2022 Will Be The Year Of The DAO, But Practical Challenges Remain
In the course of just five days in November 2021, an online collective raised $47 million dollars in Ether to purchase an original copy of the United States Constitution on auction by Sotheby’s. ConstitutionDAO, as it was coined, was the first glimpse of the power of speed, trust, efficiency, and excitement that distinguishes a DAO from a centralized entity. ConstitutionDAO was not the prevailing bidder at the auction but it successfully caught the attention of the world, onboarded thousands of individuals into crypto and the ecosystem, and inspired countless other DAO formations. In a twist of irony, the winning bidder Ken Griffin, CEO of Citadel Securities (and coincidentally at the center of another financial flash mob with Gamestop in 2021), knew prior to auction he’d need to raise his paddle at $48 billion due to the transparent nature of Ethereum. Decentralized Autonomous Organizations (DAOs) formed by and among otherwise completely disparate individuals organizing around similar beliefs, interests, hobbies, activities, etc. is anticipated to be a trending topic of 2022. However, for DAOs to truly become a mainstream feature of financial and cooperative organization, a number of legal challenges will need to be settled.
Blockchain protocols have already demonstrated new and effective systems for rethinking traditional finance, supply operations, and other use cases. Decentralized Finance (DeFi) and cryptocurrency are excellent examples of how this nascent technology will disrupt traditional industries, but at their core, blockchain protocols will transform human organization and will connect completely disparate individuals through a code-based system. DAOs are the emergence of this global and equitable connectivity. Smart contracts that are automatically executed based on an agreed upon set of rules removes the need for centralized organizations that hold too much decision-making power. DAOs utilize this technology for the benefit of its members. The membership is connected as a peer-to-peer flat structure, typically through the issuance of a token, rather than hierarchical management, and members are designated certain rights specific to that DAO. DAOs are excellent methods for gathering individuals around a general (macro) idea, but have yet to prove they are capable of performing micro decisions at scale necessary to make the organization a success.
Wyoming Forges the New Frontier
As DAOs become part of the general public lexicon—yes, I said it, your mom is going to be talking about DAOs at Thanksgiving next year (mine will probably join a Mahjong DAO) —a number of questions will need to be considered. Most basic questions, like, “how will a DAO be recognized as a legal entity?” or “what features of a particular DAO will give rise to certain liabilities to individual members?” remain to be settled. DAOs share characteristics with nearly all types of legal entities, including partnerships (both general and limited liability), corporations, non-profits, and cooperatives. Wyoming paved the way for DAOs to operate as LLCs under a new category applicable only to DAOs under the Wyoming Limited Liability Act. Under this type of legal structuring instituted in Wyoming, individual members are shielded from personal liability for actions by the DAO—similar to a limited partnership or an LLC, but different from a general partnership. But unlike a traditional hierarchical corporation or entity in which management has a fiduciary duty to the DAO, all members of the DAO share a responsibility to each other for participation and equal access to information.
Following Wyoming’s lead, other states could recognize two types of DAOs: member-managed or algorithmically managed. Member-managed DAOs are governed and managed through blockchain-based voting mechanisms, typically governance tokens. In this case, decision making power is vested in the members and controlled by a majority of the members voting on behalf of proposals. Algorithmically managed DAOs are entirely controlled by the underlying smart contracts. Under both categories of DAOs, governance of the DAO, including relations between members and the DAO, rights and voting rights, transferability of membership interest, etc., is codified in the articles of incorporation or the smart contracts of the DAO. Meaningfully, under Wyoming law, smart contracts of the DAO are now recognized as the legal equivalent to certification of a business or organization similar to Articles of Incorporation and other legal documentation.
DAOs in the Real (Traditional) World
While DAOs have significant operational benefits (i.e. transparency, tamper-resistant, ability to quickly raise and deploy funds), there are other challenges DAOs still must overcome. Questions regarding how a DAO opens a bank account or contracts with service providers have emerged. At least in the near term, the more seamless option, particularly in their interaction with traditional corporations, is what I’ll call a Council DAO. Such Council DAOs would implement a member-approved designated core group of individuals, likely creating a “real world” company, to represent and execute the approved actions of the DAO (e.g. enter into contracts or agreements with other companies) and appropriately manage organizational day-to-day business on behalf of the DAO. One example of this in action is FWB, which created four core teams — governance, board, team leads, and contributors —to make it more clear who is responsible for what, and how new community members can contribute. This also removes the operational headache of putting each item of day-to-day business a vote to the DAO. This core group is empowered to retain services, negotiate contracts, develop and publish platform terms, hire personnel, and manage the operational tasks of the DAO. However, this doesn’t entirely align with the flat decentralized vision of this technology and we’ve already seen DAOs pushing back on these structures in favor of more sufficiently or entirely decentralized decision-making formations.
Practically speaking, one pain point DAOs are experiencing is contracting with service providers on behalf of the DAO. In a Council DAO, a service provider can more easily interact, negotiate, and contract with a DAO. Conversely, firms organized under traditional legal structures need to consider more acutely how they will interact with DAOs. Corporations should think about including additional sections to its Terms of Service applicable specifically enforceable to DAOs or develop contract templates for services to DAOs that can more easily be presented and voted on by a DAO or implemented into a smart contract.
Not all DAOs are created equally. In fact, aside from the general corporate governance issues described here, DAOs may also face regulatory scrutiny depending on its structure and representations made by such DAOs. How each DAO approaches these issues will be different and will reflect the interests and values of its members. As our world becomes smaller and we are able to connect with people across the world faster and more deeply, DAOs will represent a paradigm shift in how individuals organize themselves. DAOs have inherent qualities that organize groups faster and more efficiently than traditional entity formations. It’s also imperative that current legal structures create new categories to formally recognize DAOs and properly consider their unique features. Ultimately, though, how these groups govern themselves and their intended activities and navigate a very centralized world will determine their success and likely give us a glimpse on the decentralized future of society.