Navigating the Uncharted Legal Waters of DAOs

The rise of DAOs has been one of the most exciting developments for human organization in recent years. In 2021, the total value of crypto funds held in DAO treasuries reportedly surged from $400 million to $16 billion, and the number of holders of interests in DAOs rose from just 13,000 to 1.6 million. 

Additionally, the number of DAOs has skyrocketed, increasing from about 700 in 2021 to around 6,000 as of June 2022, according to SnapShot Labs. Despite this explosive growth, only three U.S. states recognize DAOs as legal entities, leaving many DAO token holders in legal limbo. Today, DAOs and their token holders are exposed to legal vulnerabilities due to the lack of legal precedent defining compliant DAO operations. Because of the lack of clarity, everyone is at risk. 

The decentralized nature of DAOs makes them difficult to categorize under existing legal frameworks, leaving many token holders uncertain of their rights and responsibilities. According to “A Primer on DAOs,” published by the Harvard Law Review, for DAOs not “wrapped” in or “bridged” to a legally recognized entity (like an LLC, cooperative, or foundation), it is unclear what laws and regulations apply and whether the members face personal liability. 

Without clear legal guidance, DAOs are vulnerable to regulatory uncertainty, which can lead to legal challenges and possible fines or sanctions. Furthermore, token holders may be subject to individual legal liability if DAO operations are found to be in violation of existing laws or regulations. As decentralized organizations become more widespread, the need for legal clarity and regulatory guidance will only become more pressing. 

Open Case Law on DAOs

A few cases are currently making their way through the courts, the outcomes of which will be important to the landscape's evolution.

The case of the Commodity Futures Trading Commission (CFTC) vs. Ooki DAO concerns whether or not a DAO's governance token is a commodity under the Commodity Exchange Act. Tom Bean and Kyle Kistner, the founders of the decentralized trading platform bZeroX (predecessor to Ooki DAO), settled charges with the CFTC in 2022 for illegal commodities offerings on the platform. The CFTC later charged Ooki DAO token holders for their shared responsibility in the illegal offerings. 

The CFTC argued that the token falls under their jurisdiction, while Ooki DAO claimed it was not a commodity and not subject to CFTC regulations. The judge rejected Ooki DAO's argument, and ruled that the DAO was capable of being sued as a collective because it met California’s definition of an unincorporated association in that it consists of token holders who share the goal of operating the protocol. This legal interpretation of a DAO is significant because it links token holders to governance participation, marking the shift from member to owner. This case is currently facing a default judgment, as Ooki has yet to reply to the CFTC’s suit. 

The stakes of this case are already high for the industry given how little legal precedent there is, but Ooki’s decision to not fight the case out in court could be grave. On one hand, individual DAO token holders face potential legal risks for participating in DAO governance; on the other hand, they face the risk of killing the DAO participation model altogether by avoiding governance participation to eliminate legal exposure. Allowing the courts to define DAO ownership by governance activity will disincentivize voting and kill DAOs as a social coordination model. Both the forest and the tree are at risk.**

Co-Authoring the Rules

Rather than waiting to react to legal challenges and court cases, Decent believes stakeholders should be proactively engaging with regulators to help shape the legal landscape for DAOs. This will require a concerted effort to build relationships with lawmakers and regulators and to advocate for clear, fair, and effective regulation that can help minimize legal risk for everyone involved in DAOs. 

While the legal status of DAOs remains unclear at the federal level in the United States, some states have taken steps to recognize decentralized organizations as legal entities. 

As of 2023, only three U.S. states—Vermont, Wyoming, and Tennessee—have passed legislation that explicitly recognizes DAOs as legal entities. In these states, DAOs can be formed, operate, and own assets in a manner similar to traditional corporations. Other states may follow suit in the future as the popularity of DAOs continues to grow, but until a clear federal framework is established, we believe legal risks will remain.

Given the legal uncertainty surrounding DAOs, it is clear that everyone involved in these organizations is at risk of legal exposure. However, the situation can be improved through a collaborative effort between DAO participants and regulators to establish clear compliance guidelines. By co-authoring compliance requirements with regulators and legislators, DAO stakeholders can help create a framework for safer and more legally compliant ownership of these organizations. To date, co-authoring has largely been through the lobbying efforts of organizations like The Blockchain Association and political donations from organizations like FTX.

DAOs as Domestic Legal Entities 

Vermont requires DAOs to register as blockchain-based LLCs (BBLLCs) in their articles of organization. The BBLLC's operating agreement must provide a summary of its mission or purpose, information about the blockchain technology used, voting procedures, and security breach protocols, as well as outline the rights and obligations of each group of participants. This legislation also grants a BBLLC the same benefits as an LLC, such as limited liability protection and the ability to restrict fiduciary duties through the operating agreement (The Vermont Statutes, Title 11).

The Wyoming and Tennessee laws permit an LLC to state that it is a DAO in its articles of organization. According to A Primer on DAOs, within both laws, a DAO is considered to be member-managed unless its articles state that it is algorithmically- or smart contract-managed; the articles must include information about the DAO’s smart contract; and the DAO will automatically dissolve if it does not approve any proposals or take any actions for one year. 

In Wyoming, the law allows DAOs to register as limited liability companies (LLCs), which provides members with liability protection and legal recognition. The law provides that DAO members have no fiduciary duties unless otherwise specified in the articles; and that there is no obligation to furnish information or provide inspection rights to members (except to the extent that they are available on the DAO’s open blockchain). The law also specifies the requirements for registration, such as having a registered agent in the state and submitting articles of organization. 

Tennessee's law recognizes DAOs as a new type of entity called a "series LLC," which allows for the creation of multiple series or sub-entities within a single LLC. Each series can have its own assets, members, and management structure, providing greater flexibility for DAOs. The law provides that DAO members do not have fiduciary duties to the DAO except under the implied covenant of good faith and fair dealing.

Utah’s newly passed law defines DAOs as entities that are managed and governed through computer code, rather than by individuals or a centralized authority. DAOs will have legal standing and be able to enter into contracts, own property, and participate in legal disputes. The law also provides for the registration of DAOs with the state and sets requirements for transparency and accountability.

Colorado’s Uniform Limited Cooperative Association Act does not explicitly recognize DAOs, but it provides a useful framework for their operation within the state. The Act governs “limited cooperative associations” (LCAs), which are defined as “autonomous, unincorporated association[s] of persons united to meet their mutual needs through a jointly owned enterprise primarily controlled by those persons.” This law allows an LCA to distribute profits to its members based on the level of their participation and allows members to vote on governance matters. DAO-based governance principles and liability limitations can be incorporated into the LCA’s articles and bylaws. Generally, cooperatives focus on rewarding participation rather than only capital commitment, with members typically having one vote each or their voting power determined by their activity level in governance. In his recent Op-Ed for CoinDesk, Global Blockchain leader Paul Brody suggests that DAOs lean more towards co-op frameworks to weather the climate of legal uncertainty surrounding DAOs.

DAOs as International Legal Entities 

Some DAOs opt to incorporate abroad in jurisdictions with more favorable legal frameworks, like Switzerland, with its flexible corporate law and strong privacy protections. Other popular jurisdictions for DAO incorporation include Singapore, the Marshall Islands, and the Cayman Islands. 

By incorporating abroad, DAOs can potentially benefit from clearer legal frameworks and greater regulatory certainty, which may make it easier for them to operate and attract investment. However, incorporating abroad also comes with its own set of challenges, including increased complexity and potential tax implications.

MIDAO is a DAO created entirely to help other DAOs seamlessly incorporate in the Marshall Islands in as little as 30 days, with the goal of protecting contributors legally so they can build the future of DAOs stress free. MIDAO leverages the territory’s tax friendliness to build a community and a business model that offers advice, smart contract deployment, frameworks, and other forms of guidance, leading to an uptick in the region’s DAO formation. According to representatives at MIDAO, while no legal wrapping protects against fraud, limited liability protection from the LLC extends to the assets of the DAO and not the individual token holders. However, when a DAO is incorporated as a non-profit entity, the members who have to KYC (those holding over 25% of governance rights) have no fiduciary responsibility because the entity is a non-profit. When the entity is incorporated as for profit, no members have a fiduciary responsibility and thus bear no legal risk on behalf of the organization. 

The decreased legal threat for members makes international incorporation an attractive option for DAO founders; this is why DAOs like Decent opt to incorporate abroad. By choosing the path of least regulatory resistance for itself and its members, Decent is empowering people to actively participate in the design and the decision-making of this new financial frontier that promises to usher in more sustainable and enriching business practices.

Alternative Ways Forward

MakerDAO recently announced the creation of a new legal defense fund to protect itself and its members from potential regulatory action. The fund, which was seeded with 10,000 MKR tokens (worth over $4.5 million at the time of the announcement), is intended to provide financial resources for legal battles that could arise in the future. MakerDAO is taking proactive measures to prepare for potential legal challenges, acknowledging the risks and uncertainties surrounding DAOs and digital assets. This move signals a growing recognition among DAOs of the importance of legal compliance and the need for adequate resources to defend against legal action so that we don’t leave important precedent to be set by a court’s default judgment.

While individual DAOs gear up for potential legal action, the Catawba Digital Economic Zone (CDEZ) was created as a regulatory “safe zone” for fintech and digital asset growth. Established in the Catawba Indian Nation in South Carolina, the CDEZ framework offers a "sandbox" environment where companies can test and develop their products and services without being subject to the usual regulatory requirements. It aims to attract businesses and entrepreneurs seeking a supportive environment that encourages fintech and digital asset innovation in the United States. According to the Associated Press, the CDEZ offers a range of benefits, including reduced regulatory burdens, tax incentives, and access to funding and other resources. The organization will help shape the future of these industries in a way that is both safe and beneficial for consumers. More DAOs are expected to incorporate in the region in the years to come, though the risks or potential downsides have yet to be tested.

DAOs present an innovative model of social coordination and business ownership that has the potential to transform the way we conduct transactions and interact with one another. However, DAOs are moving faster than regulation, and exposure is the inevitable side effect. We at Decent are paving the way for novel economies built on regenerative decentralized systems to thrive beyond the status quo. It is important to us to be aggressive in reimagining the potential of crypto to catalyze resilient, renewable processes in the new digital era, and pioneer solutions that generate long-term value for all. While some U.S. states have taken steps to recognize DAOs as legal entities, federal regulatory bodies such as the SEC and OFAC have yet to provide definitive guidance on how to regulate and interact with decentralized organizations. This has created a challenging and murky legal environment for DAOs and their participants, who must navigate complex and often unclear legal frameworks to operate and invest in these organizations. To decrease this exposure, Decent believes DAOs must work proactively with regulators and legislators to co-author clear and effective legislation that protects their operational structures, treasuries, and token holders. By being less reactionary and more assertive, DAOs like Decent can continue to push boundaries and create a new frontier. It’s time to reclaim our rightful influence over economic policy—and do the things that matter, better.

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