Introduction
Decentralized Autonomous Organizations (DAOs) are organizations that are governed by a set of rules which are embedded into computer programs. The main characteristics of DAOs are that: (i) they can allow all their members to vote for or against every proposed management decision (thus, DAOs are democratic and not hierarchical); (ii) the decisions made by DAOs can be automatically implemented without the need for an intermediary; and (iii) all rules governing the DAOs are publicly available and can be inspected by the general public.
The fundament of a DAO is its smart contract, i.e., a contract governed by programming code. Smart contracts can be automatically enforced through software solutions. For example, if a smart contract states that Party A shall pay one Bitcoin held in an escrow to Party B upon the occurrence of a certain event, once the event occurs, the smart code will automatically send the Bitcoin to Party B. In comparison, most regular written legal contracts are not automatically enforceable which means that a party to such a contract may or may not comply with its payment obligations. In case of non-compliance, the non-breaching party will need to rely on courts and debt collection agencies to enforce the contract. Hence, smart contracts ensure more legal certainty than regular written contracts.
To illustrate how a DAO works in practice, we will briefly discuss three DAOs, namely, (i) a charity DAO, (ii) a service marketplace DAO, and (iii) a venture fund DAO. A charity DAO can receive donations (e.g., in cryptocurrencies) from donors located all over the world. Afterwards, the members of the DAO will jointly decide on how the donations will be spent. Once the decision is taken, the funds will be automatically transferred to the accounts of the beneficiaries.
A service marketplace DAO will allow a group of service providers (e.g., freelancers) to add cryptofunds in the crypto wallet of the DAO and make joint decisions on how to spend the common funds. For example, they can spend the common funds on purchasing software or hosting services that will be used by all participating service providers.
Investors can use a venture fund DAO to transfer their investments in a single cryptocurrency wallet and jointly make decisions on how the investments will be spent. Profits generated by the investments can be distributed by the DAO in accordance with the rules adopted by the members of the DAO.
In this article, we will discuss in detail various legal aspects of DAOs. More specifically, we will provide an overview of the two main types of DAOs (Section 2). Afterwards, we will discuss the management of DAOs (Section 3) as well as the liability of its members (Section 4). Next, the taxation of DAOs is examined in more detail (Section 5). We also provide a list of five DAO-friendly jurisdictions (Section 6). At the end of this article, a conclusion is drawn (Section 7).
Types of DAOs
DAOs can generally be divided into two groups, namely, a DAO linked to a legal entity (Section 2.1) and a DAO that is not linked to a legal entity (Section 2.2).
2.1 A DAO linked to a legal entity
If a DAO is linked to a legal entity (e.g., a limited liability company), it will have an official legal status and will have the capacity to sign contracts with third parties. Besides, such a DAO will benefit from the limited liability protection of the entity to which it is linked.
Some jurisdictions started adopting legislation allowing members of DAOs to create special limited liability companies and link their DAOs to those companies. For example, the U.S. State of Wyoming has recently enacted a law permitting DAO members to organize their DAOs under a Wyoming limited liability company. In Section 6.1, we discuss the DAO-related Wyoming laws in more detail.
2.2 A DAO that is not linked to a legal entity
Most jurisdictions regard DAOs that are not linked to legal entities as general partnerships. The term “general partnership” can be broadly defined as a legal structure allowing two or more persons to jointly own and manage a business. General partnerships are usually not considered to be separate legal entities and, therefore, the partners are jointly and severally liable for the obligations of the partnerships. That is why the use of DAOs that are not linked to legal entities poses significant risks to their members. Members of such DAOs may be fully liable for the debts of their DAOs even if they own only a small fraction of the total membership interest.
Another major disadvantage of DAOs that are not linked to legal entities is that there is no legal clarity as to what laws apply to them. Since they do not have a corporate registration or headquarters, the traditional legal methods used for defining the applicable laws do not work. To identify the applicable laws, one may need to engage in a complex conflict of laws analysis examining the legal provisions of hundreds of jurisdictions (if the members are based all over the world as it is often the case with DAOs). This is often a huge and virtually impossible task.
3. The management of DAOs
In contrast with traditional companies, DAOs can be fully managed by a large number of its members. There is no need for directors, Chief Executive Officers (CEOs), Chief Financial Officers (CFOs), and other similar management positions. The day-to-day management tasks can be completely assigned to the members of the DAO concerned. The decision making processes conducted by DAO members may have at least three advantages in comparison with the decision-making processes of traditional companies.
First, the decisions made by DAOs may reflect the diverse interests of a large number of DAO members. In comparison, corporate boards of directors are often criticized for having a low number of (i) representatives of different ages, (ii) representatives of color, (iii) LGBTQ representatives, and (iv) female representatives. The lack of diverse representation prevents corporate directors from getting valuable expertise and opinions.
Second, since DAO members may render decisions without the need to remunerate the decision-makers, the decisions rendered by DAOs can be more unbiased than corporate decisions. This is because company directors are usually remunerated based on the profit generated by their company. This means that they are incentivized to generate as much profit as possible in the shortest time possible. By doing this, they will focus on generating profits in the short term without caring much about the long-term goals of the company. As a result, corporate problems created and left behind by them, may, like time bombs, appear long after their directorships. It should also be noted that, in cases when the remuneration of directors is based on the profits of the company, directors may be incentivized to engage in fraudulent or illegal activities in order to generate quick corporate profits. The history of the business world is full of examples where directors were sentenced for years in prison. For example, prosecutors discovered that WorldCom (a large telecommunication company) manipulated its accounting records in such a way as to inflate its earnings by almost USD 4 billion. Its CEO was sentenced to 25 years for his involvement in the fraud.
Third, decision making processes composed by a large number of DAO members may be less likely to result in incompetent decisions than the decision making processes of a small group of people. For instance, the practice of nepotism is still widely spread in many jurisdictions. It refers to the appointment of family members to leadership positions not because of their skills, but because of their family relationships with the person in charge of the appointment. For example, if the shareholders of a regular company appoint a competent and skilled CEO, she may appoint her young and inexperienced children as low-level managers. In this way, she will entrust important management decisions to persons who were selected not because of their suitability for the positions concerned, but because of their family relationship with the CEO.
4. The liability of DAO members
The liability of DAO members depends on whether or not they are members of a DAO that is linked to a limited liability company. If a DAO is not linked to a limited liability company, the liability of its members will not be capped and debt collectors may seize and sell members’ assets and use the proceeds of the sale to satisfy the amount of the debts of the DAO. It should be clarified that members of DAOs that are not linked to limited liability companies may be liable not only for the payment obligations of the DAOs arising out of contracts and wrongdoings, but also for taxes levied on the activities of the DAOs.
A drawback of DAOs having unlimited liability is that their members are not incentivized to take risky business decisions as any business mistakes may lead to the seizure of their personal assets. This, in turn, may stifle the innovation potential of such DAOs. For example, let’s say that a DAO has assets valued at USD 30,000 and incurs liability amounting at USD 100,000. In this hypothetical situation, its members will be personally liable for the sum of USD 70,000. If the DAO members are jointly and severally liable as it is the case in many jurisdictions, each of them may be held liable for paying the sum of USD 70,000.
5. The taxation of DAOs
DAOs may be subject to taxes if they generate profits and divide them between their members. However, DAOs that are not linked to legal entities may have difficulties complying with the applicable tax laws. This is because, due to their decentralized nature, it is not clear who can file tax returns for such DAOs. It is also not clear whether they will be taxed as foreign companies if some of its members are based abroad.
DAOs that are linked to limited liability legal entities will normally be subject to tax in accordance with the laws applying to those entities. For example, DAO LLCs registered in Wyoming are usually regarded as pass-through entities which means that their members are responsible for paying income taxes. Foreign members of DAO LLCs registered in Wyoming may be subject to the standard 30% withholding tax on their U.S. source income. Since Wyoming is one of the few U.S. States without state taxes on personal and corporate income, the DAO LLC registered there is subject only to an annual state tax of USD 60 or 0,0002% of all assets located and employed in Wyoming (whichever is greater).
Persons who own tokens issued by DAOs may also be subject to capital gains tax on the capital gains generated from the sale of their tokens. The capital gains tax is usually calculated on the difference between the purchase price of the tokens and their sale price. Gas fees are also included in the purchase fees. The term “gas fee” refers to a fee charged by decentralized systems for conducting blockchain transactions.
6. Five DAO-friendly jurisdictions
In this section, we examine five jurisdictions that are suitable for the establishment of DAOs. Those jurisdictions are Wyoming (Section 6.1), Switzerland (Section 6.2), the Cayman Islands (Section 6.3), Hong Kong (Section 6.4), and Bulgaria (Section 6.5).
6.1 Wyoming
A: The DAO Supplement
The U.S. State of Wyoming became the first jurisdiction that adopted a law granting limited liability status to DAOs. The law entered into force on the 1st of July 2021 and is usually referred to as the Decentralized Autonomous Organization Supplement. It enables DAO members to organize DAOs in the form of a Wyoming limited liability company (LLC).
B: Types of DAOs
The law distinguishes between two types of DAOs, namely, (i) a member managed DAO and (ii) an algorithmically managed DAO. A DAO is regarded as member managed unless its Articles of Organization clearly state otherwise.
A member–managed DAO is managed similarly to traditional limited liability companies, i.e., a number of persons or entities listed in the corporate documents of the DAO are responsible for its management. Although the law does not specifically define the term “algorithmically managed”, it most likely refers to computer protocols residing on a blockchain and governing DAOs. To register an algorithmically managed DAO, its members need to include in the Articles of Organization a publicly available identifier of the smart contract(s) used to run the DAO. If there is an update or change to the smart contracts, the Articles of Organization need to be updated. The reason for requiring DAO members to identify the applicable smart contract(s) is that, in case of a conflict between the Articles and the smart contract(s), the smart contract(s) will prevail. Therefore, public disclosure of the smart contract(s) is required to ensure that the operation of the DAO is transparent.
It is worth mentioning that the law provides a definition of the term “smart contract”. In simple words, it defines the term as an automated transaction consisting of programming language that executes contractual teams and may transfer assets, take them in custody, or perform other instructions.
C: Requirements for registering a DAO
Each DAO registered as an LLC in Wyoming needs to comply with the following three requirements: (i) it must have a registered agent in Wyoming; (ii) its name must include “DAO”, “LAO” (i.e., Limited Autonomous Organization), or “DAO LLC”; (iii) the Articles of the Association of the DAO must clearly state that the LLC is a DAO registered in accordance with “W.S. 17-31-104”; and (iv) the Articles of the Organization must contain a specific clause specified in the law which states that the rights of members in a DAO may differ from the rights of its limited liability counterparts.
D: Dissolution of DAOs
If a DAO LLC registered in Wyoming fails to take any actions or to approve any proposals for a period of one year, it will be automatically dissolved.
E: Management of DAOs
A DAO LLC usually makes its management decisions on the basis of a vote of members holding more than 50% of the membership interests. Membership interests are calculated in one of the following two ways:
(i) by dividing the contribution of digital assets of the members to the DAO by the total amount of digital assets contributed to the DAO; or
(ii) if the members do not contribute digital assets, each member should own one membership interest and be entitled to one vote.
F: Fiduciary duties
In comparison with traditional Wyoming limited liability companies, members of DAOs do not have fiduciary duties of loyalty and care to the company and other members. They are subject to an implied contractual covenant of fair dealing and good faith.
6.2 Switzerland
Although Switzerland does not have a special legal entity dedicated to DAOs, the country has a legal framework enabling the creation and operation of Decentralized Autonomous Associations (DAAs). DAAs are nonprofit DAOs. According to the Swiss Civil Code, associations established for non-economic purposes acquire their legal personality immediately after the intention to establish them is expressed in a founding agreement. Associations that do not conduct commercial activities do not have to register in the Swiss commercial register. It is worth mentioning that associations having charitable and other public benefit purposes may be exempted from taxes if they meet certain conditions.
Swiss DAAs can have various organizational structures. Such structures often include (i) an assembly, (ii) delegates, and (iii) member community. The assembly is empowered to liquidate the DAA concerned and to change its statutes. The delegates are authorized to represent the DAA before third parties and to keep records pertaining to the operation of the DAA. The member community is the most important part of each DAA. It is responsible for making business decisions regarding the operation of the DAA. The decisions may, for example, relate to the allocation of financial resources to certain projects or to launching new projects. Members of DAAs usually have equal rights and the voting and counting process is performed and recorded on blockchain records.
People interested in founding a Swiss DAA need to agree on the text of its Articles of Association. The first section of the Articles must normally state the name of the DAA as well as its address and purpose. The next section needs to explain in detail the governance structure of the DAA, e.g., its governing bodies and their powers. An entire section needs to be devoted to the DAA members. It needs to specify the conditions that applicants for membership must meet to become members. It is desirable to include a section explaining how the DAA will be funded and how the DAA will spend its funds.
6.3 The Cayman Islands
A: The foundation company
In 2017, the Cayman Islands adopted its Foundation Companies Law. It introduced a new type of legal entity called a “foundation company”. It functions like a regular civil law foundation or a common-law trust while, at the same time, being a separate legal entity. This “hybrid” entity is perfectly suited for members of DAOs intending to give legal personality to their organizations.
B: Advantages of the foundation company
The foundation company is particularly attractive for DAO members because of the combination of the following features: (i) it offers a limited liability protection to its members; (ii) it can be structured without shareholders, thus ensuring that the principle of decentralization which is of utmost importance for most DAO members is well-implemented in the organizational structure.
Instead of shareholders, the foundation company can have supervisors who are not owners of the foundation. Their function is merely to ensure that the directors of the foundation company comply with their obligations in accordance with the governing documents of the foundation company. The supervisors are supposed to act in the interest of the foundation company and not in their own interest as they do not have any ownership shares in the foundation company.
C: Governance of foundation companies
Foundation companies in the Cayman Islands need to be governed by a memorandum and articles of association (the “constitutional documents”). Founders of foundation companies have a large discretion with regard to the organizational structure of their legal entities. This means that the organizational structure can reflect the structure of the DAO concerned. The only statutory requirement for a foundation company is to have at least one director and one secretary as well as at least one supervisor. The supervisors and the directors can be either natural or legal persons.
The constitutional documents of a foundation company can state that the director and the supervisors shall be selected by the majority votes of the DAO concerned.
D: Taxation of foundation companies
Members of DAOs are usually reluctant to link legal entities to DAOs because of concerns that this will lead to taxation of the DAOs. This should not be a concern for DAOs linked to foundation companies in the Cayman Islands. The reason is that the Cayman Islands is a no tax jurisdiction. The small Caribbean country does not charge any personal or corporate income tax, property taxes, capital gain taxes, withholding taxes, and payroll taxes. This adds legal certainty with regard to the taxation of DAOs linked to Cayman Islands foundation companies.
6.4 Hong Kong
A: A company limited by guarantee
DAO members willing to give a legal form to their organization may consider registering a company limited by guarantee in Hong Kong. Since this type of company does not have shareholders, it is well suited to the decentralized nature of DAOs. The controlling members of a company limited by guarantee are not allowed to share the profits of the company. This means that the profits must remain within the company. The liability of the members of a company limited by guarantee is limited to their contributions to the company. Although most such companies have charitable purposes, they may also conduct commercial activities.
B: Requirements for registration
A company limited by guarantee needs to have at least one member, two individual directors, and one company secretary. The members can be natural or legal persons. No nationality restrictions apply to the members. The secretary of the company needs to be a Hong Kong resident. The company must have a designated representative who also needs to be a Hong Kong resident. The registered address of the company must be in Hong Kong.
C: Use for DAO purposes
Since the profits of companies limited by guarantee cannot be distributed to its members, such companies are particularly suitable for nonprofit DAOs. By way of illustration, a not for profit DAO registered as a company limited by guarantee can collect donations from the general public and transfer the collected funds to charities selected by the DAO members. The rules prohibiting the DAO from distributing profits are particularly helpful in ensuring that the members will not act in their own interest, but in the interest of the cause promoted by the DAO.
D: Taxation
A company limited by guarantee having charitable purposes can benefit from tax exemptions in certain cases. It should be noted that Hong Kong applies the principle of territorial taxation which means that income generated outside of Hong Kong is generally not subject to tax. If a company limited by guarantee is structured in such a way as to generate profits from foreign sources, it may be able to avoid corporate taxation.
6.5 Bulgaria
Bulgaria does not have an entity specially dedicated to the creation of DAOs. However, it is particularly suitable for the creation of traditional limited liability companies which will act as DAO developing agencies. For example, (i) a foundation company in the Cayman Islands can be the official legal wrapper of a DAO and (ii) a Bulgarian company can act as a development agency that maintains the website associated with the DAO and can provide other services to the DAO. The Cayman Islands foundation company and the Bulgarian company will conclude a service agreement under which the Cayman Islands foundation company will pay A certain amount to the Bulgarian company in exchange for which the Bulgarian company will provide technical and organizational support to the foundation company.
The Bulgarian company will need to pay tax on the income generated from providing services to the Cayman Islands company. Fortunately, the corporate income tax in Bulgaria is just 10% which makes Bulgaria one of the countries with the lowest corporate tax in Europe. Bulgaria offers more than a low taxation, it offers an abundance of affordable IT specialists who will be glad to provide technical services supporting DAOs. In 2022, software developers in Bulgaria typically earned about BGN 3,030 per month (about EUR 1,500). In comparison, software developers having similar qualifications but based in the Silicon Valley around USD 12,500 (about EUR 11,000) per month.
It should be pointed out that Bulgaria has a good reputation in the blockchain field. Team members of the Bulgarian blockchain development company “LimeChain” became the founders of (the) EnterDAO, a marketplace on Ethereum that allows its users to rent land in metaverse games. For those who are not aware of the term “metaverse”, we can broadly define it as a virtual reality space allowing users to interact with each other in a computer-generated environment. EnterDAO succeeded to raise USD 1,800,000 to create infrastructure for metaverse gaming.
The Bulgarian company Comrade Cooperative develops a tool (wetonomy) that allows its users to create DAOs in accordance with their needs. The tool can be used to (i) create and distribute blockchain tokens, (ii) assign roles to token contributors, and (iii) distribute rewards to the DAO members.
- Conclusion
This article attempted to provide more understanding of the legal characteristics of DAOs. Such an understanding can be used to properly design DAO legal structures. A good DAO structure will not only protect the personal assets of the DAO members, but will also reduce the taxes applicable to the operations of the DAO. Although many DAO proponents believe that DAOs should never be linked to legal entities as such a link will undermine the fundamental ideas behind DAOs, the establishment of a DAO that is not covered by the “umbrella” of a legal entity is associated with a high degree of legal uncertainty and poses substantial liability risks to its members. That is why the registration of a Wyoming DAO LLC or a similar legal entity is strongly recommended. Such an entity will have mainly a protective function. Any services supporting the operation of the DAO may be provided by a second entity registered in a jurisdiction having low taxes and an affordable IT workforce.
