DAO – The Most Expensive Entity Structure Known to Man

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I imagine only a handful of attorneys out there took a deep dive into COALA’s Model Law for DAOs (ML). For those that don’t have the stomach to review 51 pages of model statutes and discussion, the gist of it is a proposed framework for granting legal personality to unregistered DAOs, without any level of registration or state involvement. In theory, that would be great, but I was surprised that the author’s otherwise extensive commentary did not cover one major flaw, which I’ll get to in a minute.  

 

 For background, there’s only one concept that makes this ML novel. They’re calling this concept Regulatory Equivalence (more on that later). Other than that, the ML closely mirrors existing corporate and LLC statutes, but cherry picks what requirements to keep and what to omit (e.g., keeping pass through taxation and a requirement for by-laws; omitting boards and fiduciary duties).
 

The novel idea here starts with the notion that the whole purpose and public policy served by having an off-chain business registry is to further promote publicity and reliability, “which is underwritten by the trust that people have in public authorities.” (ML). Can’t disagree with that. The ML authors then argue that the same purpose and public policy is served by the deployment of a DAO on a public blockchain, and therefore, there is “Regulatory equivalence”.
 

They further argue that “As a result, DAOs should benefit from legal personhood and at least some of the various rights and obligations of the existing frameworks of corporate law, even if they do not use an entity form under the law.”
 

Now, here’s the flaw.  From there, the ML proceeds to outline the “Formation Requirements” (e.g., deployment to permissionless blockchain, code must be open-source, code must have undergone Quality Assurance, dispute resolution mechanism, etc.). These requirements must be fulfilled before the DAO gets recognition as a legal entity and its members enjoy limited liability protection.
 

Suddenly the setup cost of a new business goes from a few hundred dollars to tens of thousands of dollars due to the cost of obtaining an industry-standard security review.  

 

Perhaps “Quality Assurance” could be specifically defined as something short of an all-out security review – for instance, reliance on a trusted code library, like OpenZeppelin.  Otherwise, this might be the double-edged sword that this ML dies on. 

 

There are several holes one could poke in this ML, but the same can be said for many existing bodies of corporate and LLC statutes. Fortunately, as a common law jurisdiction, we have generations of case law to guide us when statutes inevitably fall short. One notable hole worth pointing out is the disconnect between whether by-laws or code would control in the event of an inconsistency. Jordan Teague originally pointed out this exact issue in in her Defiant article on Wyoming and Tennessee DAO legislation.  

 

My take is this: the reason corporations and LLCs work as well as they do to facilitate business ventures is because of the trust that investors and the public have in the existing intuitions and bodies that serve as a de facto “Quality Assurance” layer. We have state-run business registries, banks, courts, boards of directors, etc., each of which developed over centuries to reach the stature and trust they enjoy today. The ML’s idea of a DAO legal entity posits that all those functions can be coded into a smart contract. It is an honorable and revolutionary idea that’s shared by many in the crypto community. That said, it is difficult to deny how highly impractical and difficult the task would be. For starters, (1) you can’t expect to resolve issues that took centuries to resolve in existing legal structures (e.g., dispute resolution in courts and the due process, discovery, appeals, etc. that come with it), and (2) it’s proved inevitable that those issues would fatally distract builders’ focus from their business or social objectives.  

 

The more realistic solution for decentralized organizations to achieve legal personhood would be for them to follow existing corporate and LLC structures and push a willing jurisdiction to adopt a series of amendments. Rather than wishfully hoping that states will pass legislation for a poorly understood, untested and trustless legal structure, I believe our efforts would be better spent in advocating for a jurisdiction like DE to loosen a handful of corporate formalities for DAOs organized as corporations or LLCs.  

 

For example, in lieu of requiring a president, DE could permit that a committee within a DAO holds authority like a president and that the acts of the committee must be recorded on chain. Similarly, the IRS might be more inclined to carve out some sort of special tax treatment for DAOs organized as corporations or LLCs rather than develop an entirely new taxable entity structure. For example, the IRS could permit pass through taxation to the extent that DAO members don’t object to receiving K-1s, and as to the members opposed to doxing themselves, the DAO and those members would be on the hook for double corporate taxation. 

 

Interestingly, the LLC as a legal entity is a creature born from a conflict between the IRS and the needs of business owners.  

 

The alternative seems to be waiting for a new DAO legal structure to develop in a natural course. If the history of LLCs has taught us anything, it is that this can take a generation to develop and deploy. Given the willingness of states like WY and TN to pass some initial DAO legislation, it would appear DAOs are on track to follow a similar birth course as the LLC. That said, it’s telling that while the first LLC was formed in Wyoming in 1977, it wasn’t until 1996 that the IRS issued its final ruling on LLC treatment that made it a practical and useful legal structure.  

 

Prior to that ruling, lawyers for business organizations needed to get creative in order to achieve both pass-through taxation (the way partnerships are taxed) and the limited liability protections (enjoyed by corporations). One such creative alternative was the use of a limited partnership, where the limited partners are protected by limited liability protections. The general partners in an LP, however, do not have these protections. The simple yet creative solution gained popularity – LPs using a corporation as the general partner. 

 

For DAOs to stay on the same path as LLCs, they must prove that they are similarly integral to commerce and give legislators no choice but to make it a top priority.

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