The article highlights the significant weaknesses that DAOs revealed in the last years and tries to identify a path forward with a specific focus on governance solutions, decentralization and legal settings. The aim is to revamp the concept of DAOs without losing the main features that make them special compared to other organizations.
1. Introduction
The bear market has undoubtedly affected the very idea surrounding DAOs. For many months starting from 2021, the decentralized organizations have been presented as the future of business and of work. Blockchain governance, flexibility and anonymity of contributors were considered the core elements for a non-hierarchical and more inclusive future. Great part of the DAO economy was based on governance token emissions. The governance token was not only the tool to express votes within the organization, but also the tool to incentivize contributors, liquidity providers and token holders. The bear market has brought to a collapse in the price of the governance tokens and to a first crisis of the concept of DAOs.
Simple DAO accounting made clear that DAOs are normally tremendously inefficient in terms of costs vs revenue. Moreover, their treasuries are usually not diversified and full of (often illiquid) governance tokens. Buyback strategies of DAO tokens turned out to be detrimental when the market went down. But the “economy” or “efficiency” of DAOs is not the only problematic issue. In fact, DAOs posed problems as to the choice of the correct governance structure and management methodology. Decentralization is the core, yet it often leads to a slow decision making process and sometimes to an over bureaucratization. Finally, DAOs pose legal challenges and risks that cannot be precisely assessed. The basic question is therefore, why should someone invest in DAOs?
Nonetheless, the idea of “DAO” is more alive than ever. Builders and tech enthusiasts continued to work on innovative tooling, treasury management systems and new ways of coordinating efforts. The DAO business development team of Polygon Labs has ascertained that only through its partners Aragon and Syndicate more than 10k DAOs are deployed on the Polygon PoS chain. Compared to traditional businesses DAOs are an almost non-existent niche, though the numbers indicate the clear existence of an interest. Not surprisingly, groups and collectives such as the DAO Research Collective and RnDAO provide deep studies and research on many aspects concerning DAOs. A DAO Handbook illustrates and tries to provide guidance on the main issues concerning DAOs and the DAO Coalition organizes lobbying activities to legally protect DAOs.
2. What is governed and who is governed?
The recent crisis amounts to an invitation to look back and reshape the original concept of DAO. The “traditional” way of presenting DAOs is by reference to a complex of smart contracts which coordinates the will of users/members that may exercise a voting power within the organization. In an early blog post of 2015, Vitalik praised the transparency of DAOs and the capacity to take arbitrary decisions where incentives should bring participants to achieve a “superrationality.” For a certain period of time, DAOs were considered as technological tools with encoded governance rules. Perhaps wrongly, compared to the first examples of DAOs, digital organizations were just defined as a bundle of smart contracts capable of managing funds through automated execution.
One thing seems clear, the DAO boom started in 2021 has led to a completely different type of organization. DAOs dispose of a multisig wallet and are usually managed through tokenized voting, but the “life” of a DAO is exercised off-chain on social networks, where people debate things, propose ideas, criticize others, a bit as it normally happens on social networks but with a more goal-oriented vision (related to the scope of the DAO). In addition, in many cases, DAOs are duly regulated through constitutional documents, which identify competences, quorums, rights and duties, and the way of behaving. People obey a kind of form of governement set by the core contributors and accepted by the DAO. In almost all cases, these rules are not encoded. It could therefore be said that DAOs became more and more social organizations rather than technological organizations. It is not uncommon to find friends in a DAO or to talk about a community of a DAO.
Is there a distinction between community and organization? Within the acronym DAO, “O” stands for organization. However a great weight has been given to the community. In the original concept “organization” does not really refer to people who form a community. Instead it refers to the technological set up that allows operations provided by smart contracts on the blockchain. It seems that in the last months many DAOs were more concerned about regulating relationships between people/members of the community than on running a business through the use of technology. This approach makes DAOs weaker, because instead of taking advantage of technology, they reveal the same weaknesses of traditional businesses or associations. Perhaps DAOs are even weaker than traditional businesses and associations, given the absence of a hierarchical order. Without a hierarchical order, rules that are not encoded are far more difficult to implement.
An example is the ongoing transformation of the Aragon project. In 2021 the project started a new DAO called Aragon Network DAO. The focus has been on non-encoded blackletter rules with the publication of a very long AN DAO Charter. I have worked for one year as a compliance Sub-DAO member and I can testify that the experiment has been great, but the application and enforcement of the rules encompassed in the charter has not been easy. Legal or “pseudo-legal” rules create doubts and uncertainty within the community. Drafting governance processes is not an easy task and rules present inherently ambiguities that need constantly to be solved. In many instances bureaucracy appeared to win over the DAO members’ actual will. After one year Aragon is now changing entirely its approach with a new form of governance which should be minimal and completely encoded. This quite innovative attempt is presented in a forum post, which encompasses “an objective, plain english description of the smart contract permissions of the Aragon DAO.” In presenting the rules, Jessica Smith states “The Aragon DAO Rules intentionally center the smart contracts granting governance permissions to Ethereum addresses, and push human-layer guidelines, and practices to the edges.”
Is this the right way of addressing things? Nobody really knows, but one thing is clear: DAOs were not born for reproducing fallacies of other organizations and the strong connection to technological evolution should not be forgotten. Written statements or principles might serve to identify the scope or the goals and bring new interested people to the DAO, but the governance must remain simple and understandable based on smart contract technologies. The technology is there to create a trustless environment where people coordinate their efforts without the need of relying on intermediaries. In this context a delegated voting system should be welcomed to extend commitment within DAOs. However, as the BanklessDAO coordinape scandal demonstrated, putting trust in persons who are anons or unknown without a smart contract or blockchain coverage should in principle be avoided.
In any case, it would not be correct to exclude written rules altogether. Community incentives and KPI must be explained and a kind of charter might be welcomed to understand how the DAO structure is conceptualized. Nevertheless, it is important to assume that written statements and explanations should ease the understanding of the governance system and not harm it. Such written indications should augment community engagement. Given the lack of complete automation, as Vitalik pointed out in the past, a DAO cannot live without the human intervention of people who fulfill certain tasks. But this does not mean that every behavior within a DAO has to be regulated in detail.
3. DAO Corporate Governance and the Absence of Default Rules
The first wide DAO experiments revealed a clear dilemma. On the one hand, DAOs present themselves as more inclusive and open compared to regular businesses. On the other hand, the lack of efficiency makes them sometimes incredibly weak. After these first years of DAOs, one aspect appears correct: to some extent DAOs have to rely on consolidated business models, otherwise they will not survive. The problem is understanding whether a decentralized organization can also be an efficient organization. Obviously, as it will be explained, decentralization does not help to foster efficiency.
According to the traditional literature, corporate governance is characterized by agency constructs. The constant attempt is to optimize incentives between principals and agents, control costs, minimize information asymmetries, control adverse selection and moral hazard, optimize risk preferences between principals and agents, and engage in monitoring. This model of governance has of course its issues, as for instance the classic division between ownership (shareholders) and management (directors). Modern corporate governance tries to align the interests of these different actors, especially by enhancing the shareholders’ power of control. Disclosure requirements and shareholders’ activism should alleviate the problems, but a definitive solution has not yet been found.
As it was well pointed out by Kaal, blockchain technology should ameliorate the situation with new ingredients: elimination of intermediaries, peer-to-peer relationships, collaboration and community. From a theoretical standpoint, DAOs may challenge Coase’s theory of the firm, as blockchain and smart contracts may eliminate the need of internalizing costs altogether. In essence, as explained by Mienert, the hierarchical order which is paramount to the typical company structure is substituted by coding and smart contracts which may also be used to attach given roles to pseudonymized DAO members. The operations should be automatically run by code and reduce expenses/transaction costs.
But the reality looks different and it is important to understand why the majority of DAOs are inefficient. A part of what has been said before, there are many reasons: lack of incentives, absence of leadership, poor governance framework based on erroneous tokenomics. Overall it seems that all the listed elements refer to one single shortcoming of DAOs, namely the lack of experience. We are still early and many mechanisms need to be tested and approved. In this regard, the most significant difference between corporate and DAO governance seems to rely on the absence of default rules. Every legal system provides rules on corporate governance that might be derogated, but that constitute a point of reference for privates aiming to start a business activity. Although it is possible to recognize some points of reference in the industry, DAOs do not have default governance rules. Every new DAO integrates a new governance experiment and not every group is capable of shaping the correct framework.The state of the art as to DAOs governance and voting is well presented in a research of the DAOResearchCollective. There is not a perfect system. The different voting mechanisms present at the same time advantages and drawbacks.
A prosperous future for DAOs requires the establishment of reliable governance models that might be adopted by newcomers. With the spirit of creating default solutions, industry players must aim at offering encoded governance structures that might be readopted with user-friendly explanations. Such models would make things easier and help to augment the number of DAOs. This would not determine “clone trooper” DAOs: scope and goals would differ for every organization. In addition, there would always be room for more sophisticated players and incentives to build innovative systems and to test something new. The number of DAOs need to grow and the access to the technological framework must become easy and user-friendly.
4. The Importance of Decentralization
Decentralization constitutes the core element of DAOs, its major characteristic feature. Nonetheless, setting up a decentralized organization is not easy and often “decentralization” is presented as a kind of process that should be achieved by the core persons. But why is decentralization that important? Its origins rely on the very idea of blockchain technology and distributed ledgers and was then transposed to the decentralized organizations. Decentralization is probably one of the most essential components of web3. Without this component, it would be difficult to foster a credible narrative for the years to come.
Decentralization is also one of the most challenging aspects as it is often surrounded by hypocritical statements that do not reflect reality. More often than not, DAOs are not decentralized at all. Decentralized protocols with on-chain governance resembles a plutocracy, whereby token holders in a given DAO with a significant share of the total supply of tokens have more power than the rest of the DAO members. Therefore, decentralization is frequently not there and DAOs might be even less decentralized than traditional businesses.
Decentralization has also a very significant role in legal matters. As Gabriel Shapiro, GC at Delphi Digital, correctly pointed out in an article on the legal definition of “Decentralization:” “Regulators such as the Securities & Exchange Commission (SEC) and the Financial Crimes Enforcement Network (FinCEN) have recognized that the applicability of financial regulations to blockchain systems can depend on the degree of control people have over them, with certain regulations being inapplicable when a system is “sufficiently decentralized” or “non-custodial”.” Basically, if the network on which the token has to function is sufficiently decentralized the asset may not represent an investment contract, because purchasers would no longer expect that there is a group who carries out a managerial or entrepreneurial effort.
Also with the European Union decentralization could achieve utmost importance within the proposed Market in Crypto-Assets Regulation (MiCA). According to recital 12a, “Where crypto-asset services as defined in this Regulation are provided in a fully decentralized manner without any intermediary they do not fall within the scope of this Regulation.” This regulatory approach is of utmost importance because it could prevent the new EU crypto-law from applying to DeFi, where the governance surrounding the protocol is “fully decentralized.”
On decentralization, a point of reference in the crypto-legal literature is the Playbook on “Sufficient Decentralization” written by Marc Boiron, Polygon Labs Chief Legal Officer, for devs and builders. Boiron argues that most legal advice around securities laws focuses on decentralizing the web3 technology stack and points to the importance of decentralizing also the day-to-day activities of community contributors. This work includes “developing the protocol or software around the protocol, engaging in business development, marketing and growing the protocol, making intellectual property available for all to use and advancing protocol governance.” In essence, to avoid the application of US securities’ law the project has to rely on the work of an “uncoordinated group of people who drive value to a protocol.” In this respect, Boiron correctly points out that there is a tension between the need to decentralize and the efficiency connected to centralization. In other words, having different groups of people that develop the project towards different directions will probably lead to a lack of efficiency. But DAOs need to accept this risk and try to balance between centralization and decentralization through flexible governance, leadership and coordination.
It is also important to notice that decentralization involves the adoption of certain words and definitions that are paramount to web3 and especially to DeFi projects. On the other side, seeking decentralization should bring projects to avoid the use of terms that refer to centralized businesses. Rebecca Rettig, GC of Aave, has published useful guidelines on the issue. The effort of DAO communities should be constant in seeking to achieve the maximum level of decentralization and at the same time configuring common goals that should provide guidance to the different components that act within the DAO. Creating sub-departments or guilds and recognizing to them a certain degree of autonomy might help. In addition, grants’ programs can foster a decentralized community of builders, who are not organized in a common enterprise, but work for the benefit of the DAO.
5. Legal Challenges and the DAO Wrapper Obsession
“Sufficient” or “full” decentralization does entail that a project becomes immune from the application of the law. Even if a token does not trigger securities’ law, the activity carried out by a DAO might potentially infringe the law. Of course the legal risks depend on the scope of the DAO. A brilliant community of poets that organizes a selection of the best works within the membership through a NFT voting system does (probably) not violate any law. Differently, everyone knows that DeFi protocols can undergo legal scrutiny in certain legal systems. In these cases, DAO contributors can be considered part of a general partnership and be considered jointly liable for the operations of the DAO. Crypto-legal communities and DAO enthusiasts have followed the Ooki DAO case, which reveals the risks for DAO members connected to a regulated activity. An ongoing discussion is therefore: how to mitigate legal risks for DAOs?
The original 2016 DAO was a decentralized organization which raised a significant amount of ethereum and did not have any physical address, nor could the DAO be connected to a given jurisdiction. As it is known, this did not prevent the DAO from being subjected to legal scrutiny by the SEC. Since then many things have changed: there is legal literature on DAO legal entities or wrappers which exposes in detail the different options. Developers and builders began to fear that the absence of a legal shield for liability could endanger their personal position. Moreover, they felt the need to fulfill practical matters off-chain (entering into contracts with third parties, paying bills, etc.). The only viable solution seemed to be the creation of a legal entity that should represent the DAO in the off-chain world. Many different solutions were proposed: for instance, ad hoc versions of LLCs, foundations, associations, special purpose trusts.
Legal experts have different theories on the issue, but some aspects related to these attempts to create a sort of off-chain representation of the DAOs do certainly present some challenges. As indicated by LawPanda, “Incorporating a DAO in any jurisdiction is generally not straightforward.” The DAO with a wrapper loses its extraterritorial and borderless nature to become an entity according to the law of a given state. Moreover, many adopted models are not tested in case-law and it is not certain whether they provide effective protection for the DAO members. Finally, the adopted legal models were originally not shaped for decentralized organization and their internal structure is somehow readapted to DAO needs. This is particularly recognizable by the fact that these entities usually have a management board or persons with fiduciary duties who should implement the indications of DAO members.
Nonetheless, there are today recognizable best practices in the space and the choice among the different options predominantly depends on the type of activity and the jurisdiction in which the initial contributors to the DAO are located. From a legal standpoint, there is not a one size fits all answer and there might be situations in which it is better not to have a wrapper. It is a fact that many bluechips DeFi projects, that are definitely here to stay, exist today without a wrapper. Protection for members or contributors who are more exposed to liability can be achieved also by other mechanisms, for instance in creating companies that act as service providers to the DAO or in wrapping only subDAOs that fulfill certain tasks.
Another problem is framing a viable and efficient connection between the legal entity and the governance expressed on-chain. The mere existence of the legal entity adds a layer of complexity to the governance structure which needs to be clearly defined ex ante. In this regard, an important contribution has been provided by the creation of Kali, an application to launch DAO smart contracts and form companies. It allows founders, funds and communities to tokenize membership, build on-chain governance, with a pure attempt of enforcing the commitment of the involved parties with code. Kali has the aim to provide a powerful tool to users who are not familiar with coding, contracts and deployment and allow them to manage proposals and voting.
Some aspects seem to be important in this discussion. A DAO wrapper does not make a DAO lawful and at the same time the absence of a wrapper does not make the DAO immune from the application of the law. Founders have to carefully assess their options, take knowledge of great guidelines as the ones provided by the Lex Punk Army, and obtain legal assistance if needed. On the other side, legal professionals must work at an international level to foster best practices. They should avoid promoting their own jurisdictions and carefully assess what is best for the DAO. Given that a national legal wrapper is a suboptimal solution, legal researchers should continue to work at a supranational solution, as the one developed and presented by COALA. Such a legal framework should not aim at setting up a slight modification of existing corporations, but just provide a legal recognition to an organization that is founded and lives on the blockchain.
6. Conclusion
It seems clear that a revamp of the concept of DAOs requires diverse expertises, knowledge of the weaknesses that DAOs revealed in the first phase of their existence, and the development of models of governance and of legal settings that might be easily adopted by founders. In doing this research and in finding solutions, one has never to forget which were the original traits of DAOs and why they were considered a model capable of revolutionizing business, investments and work.
The governance should predominantly be encoded and the “social” part of DAOs must aim at easing the onboarding of new members, generate alignment of intents and set future goals. Blackletter rules that generate bureaucratic compliance duties and that slow down operations should be avoided. There are sufficient laws, rules and regulations in the off-chain world, DAOs should remain simple and flexible. The concept of DAOs must be observant of its origins and not become a label used by corporations that assume to be connected to the web3 world. Research needs to continue with the goal of creating default governance structures that might really become mainstream. On this ground layer, communities could build their social infrastructure, focused on milestones and incentives and not on rules and bureaucracy.
In this context, decentralization must not be considered a meme. The term is in the process of acquiring legal standing and recognition in the Western legal world. Every person involved in DAOs should be aware about the importance of it and legal professionals need to implement standards and practices to ensure that a project can legally be considered decentralized. It is the only real “life anchor” for the future of blockchain organizations based on token votings. Otherwise, it will be difficult to make a case that DAOs should be subject to different rules than off-chain legal entities.
The attempt of creating DAO wrappers is understandable, but it would be wrong to consider a wrapper as a kind of non-written legal requirement. The used wrappers are often non-ideal adaptations of already existing models to a new use-case. They are not battle-tested and might create future legal issues which are difficult to assess today. Wrappers can be useful to shield liability of core contributors and fulfill practical tasks on the basis of a case-by-case analysis. Also in this area, research and testing has to continue in order to provide reliable models which should not copy-paste off-chain legal entities.
There is much work to do, DAOs showed weaknesses but the ethos is still there and it is deeply grafted in the web3 culture. DAOs are simply fundamental for everything that is made on the blockchains. The aim of all the interested stakeholders is to establish the conditions to make them mainstream.
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The majority of projects built over the blockchain have some DAO characteristics that make them different compared to traditional businesses. This is true for gaming, NFTs, DeFi etc. Working closely within the Polygon Lab growth / Decentralized Org Development (DoD) Team made me understand that the only possible solution to help developers and communities is to adopt a bottom up approach. Research and investigations should start from the dialogue with people that directly face problems any given day. Understanding the data and creating contacts between projects is the most powerful tool to provide guidance. Often the problem that appears difficult to solve for one project has already been solved by a technology or tooling that is simply unknown. Thanks to my teammates, I have learned that the creation of a true ecosystem of web3 actors requires the knowledge and the tracking of every potential tooling that might ease the adoption of blockchain technology.
This is the spirit that animates Polygon Labs DoD Team: our attempt is to create a DAO Playbook to help businesses and DAO architects articulate and describe the strengths and weaknesses of various technological and social configurations.
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eaglelex is a law professor and qualified Italian attorney. He works as a legal and partnership advisor for Polygon Labs and advises on regulatory matters concerning blockchain and crypto. He is one of the founders of the Blockchain Lawyers Group.
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