4 April 2023
April 2023 – 4 of 4 Insights
On 16 November 2022, the Law Commission (at the request of HM Treasury) published a call for evidence on decentralised autonomous organisations (DAOs) (as reported by us). We are awaiting the publication of the results of that call for evidence (which closed on 23 March 2023) and, at the end of the consultation process, advice from the Law Commission to the government on the legal status of DAOs and any changes which are required to English law.
Ahead of this, we consider what DAOs are, what they do, and how they are currently treated (or how we expect them to be treated) under existing law.
The Law Commission call for evidence forms part of a wider range of projects looking at emerging technologies. Previous consultations have focussed on various topics, including:
The Law Commission's work also sits in the broader context of the development of a regulatory framework for cryptoassets, which is the subject of a current HM Treasury consultation which does not currently specifically cover the regulation of decentralised finance (DeFi) (in which DAOs are likely to play a significant role). The consultation does note that there is ongoing "cross-governmental work on artificial intelligence and autonomous code" which will be relevant to DAOs and other actors in the DeFi space.
The Law Commission describes a DAO as a type of "technology-mediated social structure" or organisation of participants.
The Law Commission says that "decentralisation" may refer to a DAO's governance, as a DAO will typically be governed through its members interacting with smart contracts which are deployed on a public blockchain, and "voting" on the maintenance, modification or creation of smart contracts through which the DAO conducts its activities, rather than through a centralised source of governance. Alternatively (or in addition) decentralisation may also refer to a DAO's architecture: either the blockchain system on which the DAO is deployed, or the software protocol itself. Either way, there is no defined level of acceptable decentralisation which will hold true for all DAOs: governance and architecture may be conceptually decentralised whilst actual control and infrastructure is concentrated in a small or limited number of token holders, or miners and validators. What decentralisation looks like therefore changes from DAO to DAO and, for a particular DAO, from day to day.
In a similar way, there is no minimum level of autonomy which must be adopted for a DAO to be termed thus. DAOs cannot be completely operationally autonomous: there is a human aspect and according to the Law Commission the number/role of humans in a DAO will depend on the DAO's purpose and structure. For instance, a DAO will originate with a founder/developers. If a DAO adopts a legal structure (see below for discussion on this point) it will necessarily have human actors who are involved with the legal entity. A DAO might also engage third-party human actors to assist it in areas such as "legal advice, accounting, public relations and general administrative work".
Despite the challenges in defining what the term "DAO" refers to exactly, the Law Commission has proposed composite elements of DAOs to assist in defining them, and for framing the discussion around the relationships involved in a DAO, and legal implications arising from them, which are summarised below:
The Law Commission goes on to discuss interrelationships between participants (including but not limited to those specified above) and in particular the question of liability of certain participants such as developers, token holders, and the protocol itself (through any legal person involved in its development).
These questions around liability are becoming ever more important, with the growing interest of the public as well as increasing amounts of money that are being invested in cryptoasset-businesses around the world. Where DAOs lack a centralised governance structure, they also lack a central entity or person which is liable for the DAO's obligations and debts, and against which enforcement action may be taken. This has not prevented some regulators from taking action against DAOs. For example, in the US, the Commodity Futures Trading Commission (CFTC) has taken action against DAOs for activities within its regulatory purview, treating them as "unincorporated associations" (see below). An unincorporated association does not have a separate legal personality from its participants, meaning that it cannot hold property in its own name, nor can it limit the liability of its participants for debts and obligations of the association. The Law Commission's "initial thinking" is that, without a DAO taking any additional steps to structure in a particular way, a DAO might be characterised under English law as an unincorporated association, or general partnership. This is therefore the baseline position. If a DAO is characterised in this way (and the Law Commission does recognise that there are "important differences between DAOs that operate in the market today and this starting point") this could have severe consequences on participants who would not be afforded the protection of other structures where the organisation has separate legal personality.
As noted above, DAOs may be associated with DeFi software protocols which are deployed on blockchain systems and allow users to carry out transactions which function like finance transactions. This use case is unsurprisingly particularly referred to in HM Treasury's consultation on the regulatory framework for cryptoassets. However, the use cases for DAOs are broader than financial services, and the Law Commission has highlighted a selection of use cases including:
As noted above, the Law Commission's proposed starting point is that a DAO which is not designed with a particular structure in mind might be characterised under English law (as in the US) as an unincorporated association or general partnership.
General partnerships are governed by the Partnership Act 1890, and may arise where two or more persons (including bodies corporate) carrying on a business in common, with a view of profit. This type of partnership under English law arises from contract, although a partnership agreement may be expressed or inferred from the parties' conduct. Importantly, a general partnership has no legal personality distinct from its participants or partners. The partners are therefore liable for all obligations and debts that the partnership may have towards third parties, and have no rights or liabilities against the partnership itself. The partnership cannot enter into enter into contracts or own assets.
When it comes to DAOs, a general partnership could be formed if there is an express or inferred agreement between members to carry on a certain business in common (which can include any trade, occupation or profession). Some DAOs, where there is no profit motive (or the profit motive is ancillary to other motives), might not be able to be characterised as a general partnership. For other DAOs, for instance those that have investment activities as a focus, it might be argued that such DAOs constitute general partnership under English law (although other requirements, such as mutual agency of the partners, and joint participation in profits and losses, are perhaps unlikely to be present in most DAOs).
While there is no clear statutory definition of an “unincorporated association” the courts have provided a description in numerous cases. In the landmark case of “Conservative and Unionist Central Office v James Robert Samuel Burrell (HM Inspector of Taxes)”, Lord Justice Lawton described an unincorporated association as “two or more persons bound together for one or more common purposes, not being business purposes, by mutual undertakings each having mutual duties and obligations, in an organisation which has rules which identify in whom control of it and its funds rests and on what terms and which can be joined or left at will”. The Law Commission provides examples of unincorporated organisations varying from sports organisations, and local volunteer organisations to unincorporated charities.
The Law Commission summarises the characteristics of an unincorporated association as:
As for a general partnership, an unincorporated association cannot own assets, or enter into contracts with third parties. Liability under a contract entered into on behalf of an unincorporated association would attach to the members of the association at the time the contract was entered into who authorised the contract, who would be jointly and severally liable.
DAOs which do not have a profit motive, for example, DAOs that pursue some social goal or that are established for charitable purposes, might be more suitably characterised as unincorporated associations.
For a trust to arise, it is generally not necessary to set up the express trust arrangement by a trust deed, since a trust can also be created informally, including by an oral declaration in respect of property other than land. Nonetheless, for a particular arrangement to be effective as a trust it needs to satisfy the three certainties necessary to create a trust under English law: certainty of intention, subject matter and object (as defined in the landmark case Knight v Knight (1840) 49 ER 58). It is for this reason why the Law Commission concludes that in the majority of cases when it comes to DAOs, a trust arrangement will not arise unless the DAO is specifically structured to fit an English trust structure. Some trust structures available in some other common law jurisdictions such as special purpose trusts available in Cayman and Guernsey, may be more suitable for use by DAOs, and these are described below.
The Law Commission considers, in its call for evidence, centralising and decentralising elements (and corporate structures) which DAOs may seek to implement to modify the baseline characterisation as an unincorporated association or general partnership.
The key problem to be solved in structuring a DAO is likely to be how to structure so that (a) liability of the DAO's members and other players is sufficiently limited, and (b) the DAO can interact with third parties, whilst retaining the fundamental nature and purpose of the DAO.
Against this backdrop, the Law Commission asked responders to consider whether and to what extent the existing corporate and non-corporate structures available under English law are suitable for use by DAOs as part of their organisational structure.
For instance, an essential element of the limited company structure (whether a private or public company limited by shares or a private company limited by guarantee) is centralisation of the decision-making power in the hands of the governing body and the clear identification of the shareholders who are named in the register of members. The decentralised nature of a DAO, and the legal and practical implications of a company structure (such as reporting, audit, and allocation of duties and responsibilities) makes it rather unsuitable as a construct for a DAO. However, a limited company might form part of a DAO's organisational structure which contains both centralised and decentralised elements. For instance, a DAO might have an incorporated sub-DAO through which it engages third parties, holds assets (including intellectual property) and raises funds. Developers might also seek to limit their liability.
In such structure, the company (and more specifically, its board) would be responsible for day-to-day decision making and running of the business whereas DAO members would make key decisions such as decisions regarding profit sharing, and new investments. In this case, after passing the resolution within a DAO, members would give instruction to the company’s management body, that would then pass necessary resolution to give legal effect to the decision made by DAO members.
The Law Commission has asked stakeholders to comment on whether an additional corporate structuring option should be made available in England and Wales, which is designed specifically for DAOs (as has been constructed in some other jurisdictions, noted below).
The Law Commission noted that a number of other jurisdictions have either created DAO-specific structures or have made confirmations as to treatment of DAOs within existing structures:
The Cayman Islands, Panama and Switzerland all offer ownerless foundations which have separate legal personality and may be used by DAOs to hold tokens or intellectual property, and to contract with third parties to provide or receive services. These foundations can be implemented so that token holders can direct the actions of the foundation's directors without any ownership. Foundations may form part of a wider DAO structure in which (for example) a limited company is formed to provide software development services to the foundation.
The Law Commission also identifies that certain trust structures available in other jurisdictions may also be used by DAOs in structuring. In particular, special purpose trusts which are available in the Cayman Islands and Guernsey (but not recognised under the law of England and Wales allow a DAO’s founders or token holders to transfer assets into the special purpose trust whose trustees manage and deal with the assets in accordance with the specified purpose set out in the trust agreement. Unlike traditional trust structures, a special purpose trust does not have beneficiaries, and the trustee is required to manage assets in trust in accordance with the defined special purpose of the trust arrangement (which could be for example, to promote the use by network participants of the software protocol related to the DAO or wider ecosystem development).
The question of how to characterise a DAO has not been addressed by the courts in England and Wales. However, in the US there have been court and regulatory actions taken against DAOs in which those DAOs were characterised as unincorporated associations. The CFTC's actions against bZeroX, LLC (bZx) and its founders, and against Ooki DAO illustrate the requirement for founders to consider the structure of cryptoasset projects and DAOs at the beginning of the project.
Between 2019 and 2021, bZx designed, deployed and marketed a DeFi protocol (the bZx protocol) which resulted in (the CFTC said) unlawful transactions, through which bZx illegally operated as an unregistered future commission merchant in breach of the Commodity Exchange Act (CEA). In 2021 bZx transferred control of the bZx protocol to what eventually became known as Ooki DAO (with the bZx protocol being renamed the Ooki protocol).
The CFTC took action against bZx and its founders, reaching settlement in September 2022 under which the respondents were ordered to pay a $250,000 penalty, and to cease and desist any further violations of the CEA. On the same day that settlement was reached, the CFTC also filed civil enforcement action against Ooki DAO, charging it with violating the same laws as bZx. In its order, the CFTC found that Ooki DAO was an unincorporated association, under which the members (i.e. Ooki token holders) were liable for Ooki DAO's violations of the CEA and CFTC regulations.
Ooki DAO subsequently argued in a motion to dismiss that (inter alia) Ooki DAO could not be sued, as a technology rather than an entity or group of persons. There were also arguments around the service of the DAO (more on this below). However, in December 2022 the District Court ruled that the CFTC had sufficiently alleged that the Ooki DAO was an unincorporated association for the purposes of its motion as regards service (whilst not ruling on whether Ooki DAO is an association which can be held liable under the CEA).
One of Ooki DAO's arguments in its motion to dismiss was that it was not served properly. The CFTC had claimed service through posting a message on the Ooki DAO message board, as well as posting a message through the site's chat box. The court disagreed, noting that service by electronic means was not a novel concept. Ooki DAO had essentially made itself uncontactable by any other means: there was no discoverable address, and no email address available. In addition, the CFTC's posts generated a flurry of activity on the message board and other social media channels, supporting the notion that Ooki DAO had sufficient notice of the litigation.
Whilst there has been no action in the English courts against DAOs, there have been cases which are relevant.
In the UK (and in the US), novel service concepts have extended to airdrops: in D'Aloia v (1) Persons Unknown, (2) Binance Holdings Limited & Others service by an airdropped NFT was approved (in addition to email) by the High Court. Therefore it is likely that a DAO without any address information could be served in the UK.
Additionally, the long-running Tulip Trading proceedings are likely to provide clarity as to duties which developers owe to users of software protocols. Tulip Trading relates to a blockchain protocol (namely, the Bitcoin Blockchain) and the Court of Appeal recently ruled that there is an arguable case that the developers of the blockchain protocol owe fiduciary and/or tortious duties to users of the protocol. This is important: where there is no corporate structure, or where the development of the protocol is decentralised from a DAO's corporate structure, the duties which may be owed between participants will be based on private law (i.e. rights and obligations owed between the participants, rather than rights and obligations owed to the state). If developers are found to generally owe fiduciary duties to users this will be another element which will need to be considered when structuring DAOs. Legal clarity here will be a welcome change.
DAO tokens generally provide members of a DAO with certain rights that enable them to effectively participate in decision making processes within a DAO and/or participate in sharing of a profit generated by business activities that DAO as organisation engages in. As noted above, the rights and obligations of the token holders may be indicative of a DAO's status as an unincorporated association. That being said, it is also important to clarify whether DAO tokens themselves are specified investments under the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO), and therefore whether activities concerning the tokens might be regulated activities and whether an approved prospectus might be required (if there is an offer of shares which are transferable securities to the public in the UK).
Commonly, DAO tokens may provide token holders with governance rights and a right to participate in profit sharing. That being the case, the tokens might appear to function in a very similar way to shares. The definition of “shares” that fall under the scope of specified investments as defined under Part III of RAO covers both shares in a body corporate (regardless of its place of incorporation) or shares in any unincorporated body constituted under the law of a country or territory outside the United Kingdom.
Whilst it is unlikely that a DAO would be structured so that its tokens are shares in a body corporate, DAO tokens also cannot qualify as shares where a DAO is considered to constitute an English general partnership, since a general partnership does not have a separate legal personality to its partners, and thus is not considered as a body corporate.
However, DAO tokens could conceivably constitute shares in an unincorporated body constituted under the law of a country or territory outside the United Kingdom. If there is an offer of such shares to the public in the UK, the "issuer" or any other person which offers the shares would be required to make available an approved prospectus. However, there are practical challenges in enforcing this requirement, if the issuer is a DAO (as described above). In addition, any facilitation of trading in such instruments which takes place in or from the UK, or which is available to UK-based customers, could still potentially trigger an authorisation obligation for other specified activities under RAO, as well as an obligation to register with the Financial Conduct Authority for cryptoasset activities.
While lawmakers are still trying to find the way how to make existing laws sufficiently fit to accommodate this new type of organisations that exist in the digital ecosystem, DAOs and their members need to ensure that the structure they are using can function efficiently in today’s world, allowing the DAO to fulfil the purpose for which it is intended.
Against the backdrop of everything mentioned above, it is fair to conclude that there is a number of important considerations that need to be made in the process of structuring and setting up of a DAO that include, among other, the following:
Setting up a DAO that can function efficiently under existing laws and regulations in the majority of jurisdictions is everything but an easy task. Nonetheless, the bottom line is that it is always better to basically “take the bull by the horns” and structure your DAO by duly considering all potential legal and regulatory risks in advance rather than wait for a structure to be imposed by the courts.
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