, and in turn, it’s a lack of legal recognition for DAOs.  One of the main legal issues that DAOs face is that they do not retain the useful status of personhood that corporations enjoy.  As we are aware, this status allows for corporations to sue or be sued, enter contracts, offer its members protection against liability and a multitude of other things, but the ramifications of this can be quite detrimental.  For example, without formal recognition, a DAO lacks a legal forum with which to enter a contract like a traditional commercial organization.  Because of this, there are questions about how a DAO will participate in traditional commercial agreements like entering contracts or hiring service providers or even resolving disputes, so when these questions are presented to a court, they have to face the issue of deciding what recognition they provide to a DAO.  So an interesting case is in May of 2022.  The Southern District of California was faced with the question of whether a DAO would provide limited liability protection to its members.  Plaintiffs in the action brought and filed an action in federal court against the DAO which was known as “BZX.”  So BZX operated at decentralized finance, a DeFi protocol, so the DeFi protocol was hacked and the hacker was able to obtain access to the private software keys of BZX developers.  The hackers were able to access the DeFi protocol which resulted in the theft of 55 million US dollars.  The plaintiffs’ argument was that the protocol failed to reimburse what was taken as a result of the protocol’s negligence.  The argument posed the position that all defendants should be held jointly and severally responsible for making good to the plaintiffs.  The argument was on the premise that BZX is, in fact, a DAO.  Claiming that a DAO lacks any legal formalities or recognitions, the plaintiffs in the case claim that the organization is that of a general partnership and should be treated accordingly.  So certain DAOs are being shoved into the spotlight, and we’ll discuss this in a little bit, but that was one case that was recently brought forth.  Another case, in September of 2022, the CFTC, the Commodity Futures Trading Commission, sued something called “Ooki DAO” on the grounds that Ooki allegedly had set up a platform that could be used to trade cryptocurrency futures.  As a testament to the novelty of this action, the CFTC sought to effect service of process by simply posting a copy of the summons to Ooki’s online chatbot.  The District Court held that communications method of service effected but this is largely because it was coupled with personal service on two known participants in the DAO.  But it goes to show you how new the concept of DAOs are to the legal world.  Two other things that I want to touch on briefly is the sense of regulatory concerns.  So there are only a small number of states, and we’ll discuss which ones that have adopted legal protections for DAOs, but because of the limited number of states that provide these protections and to avoid having to comply with U.S. securities laws, many DAOs have decided to basically organize offshore, so popular destinations include places like the Cayman Islands where corporate regulations aren’t as strict and taxing rates are limited compared to U.S. jurisdictions.  So some DAOs have decided to form under flexible LLC laws, but this notion has not gained widespread acceptance as of yet, but the reason why this is rejected by some is because the inherent government intrusion and regulation goes completely against the ethos of decentralization, but the added benefit of retaining increased _____ regarding liability makes this a feasible option for some, but because the United States imposes costly regulatory requirements or prohibitive legislation is a constant factor that is considered and can potentially be deterring for some investors that want to invest in DAOs.  And another issue like we discussed is the personal liability concerns, so we saw that in the case of BZX.  Without recognition in a corporate forum, the law assumes that individuals working together have formed a general partnership, and this would mean token holders are not immune from personal liability that results from the DAO’s conduct.  So the court in BZX found that a protocol used by a DAO meets the definition of a general partnership, and because of how the token holders can both suggest and vote on governance proposals.  So these governance proposals include things like hiring and disbursing treasury assets, and these are the concerns that many of the DAOs are looking to face when they operate within certain regulations and jurisdictions.

ZBP

            Now you mentioned this at least a little bit already, but some states are starting to offer like a legal recognition or have a framework for DAOs.  Which states have adopted, for lack of a better term, DAO acts, and how do they work?

SS

            Sure, so there are four states right now that have adopted laws to protect DAOs, and I’ll discuss the regulations briefly.  So first Wyoming in July of 2021 passed a law that provides DAOs the ability to register as DAO LLCs.  The state provides it as a supplement that outlines the requirements that you need to be, to satisfy, to become a DAO and to be granted DAO LLC status.  There is no restriction as to who may form a DAO LLC, so the person who forms it may or may not be a member of the organization as long as they maintain a registered agent and abide by the already established laws within the state of Wyoming pertaining to those registered agents, but the Wyoming law provides DAOs with many of the same protections it provided to a traditional LLC.  For example, the law allows DAOs to set up individual quorum requirements similar to those exhibited in LLCs.  A unique aspect of the Wyoming law is that sets a maximum period for inactivity for a DAO, so for example, if a DAO is inactive for an entire year, it’ll automatically be dissolved.  Another state that’s taken on a framework to protect DAOs is Tennessee.  So Tennessee has enacted its own DAO-specific framework also.  The Tennessee bill actually removes “autonomous” from DAO and it just pertains the rules to decentralized organization, so it’s very similar to Wyoming’s as it pertains to registration processes, amending smart contracts and dissolution periods, but there are two differences between those two states’ approaches.  The quorum requirement of 50% to be valid in Wyoming is unlike the one in Tennessee, and Tennessee’s law requires organizations to be member-managed and smart-managed and to basically make the distinction between the two, but it’s a little difficult to do this because DAOs are rarely entirely member-managed or exclusively smart contract-managed, but there are adaptations to this law and there are regulations that have made distinction of that.  Vermont is the third state that has acknowledged some sort of protection to DAOs.  Although this state does not have DAO-tailored rules, it does offer DAOs the option to register as a blockchain-based limited liability company so that’s short for “BBLLC.”  So the legislation applies to any company that uses blockchain technology for a major portion of its commercial business activities, so DAOs operate on the blockchain like we discussed and the pertinent legislation fall under the definition of a BBLLC, and in order to register as a BBLLC, a company needs to disclose its operating agreement that includes information about the mission of the BBLLC, the information on the blockchain with which the BBLLC interacts and also other information like voting procedures and safety regulations.  So and the last state that we have, the fourth one, is Utah.  So it’s a little different.  Although Wyoming, Tennessee and Vermont have enacted their own legislation to enable DAOs to be formed as limited liability companies, Utah has a different, a little bit of a different approach.  The state of Utah is the first to classify DAOs as a distinct legal entity, so they’re called “limited liability decentralized autonomous organizations," short for "LLD."  So an LLD is defined as an organization that exists as a set of rules embedded on a blockchain in one or more smart contracts.  That definition goes in, exactly in line with what we discussed earlier about how a DAO is defined, but LLDs can vary in the class of members but must be formed by at least one natural person.  The Utah DAO act requires each LLD to provide evidence that its software code is undergoing the appropriate quality assurance and that it has user interface that allows all of the LLD smart contracts to be monitored, so you can see this strict sense of security that Utah already places on DAOs.  One of the major hurdles that DAOs’ members face is, involves the lack of protection in terms of personal liability.  So members of an LLD are only liable for their on-chain contributions which means that the members are not personally liable for the actions of other members, so that’s the key deterrent factor that a lot of DAOs have been facing, and Utah is really providing this protection for them.  So that that means is they’re not personally liable for any of the LLD’s obligations that exceed its assets, so the Utah DAO act is constructed very much like Wyoming’s and Tennessee’s law, but the decision to classify DAOs as distinct legal entities aids in Utah’s goal because what they’re trying to achieve is becoming the Delaware of web businesses, including DAOs.  So lawmakers in the state believe that the state can also attract DAOs from all over the world including overseas markets and different continents, and most DAOs operate outside of the United States due to these regulatory uncertainties, and this is a massive step forward regarding a safe haven, really, for DAOs to be established here, and it’s a glimmer of hope considering the anti-crypto sentiment that we see pushed by the federal government as of late.

ZBP

            So for the rest of the states that don’t have acts that address DAOs, how do we provide legal rights to them without those type of legislative acts being adopted?

SS

            It’s in a state of limbo for a lot of the DAOs because we touched on it briefly earlier, but the legal status of these entities is important for a number of reasons.  For one, without legal recognition, investors of a DAO are not protected under limited liability laws.  The risk of personal legal liability may deter potential members from investing in, participating or even creating these DAOs.  So in the United States, we have witnessed recent proceedings that we discussed and DAOs are likely to be viewed as general partnerships and therefore will be subject to personal liability in the event of insolvency or a situation of tort liability, and generally courts in the state whose partnership laws are modeled under the UPA, the Uniform Partnership Act, will find that a partnership exists where a person has placed their money into a business and share in the profits and losses.  So when we apply these general rules of construction of a general partnership, the DAO and other decentralized organizations are likely general partnerships in the United States, and when we determine a DAO as a general partnership, we consider these three factors - whether the co-owners share property ownership, if the co-owners share in gross returns and if there is a presumption that a person who shares in the profits is a partner in the enterprise.  So based on these elements, a court may find that a DAO creates a general partnership for its investors, but even if a court doesn’t find that a partnership exists, it most likely will find that it could be classified as a joint venture, and they’ve also faced the same legal liability issues.  So we have, unlike general partnerships, joint ventures are usually formed for a limited purpose, but unlike the almost uniform adoption among the states of the UPA, not all states distinguish between a joint venture and a partnership, so many states have a different definition of joint venture and joint partnership but treat them almost identical under the law, so we will see those situations where not only are they being defined as general partnerships but also as joint ventures according to the circumstances of each DAO.

ZBP

            Now again, I know that these organizations in the grand scheme of things are relatively new.  If you’ve got a crystal ball, what would you predict the future holds for DAOs?

SS

            It’s, it’s a very unique place in the world of DAOs.  Many DAO enthusiasts believe there will be a hybrid economy where DAOs and traditional corporations co-exist, so the idea is that organizations will operate together and then DAOs will over time gain an incremental market share and really position themselves, but they have to achieve this through the use of DAO-facilitating technologies.  So in the interim, until we have more states adopt these acts, until there’s federal legislation that provides protection to DAOs, the majority of DAOs will need to comply with the existing legal structures.  There’s no running around that.  To not comply runs the risk of both being stamped out by incumbent institutions and deterring engagement from mainstream market participants like institutional investors, and to overcome these issues, many startup organizations have adopted a hybrid approach by conforming to recognizable legal statuses but publicly announcing their intentions to shift to a DAO over time.  So the benefits provided by legal compliance are that DAOs are developing new ways to encourage this hybrid approach.  OpenLaw, a New York-based company, has developed several open-source libraries containing so-called legal wrappers for DAOs to incorporate into their code, so OpenLaw has created limited liability wrappers which extend the corporate veil over DAO business activities and encourage member involvement by those who would otherwise be deterred due to the issues with legal indeterminacy.  But development of these _______  _______ will help the proliferation of DAOs in the short term.  The long term is still somewhat unique as we have an exact idea of what will happen, but the states adopting these acts is a huge step forward and Utah’s approach really sets the precedent for other states to follow suit, and despite the current uncertainties and limitations surrounding DAOs, it is evident that the concept and technologies have a promising future.  The tools and solutions must be improved to increase usability like we discussed, and they’ll drive a shift towards a more digital, decentralized workspace, but the sense that we can see this achieved still remains to be seen, but the potential is amazing for DAOs to transform the way we work and it’s truly undeniable, Zach.

ZBP

            That’s great.  Sabhi, I really appreciate you taking the time to speak with us today.  I mean, this is a fascinating topic, and I look forward to seeing how this kind of continues to develop and play out in the future, so thank you for taking the time today to talk with us.

SS

            Thank you, Zach.  I’m glad to be a part of the podcast.