Making Sense of DAOs (1): An Introduction to DAOs and English Law - jmo

Preface

None of what follows is legal advice; though I have a law degree, I am not a lawyer, which means I am certainly not your lawyer.

Fair warning: what follows is riddled with technical terminology. Where possible, I have tried to elucidate said terms, not least to ensure my own understanding of them (which may well be deficient – I’m also no computer scientist, as will become apparent). However, in the interests of brevity, if you are a blockchain neophyte, it may be worth reading up on distributed ledger technology (DLT) , blockchain , public-key cryptography , Bitcoin , and Ethereum as a minimum. In addition to the links provided, I recommend delving into this canonical compilation on everything crypto from venture fund A16Z .

Introduction

For newcomers to the world of Web 3 and crypto, the term “decentralised autonomous organisation” (DAO) may be unfamiliar. DAOs are purportedly a novel organisational structure consisting of online communities who cooperate with a shared purpose of some kind, which often involves the pooling of resources, financial or otherwise.

In the ‘Making Sense of DAOs’ series, I intend to explore how different categories of DAOs map onto existing legal structures, hopefully shedding light on an entity that, due to the variety of forms it might take, may be confusing to the uninitiated. Certainly, my own motivation for writing this series was to improve my understanding as a wet-behind-the-ears lawyer-in-training. Plenty of others have written about DAOs, many of whom are more involved and knowledgeable, and some of whom are actually qualified lawyers, so I shall provide links to their articles where appropriate.

This first instalment of the series will provide background to DAOs, the catalytic technologies that facilitate them, and existing organisational legal structures under English law.

What is a decentralised autonomous organisation (DAO)?

A decentralised autonomous organisation (DAO) consists of an online community with a collective purpose, which, in theory, operates and is governed according to rules delineated in smart contracts: a program that runs on the Ethereum blockchain. Smart contracts are collections of code (the contract’s functions) and data (the contract’s state) that are stored, secured and operated by blockchain technology. A DAO member’s relationship to the DAO and other participants, as well as any shared property, is therefore governed, to some extent, autonomously via these smart contracts. There are thus two core technologies that have facilitated the creation of DAOs in their current form: blockchain (a decentralised distributed ledger, or DLT) and smart contracts.

Blockchain

In Blockchain Revolution (which I highly recommend), Alex and Don Tapscott explain that blockchain is a digital ledger that records transactional data between a shared network of participants. This peer-to-peer network validates and confirms each transaction, ensuring no participant double-spends their resources; it is thus decentralised. The network is run via software installed on computers around the globe; it is thus distributed. Anyone can view the ledger of transactions at any time (on public blockchains like Bitcoin); it is thus public. Finally, transactions are secured via public and private key encryption making the network encrypted and secure . Participants in the network are therefore able to transact without relying on centralised intermediaries such as banks.

Smart Contracts

Smart contracts are computer programs stored on a blockchain (or another form of DLT) that run when predetermined conditions are met . Because they exist on the blockchain, smart contracts are tamper-resistant and transparent – anyone can examine the code, and they benefit from the same robust security as the blockchain itself. Programmable blockchains are computers; it is possible to write Turing-complete (a system that can [almost] solve any computation problem) code, store information, and other activities that require computation. The Ethereum network is one such blockchain, and the smart contracts of many DAOs exist on that network .

Existing DAOs make use of both technologies as well as other innovative software solutions that integrate with DLTs to facilitate governance (e.g., Snapshot), communication (e.g., Discord ), or templates for creating smart contracts (e.g., Colony).

Unpacking DAOs

Many others in the space have offered their own definitions of DAOs, which are worth considering in conjunction with my own:

“An entity that lives on the internet and exists autonomously, but also heavily relies on hiring individuals to perform certain tasks that the automaton itself cannot do.” (Vitalik Buterin)

“Smart contracts with their own tokens and governance that own assets and take actions. Endless potential, but 👀for the SEC" (Punk 6529)

“DAOs aren’t companies. They’re networks. Networks are more valuable than companies” (Aaron Wright)

“A decentralised autonomous organization (DAO) is a group organized around a mission that coordinates through a shared set of rules enforced on the blockchain” (Linda Xie)

“DAOs are internet communities with a shared cap table and bank account” (Cooper Turley)

The definitions offered by Vitalik Buterin (co-founder of the Ethereum network and renowned big-brain) and Punk 6529 (a pseudonymous participant who goes by the name of their Cryptopunk NFT) suggest that DAOs are the protocol itself (the smart contracts). Whereas Linda Xie and Cooper Turley emphasise the humanity of DAOs, and Aaron Wright sees them as networks. It is thus worth further unpacking the term “decentralised autonomous organisation” to see why this definitional disparity exists.

Organisation

A DAO consists, in part, of a group of individuals with a shared purpose. DAOs often collectively own property of some kind. For example, many DAOs have treasuries (an account on the Ethereum network, for example) consisting of pooled digital assets, which exist on the blockchain. The relationship between members of the DAO and access to DAO property (the pooled assets) is governed by a predefined system of rules, encoded in smart contracts.

Autonomous

A DAO is autonomous insofar as its system of rules, encoded in smart contracts, execute automatically when certain conditions are met. However, the autonomy of many DAOs is debatable. In a 2014 article on the topic, Vitalik Buterin drew a distinction between DAOs and DOs, or decentralised organisations . A DO is an entity in which humans make decisions, whereas a DAO, to some extent, makes decisions for itself. According to this relatively strict taxonomy, the extent of automation determines whether an entity may be classed as a DO or a DAO. Depending on the function of the organisation and the role of smart contracts in it, it may be more or less automated: i.e., humans may be more or less involved in its operation.

However, once its smart contracts have been deployed, a DAO is not necessarily devoid of human input. For example, in many DAOs, members vote on how DAO resources should be allocated. In the more autonomous DAOs, a vote in favour of allocating resources in a particular way would trigger the execution of the relevant transaction as per the logic of the underlying smart contracts. In other words, once the DAO collectively makes its decision, no human would be required to enact it. Subsequent articles in the “Making Sense of DAOs” series will demonstrate that many purported DAOs might be considered DOs under this definitional framework, i.e., they may not be as autonomous as they purport to be.

For this reason, Vitalik Buterin characterised DAOs as automated at the centre and human at the edges: humans collectively make decisions, and the smart contracts execute. Contrast this with a traditional company where shareholders (the owners) vote for a particular thing to happen. It is then up to the company’s directors, or their delegates, to enact the will of the shareholders. In this situation, the organisation is human at the edges and human at the centre.

Figure 1. DAO Quadrants by Vitalik Buterin

Decentralised

Finally, a DAO is decentralised. Instead of a central governing body of individuals making decisions and enforcing organisational rules that are predicated on the legal system, in DAOs, decisions are made democratically, and rules are enforced via smart contracts and the resulting change in state is recorded on the blockchain. For example, in a company, the company’s Board (comprised of its directors) and the legal system are the relevant centralised entities whose role is to oversee and enforce company rules and governance. Moreover, the company’s treasury will usually be a bank account, managed by the bank (another centralised entity) and subject to relevant transaction fees.

In a DAO, there are no such centralised bodies: members democratically make decisions, smart contracts enforce the rules of the DAO, and funds are pooled using a distributed ledger (e.g., Ethereum). No individual DAO member can alter said rules without consent, and in some DAOs, it may be impossible to alter the protocol once the smart contracts have been deployed.

DAO Governance

In theory, DAOs are governed according to the rules of the underlying smart contracts. In practice, there may be reliance on more conventional modes of governance: for example, where smaller groups of custodians make key decisions about the DAO (i.e., traditional corporate governance); it is arguable whether such an entity could be called a DAO. There is thus not a one-size-fits-all model of DAO governance. Nevertheless, many DAOs use voting to enable DAO members to steer the future direction of a DAO.

In some DAOs, a prerequisite for joining may be to exchange funds (digital assets such as Ether [ETH] – the native cryptocurrency of the Ethereum blockchain) for tokens that represent fractional ownership and/or membership of the DAO. Such tokens may entitle holders to a proportional share of the DAO treasury – a pool of digital assets – as well as the right to vote on the future direction of the DAO. What voting weight any individual participant enjoys, and what constitutes quorum, will be determined by the rules of the DAO, and enforced via its smart contracts.

The Ethereum network, for example, is not constrained by geography, and thus nor are the digital assets that exist on it. Though converting fiat (government-issued) currencies to cryptocurrencies often requires interfacing with a centralised regulated body like Coinbase (a cryptocurrency exchange), once on the network, the assets are held in anonymous accounts (or, increasingly, pseudonymous where, for example, an account is associated with an Ethereum Name Service domain – for example, jamoo.eth). Thus, many participants in DAOs use pseudonyms and, in theory, could be based anywhere in the world with an internet connection.

Many commentators have discussed DAO governance at length, and for a more thorough discussion of the topic and the specific mechanics, see the recommended reading at the end of this article.

What is the legal status of DAOs in England (& Wales)?

At present, under English law, there exists no specific legislation or case law that explicitly references DAOs. Therefore, the legal status of any given DAO will be determined with reference to existing rules and principles. Moreover, a DAO’s purpose will affect its legal status. For example, it is likely that a not-for-profit DAO will be classed as a different entity than one which seeks to turn a profit. Many existing DAOs have a strong member base in the US, so their concern is compliance with US law, as will be explored in future articles in the “Making Sense of DAOs” series.

Partnership

Under existing English law, where persons carry on a business in common with a view to profit, and where said persons have agreed to work together to this end, it may be classed as a partnership, as per section 1(1) of the Partnership Act 1980 (PA 1890). In such a partnership, there must be a minimum of two partners (there is no maximum). Unless it is stated otherwise in a written agreement regarding the sharing of profit and loss, partners have unlimited personal liability; the partnership and partners are one and the same. If the partnership incurs debts, the partners are jointly and severally liable to meet these debts (s9 PA 1890).

No formalities are required to form a partnership; simply two or more people working together with a view to profit will suffice. When determining the existence of a partnership the following factors are considered: the extent to which profits and losses are shared; whether a loan has been made from one party to another; and whether any property is held jointly (s2 PA 1890). None of these factors alone would be sufficient to determine the existence of a partnership; in each case, all facts will be considered. Even so, an agreement to share losses as well as profits makes the existence of a partnership more likely (Northern Sales (1963) Ltd v Ministry of National Revenue (1973)).

Thus, any DAO that forms with the intention of making a profit may be a partnership, so long as a minimum of two DAO members exist; such a partnership can form without formalities, and unintentionally. Usually, the rights and obligations of partners will be determined by a partnership agreement, and where one does not exist, the partnership will be governed by the default provisions of the Partnership Act 1890. For example, section 24(1) of the Partnership Act 1890 provides that partners are entitled to share equally in the profits of the business but must also share equally in the losses; this is true even where the initial contributions were unequal .

If a court viewed a DAO as a partnership, it would have potentially deleterious implications for DAO members: a partnership is not a separate legal entity, so the liability of partners is unlimited, i.e., investors could lose more than their initial investment – including their personal assets. For example, where the partnership becomes insolvent and has outstanding debts. Furthermore, even where a partner retires from the firm (leaves the DAO), they remain liable for any partnership debts or obligations incurred before retirement (s17(2) PA 1890).

However, the existence of smart contracts may constitute a partnership agreement of sorts, which can be either express or inferred from a course of dealing . For example, code-based smart contracts could help a court to infer the existence of an agreement between partners. However, they would most likely be considered in conjunction with factors extrinsic to the code such as, for example, any agreements written in natural language on the DAO’s website or internal communications.

Limited Partnership

The second article in the “Making Sense of Crypto” series will explore investment DAOs in which members’ funds are pooled and invested by the DAO (The LAO, Seed Club). It is therefore worth considering how other UK-based private equity (PE) and venture capital (VC) funds are structured.

A useful analogy for thinking about fund structures is Russian dolls: the fund itself may be a limited partnership, but the entities investing in it (LPs), those operating and managing it (GPs and fund managers), as well as the companies it invests in can be limited liability companies, limited liability partnerships, limited partnerships, or other specialised legal structures; the aim is to limit liability as much as possible. UK limited partnerships (both English and Scottish) are commonly used as fund structures for PE and VC funds. Indeed, on 6th April 2017, a new sub-category of limited partnership was created for this purpose: the private fund limited partnership (PFLP).

One advantage of a limited partnership (or a PFLP) is that partners are divided into two groups: general partners (GP) and limited partners (LP) – there must be at least one of each (s4(2) Limited Partnerships Act [LPA] 1907). GPs manage and run the partnership but have unlimited liability. The GP itself, therefore, is often a limited liability company, which limits liability to that company’s assets, as opposed to the personal assets of those operating it . LPs are the investors in the fund, and they contribute capital which is pooled and invested in portfolio companies (PC), often via special purpose vehicles (SPV), which are subsidiary companies formed as a means of isolating financial risk to the SPV’s assets as opposed to those of the parent company.

The GP can, and often does, delegate its power and authority to a fund manager, regulated by the Financial Conduct Authority (FCA). The fund manager, too, is often a limited liability partnership (which is different from a limited partnership) in which the partners are the PE or VC executives, and they earn a management fee. Moreover, because the PE/VC executives stand to profit via from the fund by way of carried interest (a percentage cut of any profits), having them manage the fund management LPP means they are incentivised to ensure the fund performs well. In a limited liability partnership (LLP) (in contrast to a limited partnership), all partners have limited liability, and the LLP has a separate legal personality (Limited Liability Partnerships Act 2000).

These layers of legal structures can be difficult to conceive of, so to assist, the following diagram depicts an example of how a traditional VC/PE fund might be structured.

Figure 2. Example PE/VC fund structure

The liability of LPs in the PE/VC fund (the limited partnership) is limited to the amount they contributed – this is probably what most investors in a DAO would hope the extent of their liability would be.

However, limited partnerships must be registered at Companies House (s5 LPA 1907). Thus, any DAO would not be considered a limited partnership unless the relevant formalities had been undertaken. It is unlikely that many, if any, DAOs at present have registered as limited partnerships, not least because the names of the general and limited partners must be disclosed upon registration (s8A(2)(b) and (c) LPA 1907) – a difficult feat in DAOs with pseudonymous members. Moreover, many existing DAOs appear to be more US-centric in their efforts to be legally compliant. For DAOs that are joined informally via the exchange of digital assets for governance tokens, meeting statutory registration requirements is unlikely to be feasible.

Typically, a UK limited partnership will be considered a collective investment scheme (CIS) for the purposes of the Financial Services and Markets Act 2000: any arrangement in which the capital of participants and any resultant income of profits are pooled, and where the scheme’s property is managed by an operator. Any CIS that is not authorised or recognised by the Financial Conduct Authority (FCA) is therefore considered to be unregulated collective investment scheme (UCIS). The FCA does not regulate such schemes, so they often invest in riskier assets or use riskier investment strategies that regulated schemes. However, the FCA does regulate the promotion of such schemes in the UK: they cannot be promoted to the public but can be promoted to certified high net worth investors, certified sophisticated investors, and self-certified sophisticated investors.

Therefore, even if a DAO registered as a limited partnership, it would likely be considered a UCIS and would thus be subject to restrictions concerning to whom it could advertise for investment, i.e., not the public. It is likely that many DAOs do not limit their promotional activities to the FCA-approved groups of investors, not least because some investors will join via a pseudonym. In addition, the operator of a UCIS must be authorised by the FCA for its activities to be legal. Any DAOs wishing to register as limited partnerships in the UK would therefore need to appoint an FCA approved operator to be compliant.

Private Limited Company

One of the key advantages of a private limited company is that it has a separate legal personality (s74 Insolvency Act 1986): it can own property (Macaura v Northern Assurance Co [1925]), enter contracts (Lee v Lee’s Air Farming Ltd [1961], and can sue and be sued in its own name (Adams v Cape Industries plc [1990]). Any profits and losses belong to the company and not shareholders (s16 Companies Act [CA] 2006) – it is the company that bears liability for debts and not its shareholders, who therefore benefit from limited liability. The shareholders are the company’s owners who invest money in return for shares and sometimes dividends (a share of a company’s post-tax profits).

Such companies are run by company directors: officers or managers of the company who are closely involved with its day-to-day functioning; they are collectively known as the Board. The shareholders (owners) are not involved in everyday operational matters, but they usually have voting rights and control over key decisions, such as the removal of a director (s168 CA 2006). Private limited companies are thus attractive to investors as their liability is limited, and while they need not concern themselves with the day-to-day running of the company, they often retain the right to participate in key decisions.

However, a private limited company must register with Companies House and file public accounts. Moreover, the Companies Act 2006 stipulates a series of requirements concerning how a company should be run, including a list of the filings and other disclosures that must be submitted. As with limited partnerships, any DAO that wishes to operate as a private limited company would need to complete the relevant formalities to create a valid legal entity (s9 CA 2006). Furthermore, the identities of any directors and shareholders must be disclosed, which may be a problem in DAOs where members are pseudonymous and located in different jurisdictions.

Unincorporated Organisation

One way to characterise some DAOs would be as an organisation of two or more persons, where the membership may change from time to time, and in which the members agree, usually via some written constitution, to cooperate to further a common purpose. Incidentally, this is also a description of an unincorporated organisation. However, such an organisation is not a legal entity, and its members do not have limited liability. A club is an example of an unincorporated organisation. No registration is required of such an organisation, and evidence of the existence of one would usually consist of an agreed set of rules for the management and operation of the joint activity. The existence of smart contracts and any associated set of rules written in natural language may constitute such a set of rules.

In 2019, the UK Jurisdiction Taskforce, chaired by Master of the Rolls (President of the Civil Division of the Court of Appeal of England and Wales and Head of Civil Justice) Sir Geoffrey Vos, published a legal statement on cryptoassets and smart contracts . The statement addresses DAOs, questioning whether it is possible to contract with a DAO. UKJT’s analysis was that a DAO could be seen as an unincorporated association as it has no legal status, but its members, due to their membership, are bound by the rules of the association. Each member of the association contracts with the membership, and thus their agreement and intention to be bound by any contract with the association may be evidenced by their joining of it with an awareness of the rules. As the UKJT put it, a “party who transacts with a DAO can be taken to have agreed to and abide by and be legally bound by its terms”.

However, crucially, where an organisation formed of two or more persons is formed for the purpose of generating a profit, a partnership will be established, and partnership law will apply (s1(1) PA 1890).

How do these legal structures map onto existing DAOs?

Existing DAOs are enormously varied in their constitution. However, in a briefing on DAOs in The Generalist, the team usefully subdivided DAOs into rough categories:

Protocol DAOs, collectives centred around building and maintaining a protocol (e.g., Sushiswap or Uniswap);
Social DAOs where the focus is community building (e.g., Friends with Benefits [FWB]);
Investment DAOs whose goal is to pool and invest capital with democratic decision-making (e.g., The LAO and Seed Club);
Grants DAOs that deploy capital in the form of grants to advance a particular aspect of the web3 ecosystem (e.g., Unswap Grants and Compound);
Media DAOs that produce public content (e.g., Bankless and Darkstar);
Creator DAOs that form around an individual, where fans become stakeholders;
Collector DAOs, which are committed to amassing collections, often of crypto-native non-fungible tokens or NFTs (for example, PleasrDAO and SquiggleDAO).

These DAOs have been formed for different purposes and are structured accordingly. For this reason, each subsequent instalment of “Making Sense of DAOs” will focus on one category of DAO, using case studies to assess which existing legal entities might apply to each. I hasten to add that none of these DAOs purports to be an organisation domiciled in the UK, so viewing them through the lens of English law is largely academic. Nevertheless, I hope such analyses will prove of interest to someone, somewhere – even if that someone turns out to be me.

Next instalment of ‘Making Sense of DAOs’: Investment DAOs

Preface

Introduction

What is a decentralised autonomous organisation (DAO)?

Blockchain

Smart Contracts

Unpacking DAOs

Organisation

Autonomous

Decentralised

DAO Governance

What is the legal status of DAOs in England (& Wales)?

Partnership

Limited Partnership

Private Limited Company

Unincorporated Organisation

How do these legal structures map onto existing DAOs?

Recommended Reading

DAO Overviews

DAO Governance