DAOs: To Be or Not To Be Regulated

Due to the growing obsession with decentralized finance (“DeFi”) and tighter governmental regulation over cryptocurrency products, Decentralized Autonomous Organizations (“DAOs”) have emerged as a novel attraction. (Joon Kim & Daniel Forester, Bloomberg Law; Cathy Hackl, Forbes). DAOs are run autonomously and give individuals a safe and effective way to work with like-minded people around the world. (Cathy Hackl, Forbes; Ethereum). A DAO’s control and governance functions are distributed horizontally across its members, which eliminates the need for a central authority and thus makes them attractive to DeFi enthusiasts. (M. Ridgeway Barker & Joseph Bambara, Withers Worldwide). Another interesting potential reason for the rise of DAOs is the desire to avoid governmental regulation. (Joon Kim & Daniel Forester, Bloomberg Law). Erik Voorhees, the CEO of the crypto exchange ShapeShift, says his move to change his company from an existing legal entity into a DAO “removes some of the ability for regulations to apply” (Alexis Goldstein, Bloomberg), presenting questions of how DAOs are to be regulated and, in the case when regulations do apply, what qualities may a DAO be forced to sacrifice.

A DAO operates by a set of encoded and self-enforcing rules that are entirely determined by the organization’s voting membership. (Joon Kim & Daniel Forester, Bloomberg Law; Cathy Hackl, Forbes). While traditional governance of a business is based on the decisions of executives and boards of directors, a DAO’s governance function is decentralized and democratized among its members. (Cathy Hackl, Forbes). Implementations and changes to the DAO’s rules come solely from member “on-chain” voting, which is voting that is recorded on the blockchain and available for public viewing due to DAOs’ transparent nature. Id. The rules of the organization are represented in the form of smart contracts, which are self-executing contracts that exist across a decentralized blockchain network. (Jake Frankenfield, Investopedia). Because the rules are recorded on a blockchain and self-execute when the contract is satisfied, there is little to no reliance on third parties for financial transactions. (Joon Kim & Daniel Forester, Bloomberg Law; Cathy Hackl, Forbes). A venture fund is a practical example of a DAO, where individuals can collectively create a fund that pools capital from anywhere in the world, decide which ventures to back, and determine a way to redistribute repaid money all through the voting of its members.

Regulating DAOs presents a unique issue of legal identity due to the lack of formal, legal recognition which implicates a serious question of liability for a DAO and its members. (Aaron Wright Stanford). Wyoming tried to address this issue by enacting a law that “is designed to allow DAOs to fit within an LLC structure,” which is intended to combat the concerns of a DAO’s members regarding personally liability under the current “general partnership” principles. (Joon Kim & Daniel Forester, Bloomberg Law; M. Ridgeway Barker & Joseph Bambara, Withers Worldwide). However, this Wyoming Senate Bill 38 could defeat the purpose of, and the idea behind, DeFi, by requiring managers to be present and exercise discretion over the governance functions of the DAO, such as member voting. (Joon Kim & Daniel Forester, Bloomberg Law). If the issue of liability is left unaddressed, DAOs may be forced to adapt, or completely dissolve, because of concerns that members may be held personally liable for the organization’s financial liabilities and responsibilities. Another legal identity issue for DAOs is their present inability to enforce their legal rights in litigation. Id. Due to the absence of legal recognition, “there is no entity to be a plaintiff.” Id. There can also be no recourse in the event of a contract breach due to a DAOs reliance on smart contracts, which in and of themselves lack legal enforceability. Id. Therefore, for the sake of the DAO and its members, a push for legal recognition may be essential for its sustained existence in today’s markets.

Aside from the issues surrounding legal recognition, there is a dispute over whether a DAO can avoid legislation addressing crypto tax reporting. (Alexis Goldstein, Bloomberg). Voorhees was referring to this form of regulation when he stated that switching to a DAO removed the ability of regulations to attach to the organization. (Ethan Lou, Financial Post). Other crypto enthusiasts, such as Twitter CEO Jack Dorsey, have expressed their own opinions on how the crypto industry is “ill-suited for meeting tax-reporting requirements” due to the anonymous nature of the industry. (Alexis Goldstein, Bloomberg). However, Alexis Goldstein, Director of Financial Policy at Open Markets Institute, believes that complying with the tax provision is not a technological limitation, but rather, is a design decision to stay outside of a regulatory framework. Id. She explains that there has already been a DeFi company who has implemented a system with identity verification to become compliant with rules requiring information from its consumers. Id. Although it is unclear how the crypto industry will comply with this type of legislation, DeFi advocates clearly do not intend to give up easily.

While future regulation involving DeFi and DAOs will be a challenge, there are some considerations that should be discussed. Though faced with current and impending regulation, DAOs still offer a unique way for individuals around the world to crowdfund their money and create an organization that aligns with their own collective goals. DAOs were made to operate as a self-regulated organization that strives to connect the ideas of its members and allow for a decentralized governance system without bias from individual decision makers. Limiting the decentralization and autonomous aspects could have unintended consequences that diminish the very reasons that have attracted many people to DAOs. On the other hand, there will likely be some regulation of DAOs for the protection of its members and to create more certainty for the market. Forcing DAOs to conform with an existing business structure, however, may take away from the autonomous quality or negate the decentralized aspect of a DAO. Instead, legislatures may consider other alternatives, such as developing a completely new legal entity, which could theoretically preserve the DAOs current form. Although providing limitations on liability would be advantageous to DAOs’ members, it may not be enough for some organizations to give up their core principles.