Illegible Enterprises: The Problem of DAO Legal Structuring

This is the first in a series on legal entity structuring for DAOs. Part I redefines the fundamental problem facing DAOs and their counsel with respect to legal structuring, and Parts II and III outline two potential solutions, with additional Parts to follow as the law of DAOs evolves.

DISCLAIMER: As my ENS address clearly states, I am not your lawyer. Nothing herein should be construed as legal advice. The material published below is intended for informational, educational, and entertainment purposes only. Please seek the advice of counsel, and do not apply any of the generalized material below to your individual facts or circumstances without speaking to an attorney.

Let’s start at the very beginning:

What's a DAO?

Depending on who you ask, a decentralized autonomous organization is:

  1. “a group chat and a bank account” (Kei Kreutler, A Prehistory of DAOs)
  2. “a member controlled organizational structure that operates absent a centralized authority” (David Kerr and Miles Jennings, A Legal Framework for Decentralized Autonomous Organizations)
  3. “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, DAOs, DACs, DAs and More: An Incomplete Terminology Guide)
  4. “a ‘virtual’ organization embodied in computer code and executed on a distributed ledger or blockchain” (Securities and Exchange Commission, The DAO Report)
  5. "a set of smart contracts that encode the bylaws of the entire organization" (Laila Metjahic, Deconstructing the DAO)
  6. “a decentralized network of autonomous agents coordinating resources with cryptographic fidelity” (Tracheopteryx, DISRUPTORS: Why DAOs?)
  7. “a mechanism of governance enabled by smart contract execution of tokenized commands” (Dane Lund, DAO Governance Primer: The Initial State)
  8. “an organization represented by rules encoded as a computer program that is transparent, controlled by the organization members and not influenced by a central government” (Wikipedia)
  9. “an unincorporated association of persons (an organization) utilizing censorship-resistant technologies to permissionlessly (autonomously) engage in non-hierarchical, widely distributed (decentralized) governance of shared resources and goals” (Gabriel Shapiro, Defining Real and Fake DAOs)

…and on, and on.

Why is this so hard?

Because decentralized autonomous organizations are illegible, meaning they resist a particular type of definition: they cannot be easily categorized or labeled in a way that makes them easy to administer and control. Bureaucrats cannot do their job unless they make the subjects of their administration legible. They must reduce economic activity into “income” or “investment” so they can tax it, people into “citizen” or “alien” so they can distribute (or revoke) privileges, organizations into “corporation” or “partnership” so they can assign duties and responsibilities, and so on.

Illegibility is a problem for bureaucrats because they do not know what rules to apply. It must be particularly frustrating when the individual entities themselves are rather easy to define: DAO assets and membership are often transparently verifiable on public blockchains. But trying to define “DAO” as a category is like trying to define “scenes” or “movements” or “markets” with enough precision to meaningfully regulate them—we may be able to clearly define the “Punk rock scene” but how might we design regulations for “scenes” writ large that are not ambiguous or vague? Much easier to focus exclusively on legible actors (like Punk bars, fashion outlets, record labels, etc.) and legible conduct (like nuisance and obscenity laws).

What makes DAOs different from more legible enterprises, like corporations or partnerships? In reality, not much—all enterprises are groups of people voluntarily working together toward a common goal. Every group of people contains within it a unique bundle of contracts—actual and potential relationships, transactions, and disputes. Reducing all that to a legible order that can be managed is an incredibly expensive exercise. To estimate the cost, add up the budgets of every single bureaucracy tasked with regulating economic activity. It’s a big number.

Corporations, partnerships, and DAOs all share a basic structure; they’re each just a bundle of contracts, smart or not. All enterprises look more-or-less the same at the application layer. To see what makes DAOs different, we should look instead at the protocol layer, the coordination mechanism on which they run their affairs.

Before distributed ledgers, the best coordination mechanism available to enterprises was the legal-financial protocol provided by liberal, capitalist democracies. A (relatively) stable monetary system, (relatively) liberal property and contract rights regimes, and a (relatively) independent and impartial judiciary are the three critical elements of the protocol that brought unprecedented prosperity to America and its allies. Other protocols were tried, most notably the Second World protocol operated by the Soviet Union, but in time the smart money moved West for the promise of greater returns. (Even Communist China eventually started running its own hard-forked version of the Liberal Capitalist protocol so they could better integrate with the West.)

Both the Liberal Capitalist protocol and the Second World protocol are analog, pen-and-paper, human-executed protocols. We call those humans in charge of execution “bureaucrats” and they cannot do their job unless the activities of the protocol are made legible.

How do they do that? With the only two tools a bureaucrat knows: carrots and sticks.

Enterprises make themselves legible to the state by incorporating into a recognized legal entity, like an LLC, Foundation Company, Nonprofit Association, General Partnership, and so on. By incorporating, the enterprise agrees to follow every law that attaches to their respective entities, to conduct themselves consistent with applicable regulations, and to turn over any assets or information the state deems necessary upon request—and, if they have a problem with any of that, they can file a complaint with their local judge and be adjudicated according to the logic of the protocol.

With the incorporation documents signed, the ritual is complete and a new entity is born into legal personhood: the corporation. The state grants limited liability to the human persons in the enterprise as a reward for registering. When they act on behalf or under the direction of the corporation, it is the corporate person that is acting, not them, and therefore the corporation will be held responsible. Its assets, and not theirs, will be used to satisfy creditors.

Most DAOs today are unable or unwilling to go through this ritual, because legibility is in an inherent tension with principles of decentralization and autonomy. DAOs exist because free people prefer organizations that are more democratic, less hierarchical, more egalitarian, less coercive, and thereby more illegible. DAOs that become legal persons must accept a centralized authority—the state—as their ultimate arbiter if they choose to run on the legacy protocol, thereby sacrificing decentralization and autonomy.

Legal personhood plus limited liability, or decentralization plus autonomy. You cannot have both.

Faced with this trade-off, most enterprises understandably choose the latter—but by doing so, they put their members at risk. This is no longer a hypothetical concern: in May 2022, a lawsuit was filed in California naming a DAO as a defendant, together with several core contributors and investors in their personal capacity:

"The [DeFi protocol] purports to be a so-called DAO, or decentralized autonomous organization, that lacks any legal formalities or recognition. There is another phrase in American law for that kind of arrangement: general partnership. That means each of the partners is jointly and severally liable to the Plaintiffs and must make good on the full amount of its debts."

(You can read the complaint here.)

Plaintiffs’ counsel is putting all DAOs on notice that if they don’t make themselves legible, they will do it for them. Setting aside for the moment the utter incoherence of applying general partnership principles to DAOs by default, these are the sticks that bureaucrats and trial lawyers will reach for to strike any DAO that refuses the carrot of legal personhood.

Herein lies the problem: legal personhood is an operational requirement to access the legacy protocol. Most illegible organizations cannot function without access to that protocol’s banks and courts, so they either concede and incorporate, or they get driven underground to coordinate on a less elegant, more violent protocol.

DAOs are the first illegible organization with the power to make a different choice.

So, getting back to our original question: what’s a DAO?

A DAO is an organizational form built on top trustless and permissionless coordination technology that allows anyone to build and use new digital, networked, software-executed legal-financial protocols. These protocols do not demand legibility from their users, so they are free to organize and coordinate as they please. Anyone can encode innovative and creative rules around relationships and duties, property and contract rights, and dispute resolution. Anyone is free to join or leave any of those organizations as they choose.

Nevertheless, until these new protocols can fully support complex enterprises, we have two relatively imperfect options:

(1) we can operate entirely on the new protocol ecosystem and forego all the applications on the legacy protocol (like contractual enforcement, physical property ownership, limited liability, etc.); or

(2) we can use existing legal formalities like corporations and contracts as cross-protocol bridges.

However, just as bridges between blockchains are vulnerable to malicious interference, bridges between the analog and digital protocols make DAOs vulnerable to state interference. “Retrofitting” your DAO into the legacy system unavoidably requires that the DAO become legible, at least in part, which introduces all of the tradeoffs against decentralization and autonomy described above.

There are no easy or obviously correct answers. A strong mission statement and a core set of values are important guides, as are lawyers who develop skillsets as legal engineers and protocol counsel. They are best equipped to help clients build these bridges that allow their DAOs to run applications as necessary on the legacy protocol—to pay taxes, hold assets, hire employees, and defend themselves from malicious actors.

We’re still early, as they say. Best practices are emerging in real time as attorneys work with their clients to build better risk mitigation strategies that are consistent with principles of decentralization and autonomy. Until then, legal entity formation can be an effective way for DAOs to deploy strategic legibility and protect themselves and their contributors, which we will discuss in Part II.

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