Introduction
A decentralised autonomous organisation (“DAO”) is an association of participants where software/computer code and ‘smart contracts’ (usually based on distributed ledger technology (DLT)) automatically perform certain organisational actions. Their potential benefits include ensuring neutrality, resisting central control or third party attacks and avoiding the cost of traditional structures.
Many DAOs exist. They allocate grants, conduct finance operations, invest for a return provide services or other resources to other DAOs, organise people around an event or club, acquire collectibles, engage in lobbying or advocacy, or help other people start DAOs. Their existence and purpose raises questions about their legal status and liability of participants. DAOs usually include some form of legal entity for certain purposes.
While the law of England and Wales should be flexible enough to accommodate DAOs, few DAOs have chosen to organise here, so the government has asked the Law Commission to find out why and how English law might better accommodate them. The Commission has issued a call for evidence1 to identify the main options for legal reforms or innovations that might be required to existing company law and other legislation to make DAOs viable and facilitate their establishment in the UK These might include identifying different “types” or “classes” of DAOs. Issues out of scope include: regulation, tax, data protection and anti-money laundering issues (which could well be more influential on DAO founders’ decisions about where to organise). Other such initiatives are being undertaken by HM Treasury, HMRC, The Financial Markets Law Committee and CryptoUK.
This note summarises the Commission’s call for evidence with some additional commentary. You can respond to the call online by 25 January 2023.
Components of a DAO
DAOs have various components and participants…
Software (computer code) that causes ‘smart contracts’ to operate without human involvement; a set of rules that specify how those smart contracts operate together (“DAO protocol”)network of participants“blockchain” system with its own protocol and network of participants with which the DAO interoperates (or that that DAO protocol assumes will operate in certain ways); and possibly a decentralised finance (DeFi) system with which the DAO also interoperates.
DAO protocols build on blockchain systems to leverage their underlying functionality and network. The DAO’s system of smart contracts comes into existence by sending (a series of) transaction(s) to the participants within the blockchain network. The operations that constitute the DAO protocol are executed or validated by the blockchain system’s miners/validators (depending on the type of blockchain system), who receive a transaction fee according to the blockchain protocol.
Miners/validators: are participants in a blockchain system who are separate from any particular DAO, yet DAO protocols assume – and depend on – their active participation in the blockchain system to execute or validate their DAO smart contract transactions.
Developers: design and write the software required for DAO protocols, smart contracts, blockchain protocols, and the broader crypto-token ecosystems. They use a variety of software, hardware and perhaps pre-existing blockchain protocols, blockchain systems and software protocols in their work. Their software and code is often open-source and freely available. Developers may be more or less closely associated with a DAO and its protocol and might act individually, collaborate loosely or be employed by a business entity.
DAO token holders
DAOs may issue their own crypto-tokens or specify the need to hold a pre-existing crypto-token. Some DAO protocol-specified tokens (“DAO tokens”) allow holders to participate in “governance” decisions relating to a particular software protocol or give holders additional benefits or utility when interacting; in some way capture all or part of the value of a DAO protocol; and may be transferable within public crypto-token markets/exchanges.
The use of some terms is also worth clarifying.
“Decentralised”
The term “decentralised” may refer to a DAO’s governance or architecture (or both).
Decision-making and oversight may be widely dispersed among participants so that there is no central body responsible. The DAO protocol may include certain rules or operational functions or may specify circumstances and thresholds for decisions or changes to be made, e.g. voting by means of certain tokens. Decision making within a related legal entity would be made in accordance with the rules of the entity.
This term could also refer to the level of distribution within the blockchain system on which the DAO protocol is deployed; or the DAO protocol, as a system of smart contracts; or the DAO itself.
This is a dynamic concept. DAOs may start under centralised control that becomes more decentralised over time, as the protocol and smart contracts are deployed, but use traditional structures as they become more successful and so re-centralise.
“Autonomous”
Autonomy from human oversight within a DAO is a function of the extent to which the DAO’s network of smart contracts rather than centralised management controls a large part of the activities and governance of the organisation.
The number and role of humans involved will vary with the DAO’s stage of development, purpose and structure. They could be founders, developers, shareholders, directors, advisers and general staff. There is disagreement on whether human involvement means the organisation is not autonomous (just a ‘decentralised organisation’ (DO) or whether “autonomous” refers to self-governance, rather than outside influence or control.
“Organisation”
Organisation may seem as simply an association of two or more participants pursuing a common interest or purpose, as may be prescribed by the DAO protocol or an event such as buying a certain token. Participants might also be pseudonymous and anonymous.
Legal status of DAOs and Participants?
Participants in DAOs run the risk that their arrangements are characterised in ways that create personal or other liabilities they might not have foreseen.
Unincorporated Associations – not for business/profit
There is no statutory definition of an “unincorporated association” but they are referred to in statutes and case law. The leading case described an unincorporated association as:
… two or more persons bound together for one or more common purposes, not being business purposes, by mutual undertakings each having mutual duties and obligations, in an organisation which has rules which identify in whom control of it and its funds rests and on what terms and which can be joined or left at will: Conservative and Unionist Central Office v Burrell
Examples include small sporting football clubs, trade bodies and charities. Adoption of the rules is enough, even implicitly on a clear understanding and without any formality.
Unincorporated associations do not have any legal identity separate from their members, so cannot own property or enter into contracts.
Usually one or more members or committee members enter into a contract on behalf of the unincorporated association, who will be liable for the relevant obligation(s) and/or debt(s) jointly and severally unless liability is expressly limited under the contract to the amount of the association’s funds.
If an unincorporated association is a charity, its property will be held on trust by trustees for its charitable purposes. Otherwise, any property will be held by way of joint tenancy on behalf of its members and subject to the contract between them as to the rules of the association, but they will be contractually restrained from severing their share from the whole. Where the property is land or shares, one more more of the officers of the association will be the legal owners of the property on ‘bare trust’ for the current members, subject to the rules of the association.
General Partnerships – for profit
General partnerships are defined in the Partnership Act 1890 as the “relation which subsists between persons carrying on a business [together for their common benefit] with a view of profit“.
A partner relationship arises from contract which may be either expressly agreed or be inferred from the parties’ conduct. Each time a partner leaves the partnership or a new person joins, legally the old partnership is dissolved and replaced by a new partnership whose partners take on the assets and liabilities of the old firm and continue its business.
In determining whether a partnership has been created, a court will look at the substance of the parties’ agreement, rather than any attempt to declare whether or not the arrangement is a “partnership”, and consider whether key features are present:
- sharing the profits/losses of the business;
- correspondence in the name of the partnership;
- mutual agency of the partners;
- joint bank account, contributions to common assets/capital;
- tax returns;
- non-assignability of the partnership rights/obligations; and
- a relation of mutual trust and confidence between the partners.
Like unincorporated associations, general partnerships in England and Wales do not have legal personality separate from the partners who constitute them, again meaning that they cannot enter contracts, own, or grant security over, assets. Any property is normally held in the names of individual partners as trustees for the partnership. Rights and liabilities of the partnership are actually rights and liabilities of each of the partners either against third parties or each other. However, actions can be brought by or against partners in the name of the partnership.
The Commission notes that some DAOs intentionally use a variety of structuring elements explicitly to ensure that the above features are not present.
In these circumstances, it may be unfair or inappropriate to impose personal liability on token holders and other participants when they have gone to considerable lengths to negate a partnership. Conversely, it may undermine partnership law to extend it to cover DAO scenarios explicitly chosen to organise in ways that are intended to avoid such a relationship.
An Unincorporated Association or a General Partnership?
Of course, if a DAO were an unincorporated association or general partnership awkward questions would arise as to whether and how liability can and should be attributed between different types of participants. There may also be challenges to opting for other structures to avoid such issues.
Trust Structures
A trust arises where one person (the settlor) transfers property to another person (the trustee) to hold for some other person (the beneficiary). This separates the management of property from the benefits arising from it. A trust can be created informally, including an oral declaration in respect of property (other than land), so long as there is certainty of intention, the subject matter and the object of trust.
Joint Ownership of Assets
Legal title to property can be held by two or more persons, either as a joint tenancy (where each person jointly with the others holds title to the entire property), or as a tenancy in common (where each person owns a specified portion). A joint tenancy will arise where there are no indications of an intention to sever the interest in the property, and there is:
- unity of possession (each tenant is equally entitles to possession of any part of the property);
- unity of interest (the interest of each tenant is of the same extent, nature and duration as that of the others);
- unity of title (each tenant holds under the same document or act); and
- unity of time (the interests all vest at the same time).
A tenancy in common will arise where: there is an indication of an intention to sever in the grant of property; an equitable presumption applies, or there is subsequent severance.
A DAO might be viewed partly as the participants jointly holding property but with extra arrangements for its purpose and how it should be managed etc.
Collective Investment scheme (CIS)
While the Law Commission has not referred to CISs in this context, it is a concept relevant to the formation of DAOs that may own property or for investment purposes. Establishing, operating or winding up a CIS is specified as an activity that is prohibited without authorisation by the Financial Conduct Authority (“FCA”). Other specified activities also apply in respect of units in a CIS; and there are severe restrictions on the ability for even authorised persons to promote an unregulated CIS.
A CIS is generally defined in the Financial Services and Markets Act 2000 as:
“any arrangements with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangements (whether by becoming owners of the property or any part of it or otherwise) to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income”.
However, other conditions mean that a CIS essentially has three elements:
- the arrangements with respect to property have the purpose of enabling persons taking part (investors) to participate in, or receive profits arising from, their acquisition and disposal of the property;
- investors have no day-to-day control over management of the property;
- pooled contributions and profits/income which are managed by the operator as a whole.
There is no restriction on the type of underlying property and arrangements that may constitute a CIS even if the underlying property would not itself be an investment regulated by FSMA (for example, real property). The UK courts are prepared to find that cryptoassets constitute “property” (also the subject of a Law Commission consultation I have reviewed for SCL).
The arrangements may involve a contract and may even include an understanding or a course of conduct. It is not necessary for all of the investors to have the same understanding of the arrangement or all to be a party to the arrangement. An “arrangement” may exist even if the representations were fraudulent and there was no intention to honour them.
Knowledge is not required as an element of the offence. If the three elements are proved, the scheme amounts to a CIS. It is not necessary for the prosecution to prove that the defendants knew that it amounts to a CIS or that arrangements were being made.
Although the definition of a CIS in FSMA is very wide, there are many exclusions from it which might apply in certain DAO contexts, though none precisely on point.
Consequences of being a CIS
If arrangements constitute a CIS the following consequences arise:
- It is a criminal offence to carry on a regulated activity in the UK, or purport to do so, unless a person is authorised or exempt. The maximum sentence is two years’ imprisonment. The court must also impose a victim surcharge. Any proceeds from it will be the proceeds of crime, which can also result in the operator being convicted of money laundering, which also carries a prison term in itself.
- It is a defence for a defendant to show on the balance of probabilities that he took all reasonable precautions and exercised all due diligence to avoid committing the offence.
- An agreement by an unauthorised person in the course of carrying on a regulated activity is unenforceable and entitles the other party to recover money or property transferred or compensation for loss.
- The court has power to allow the agreement to be enforced if satisfied that it is just and equitable in the circumstances of the case.
- The court to require persons who have contravened the Act, or been knowingly concerned in a contravention, to make appropriate restitution to investors who have suffered loss.
- Where a CIS is established outside the UK, generally any gain accruing to a UK tax resident investor on the disposal of its units will be taxed as income and not as capital gain.
Accordingly, there is more risk in creating and operating a DAO than traditional structures, including the risk of simply choosing the ‘wrong’ structure or misunderstanding the rights, obligations and the risks/liability involved. In these circumstances, specific recognition of DAOs could be a source of competitive advantage against other jurisdictions (assuming bad actors can be kept at bay); and may also help protect participants who inadvertently take on personal liability when acquiring or receiving DAO tokens or tokens that qualify for participation in a DAO in circumstances where that DAO is characterised as an unincorporated association or general partnership, for example.
DAOs and Centralising Structures
To avoid some of the problems described above, DAO participants might opt for one or more centralised structures, at least for certain elements of DAO activity such as: employing staff; holding certain assets (e.g. land); raising capital, particularly through public offerings of securities (including security tokens); and obtaining regulatory licences or authorisations that require such a structure and local ‘head office’ (though declaring full ownership and control would appear problematic). The Commission notes that such structures primarily include the following in England & Wales:
- private companies limited by shares;
- private companies limited by guarantee;
- public companies limited by shares;
- unlimited companies;
- community interest companies;
- limited partnerships (LPs);
- private fund limited partnerships (PFLPs);
- limited liability partnerships (LLPs);
- charitable incorporated organisations (CIOs); and
- registered societies (co-operative societies and community benefit societies).
There are also the concepts of a “corporation sole” and “unregistered companies” which may be relevant in some DAO scenarios.
Requirements for Body Corporates
Forming a body corporate requires an act of incorporation, the nature of which varies depending on the type. Most have a distinct legal identity separate from their members (but not all afford their members limited liability), along with legal restrictions, obligations and liability associated with the type of structure and being a director or officer. There may also be ongoing corporate governance and disclosure, requirements such as:
- a registered office/address, the names and addresses of directors and revealing who has ‘significant control’;
- filing audited/unaudited annual accounts according to generally accepted accounting standards;
- reporting and corporate governance statements.
Legal Forms used by DAOs in other Jurisdictions
Some jurisdictions have created legal forms for DAOs, while others have legal forms that have attracted DAOs. Yet none appears to fully satisfy public policy and/or the requirements of DAO participants. For instance:
- Ownerless foundation companies (e.g. Cayman Islands, Panama and Switzerland): have separate legal status; can be structured to have no shareholders, overseen by a supervisor or supervisory authority who has no ownership of, or economic entitlement to, the foundation itself. Directors act accordingly to the best interests of the DAO and/or on the votes of DAO token holders.
- Special purpose trust (e.g. Cayman Islands or Guernsey): the DAO’s founders or token holders can transfer assets to trustees of the special purpose trust, but there are no beneficiaries. Trustees manage the assets in accordance with the specified purpose set out in the trust agreement and their fiduciary duty to act in the best interests of the trust, so DAO founders or token holders can design the trust agreement to serve the interests of the DAO, including right to direct/remove trustees and transfer the assets to a different entity. An enforcer must be appointed to monitor the trustees and take action against them. There are no registration, filing or reporting obligations; but they do not have separate legal personality.
- Vermont allows for Blockchain-based Limited Liability Company (BBLLC) “for the purpose of operating a business that utilizes blockchain technology for a material portion of its business activities”.
- Wyoming has enacted a supplementary act to enable DAOs to register as a “DAO LLC”.
- The Marshall Islands enables a DAO to register as a non-profit limited liability company (LLC).
- Tennessee has amended its corporation code to provide for “decentralised organisations”.
Given the shortcomings of each of these options, it seems likely that DAOs formed in or subject to the jurisdiction of England & Wales would choose from existing structures for certain purposes; and any overarching new type of entity catering specifically for local DAOs would likely have obligations similar to all of some of the existing structures where the DAO has features or risks that align with the purpose, intent or benefit of the requirements applicable to those existing structure(s). Hence, the Law Commission is interested in how such requirements could be tailored to DAOs.
Developer Liability
The courts of England and Wales have begun to consider whether (and if so, how) developers might owe fiduciary duties and duties of care to users of DLT protocols and blockchain systems.
The Commission cites Tulip Trading v Bitcoin Association for BSV [2022] EWHC 667 (Ch), where the claimant alleged that it had entrusted the care of its bitcoin and other crypto-tokens to the developers of the Bitcoin software protocol; that those developers exercised “complete power over the system” through which such tokens were held; and were legally obliged to develop and issue software updates to facilitate the recovery of any tokens to which the claimant had lost access. A lower court rejected the proposition in deciding the preliminary issue of whether it had jurisdiction, but this was reversed on appeal given the importance of legal clarity in this respect, paving the way for service on the defendants and a full trial:
“The issue as to whether developers owe duties of care and/or fiduciary duties to the owners of digital assets and if so, what is the nature and scope of those duties is one of considerable importance and is rightly characterised as a matter of some complexity and difficulty… Lady Justice Andrews in Tulip Trading Ltd. v. Van Der Laan and others, claim number CA-2022-001050.
It should also be noted that the trial judge had already observed that:
“…it might be arguable that, when making software changes, developers assume some level of responsibility to ensure that they take reasonable care not to harm the interests of users, for example by introducing a malicious software bug or doing something else that compromised the security of the Network. Further, if the [developers] do control the Networks as [Tulip Trading Limited] alleges, it is conceivable that some duty might be imposed to address bugs or other defects that arise in the course of operation of the system and which threaten that operation.”
The outcome is likely to differ depending on factors such as the nature of the protocol, network, blockchain system, smart contract and/or token in question, and their respective levels of decentralisation; the terms of any licence(s); the developers’ practical and legal control over core functionalities; and whether there has been damage or loss to objects of property rights like crypto-tokens, or purely economic loss.
Legal Status of Smart Legal Contracts
Smart contracts may be purely operational but may also define and perform the obligations of a legally binding contract. The distinction is whether they merely perform executory obligations of legal agreements without the express intention of being a function of, or creating, any legal obligation; or go further. Contracts may arise from conduct, but a transaction conducted purely by code among computers would seem unlikely to be intended to give rise to contractual relations on its own.
However, an open-source smart contract could be interacted with anyone publicly who may have that intent, raising the question whether the result would be a smart legal contract as between the user and a DAO or the DAO protocol (or indeed the smart contract itself, if it were to have some form of legal personality in its own right – a concept that the Law Commission also wishes to explore).
Privacy
The Commission is also interested in how the privacy of participants can be protected where organisational structures and market systems rely on open-source code, public trading and accessibility.
How the Constituent Elements of a DAO Interrelate
Given that DAOs may separate their elements into centralised and decentralised components, it is more important to establish the nature of the relationship between, say, the holders of DAO tokens and other users of blockchain protocols and systems to which they are deployed; as well as between developers of either private or open source code and the users of DAO protocols and the blockchain protocols/systems to which they are deployed.
Practicalities of Operating a DAO
The various components of a DAO’s organisational structure raise a wide variety of potential decision-making processes, disputes and means of dispute resolution.
Some of a DAO’s decision-making might be undertaken automatically, programmatically or deterministically through the use of smart contracts or the operation of DAO protocols; some by developers or employees; and some by token-holders exercising their right to vote.
Disputes could arise where, for example, participants disagree politically or are consistently outvoted, or not consulted when decisions are made due to concentration of governance or types/amount of tokens held; or decisions are more slowly than required or not at all due to low voter participation. Such issues and/or lack of certainty on how they would be resolved might deter participation.
Where a DAO has defined legal status and/or adopts exiting types of legal entities, those forms are likely to have clear methods of managing disputes among participants, such as the rules of an unincorporated association, partnership agreement or a shareholder agreement.
Equally, the DAO protocols could specify alternative forms of dispute resolution, such as international arbitration.
Anti-Money Laundering
UK money laundering regulation requires ‘relevant persons’ to carry out certain activities, including due diligence on customers, transaction monitoring and reporting suspicious activity. Such a person includes a “cryptoasset exchange provider” and “custodian wallet provider” as well as a “trust or company service provider” doing business in the UK:
“…a firm or sole practitioner who by way of business provides any of the following services to other persons, when that firm or practitioner is providing such services –
(a) forming companies or other legal persons;
(b) acting, or arranging for another person to act –
(i) as a director or secretary of a company;
(ii) as a partner of a partnership; or
(iii) in a similar capacity in relation to other legal persons;
(c) providing a registered office, business address, correspondence or administrative address or other related services for a company, partnership or any other legal person or legal arrangement;
(d) acting, or arranging for another person to act, as –
(i) a trustee of an express trust or similar legal arrangement; or
(ii) a nominee shareholder for a person other than a company whose securities are listed on a regulated market.
Cryptoasset exchange or custodian wallet providers doing business in or from the UK therefore have a number of anti-money laundering obligations, including: (a) successfully registering with the FCA prior to starting business; (b) carrying out risk assessments; (c) putting in place policies, controls and procedures to mitigate and manage money-laundering risks; and (d) accompanying certain cross-border cryptoasset transfers with specified information about the originator and recipient.
Trust or company service providers must register with HMRC (unless they are already authorised by the FCA, in which case they must notify the FCA of their activities). This is generally a lighter form of registration than required by the FCA.
It is conceivable that a DAO itself might fall within the scope of cryptoasset exchange or custodian wallet activity; and that those facilitating the creation of a DAO might be operating as a trust or company service provider. Legislative clarity on these issues will be desirable.
1 https://www.lawcom.gov.uk/project/decentralised-autonomous-organisations-daos/
Simon Deane-Johns, Consultant Solicitor Keystone Law and a Fellow of the SCL
