DAOs and Compliance: The Importance of Legal Wrappers

@atambobby

Web3 Writer

Credibility

Decentralized autonomous organizations, or DAOs, hold immense potential to redefine collaboration and wealth distribution, ushering in a new era of equitable participation. By reshaping traditional hierarchical structures and aligning rewards with contribution and labor, DAOs enable token holders to actively shape the organization’s direction and collectively achieve meaningful outcomes.

However, alongside these transformative benefits, DAOs face a multitude of legal challenges. Regulatory uncertainties, liability risks, tax compliance, and contractual enforceability pose significant obstacles on their path to mainstream acceptance. To ensure compliance with existing laws while preserving their decentralized ethos, DAOs must adopt legal wrappers.

The OOKI DAO vs CFTC case on September 22, 2022, serves as a stark reminder that DAOs are not exempt from laws and regulations. The case demonstrated that DAOs must operate within the legal framework and comply with regulatory requirements to avoid legal repercussions. Failure to do so can not only harm the DAO’s operations and reputation but also expose contributors and token holders to legal implications.

The CFTC’s order against OOKI DAO highlights the fact that regulators can penetrate the legal status, declared or undeclared, of DAOs, holding responsible individuals liable. Also, token holders in DAOs lacking legal status may face serious personal liabilities.

In light of these challenges, this article provides answers to questions like:

• Why do DAOs need legal wrappers?
• What are the best entities and countries for DAO incorporation?
• How to choose the most suitable legal wrapper for a DAO?

By exploring DAO legal wrappers, understanding their importance, and employing seasoned legal counsel steps to adopt the best fit for any DAO, DAOs can bolster their compliance efforts, safeguard their operations, and build stronger relationships with regulators, ultimately paving the way for their broader adoption and long-term success.

Content Overview

• Why do DAOs Need A Legal Wrapper?
• Types of Legal Wrappers
• Legal Wrappers in the United States
• Legal Wrappers in International Countries
• How to Choose a Suitable Legal Wrapper

Why Do DAOs Need A Legal Wrapper?

Generally, a legal wrapper is a legal entity or framework that encapsulates an organization and its operations, providing a defined interface between the organization and its legal and regulatory environment. They serve as a crucial tool to enable DAOs to operate in the real world while safeguarding their members from potential legal complications.

By adopting legal wrappers, DAOs can effectively address the following key aspects of their operations:

• Interacting with other parties: DAOs require corporate personhood, which is attained through a legal wrapper, in order to sign contracts and enter into agreements.

• Liability protection for contributors: If a DAO is not incorporated, it may be treated as a general partnership, making all contributors liable in the event of a lawsuit or legal issue.

• Hiring employees: To legitimately hire employees or contractors, a DAO needs a legal wrapper. Engaging in off-the-books arrangements would be considered tax evasion, which is not advisable.

• Tax compliance: DAOs must fulfill their tax obligations to ensure legal compliance. It is important to consider the tax implications associated with any financial transactions within a DAO.

• Legal protection and compliance for digital assets: Legal wrappers offer vital safeguards for DAOs and their digital assets, protecting them from potential attacks or disputes.

Types of Legal Wrappers

DAOs have access to a range of legal wrappers, each offering distinct advantages and considerations in different jurisdictions. They are:

Legal Wrappers in the United States

Wyoming LLCs

Wyoming implemented a groundbreaking legal framework, enabling the establishment of Decentralized Autonomous Organizations (DAOs) as Limited Liability Companies (LLCs) with enhanced legal protection. This significant development, as highlighted by Rodrigo Sierra and Chris Bummer, introduces a governance structure that is notably more permissive compared to traditional corporations. Also, any individual, regardless of affiliation with the DAO, can establish a DAO LLC in Wyoming by filing a certification of formation with the state’s secretary.

Any organization looking to establish itself as a DAO LLC in Wyoming must provide articles of organization meeting specific criteria outlined in the Wyoming Decentralized Autonomous Organization Supplement.

Attributes of Wyoming LLCs

• Wyoming legislature grants a default waiver of fiduciary duty among DAO LLC members, and the DAO unless explicitly stated otherwise in the articles of organization.
• A DAO LLC cannot be manager-managed.
• The articles of organization for a DAO LLC must explicitly incorporate the terms DAO, DAO LLC, or LAO (which stands for “Limited Autonomous Organization”) in the name.

Unincorporated Non-Profit Associations (UNAs)

The UNA entity structure is available across numerous states in the US for DAO adoption, although the specific regulations may vary depending on whether the state has fully or partially adopted the Uniform Unincorporated Nonprofit Association Act (UUNAA).

A UNA can engage in for-profit activities and distribute funds in some states that have adopted the UUNAA as long as these actions contribute to furthering the organization’s nonprofit goals. However, it is crucial to recognize that such activities can impact the UNA’s eligibility for tax-exempt status under Section 501(c)(3) of the tax code.

Attributes of UNAs

• UNAs are uncomplicated and time-efficient in formal requirements.

• Although the rules vary across states, UNAs are typically not required to make any state filing in order to form and can arise from an oral agreement between participants.

• In certain states, UNAs provide a separate legal identity and limited liability for their members.

• There’s less certainty with UNAs as their governing statutes vary across jurisdictions and are untested by courts.

Tennessee Decentralized Organization LLC

Tennessee introduced legislation that allows DAOs to register as Limited Liability Companies (LLCs) within the state. This statute provides members of DAO LLCs with limited liability protections, akin to those extended to traditional LLCs, safeguarding their personal assets. To register as an LLC, a DAO must submit articles of organization that meet requirements similar to those mandated for DAOs intending to register in Wyoming.

There are notable differences between Tennessee and Wyoming regarding the laws governing DAO LLCs. Firstly, the Tennessee statute specifies that a quorum of 50% is necessary for a valid vote. Secondly, unlike Wyoming’s law, Tennessee requires organizations to choose between a “member-managed” and “smart contract-managed” structure. However, in practice, DAOs often incorporate elements of both approaches and are rarely exclusively “member-managed” or solely “smart-contract-managed.”

Utah Limited Liability DAOs (LLDs) (Utah DAO Act)

The Utah State Legislation passed the Utah DAO Act, granting DAOs legal recognition and limited liability protections. This legislation, resulting from collaboration between the Digital Innovation Taskforce and the Utah Blockchain Legislature, establishes ownership guidelines, protects DAO-compliant anonymity through bylaws, and introduces quality assurance DAO protocols.

This new law provides legal recognition and limited liability to DAOs, legally framing them as “Utah LLDs.“. It emphasizes ownership guidelines, and anonymity protection, and introduces quality assurance protocols.

Attributes of Utah LLDs

• Utah LLDs may offer liability protection to its members, shielding them from personal liability for the entity’s debts and obligations.

• It defines ownership of DAOs and protects DAO-compliant anonymity through bylaw.

• The legislation established a nuanced tax arrangement as mentioned in Section 48–5–406 of the Bill.

Vermont Blockchain-based Limited Liability Company (BBLLC)

In 2018, Vermont introduced an LLC legislation that can be utilized by organizations using blockchain technology for a significant part of their operations, including DAOs, although the term “DAO’’ is not explicitly mentioned. To register as a Blockchain-Based Limited Liability Company (BBLLC), an organization must include relevant details in its operating agreement, such as its purpose, voting requirements, the intended use of blockchain technology, and the rights of members.

By providing a framework that allows for the incorporation of blockchain-based activities, the state encourages innovation and creates a supportive environment for DAOs to operate effectively. Furthermore, the legislation permits participants in a DAO to assume various roles, such as managers and developers, as long as they adhere to the fiduciary duties outlined in Vermont’s LLC laws.

Colorado Limited Cooperative Association (LCA)

An LCA (Limited Cooperative Association) is a unique entity that combines aspects of both cooperatives and corporations. It offers a flexible capital model and governance structure. Within an LCA, members can assume the roles of investors or patrons, with each having the right to vote and a share of the revenues. The voting system can be based on the “one member, one vote” principle or on patronage or equity considerations.

To establish an LCA, at least two organizers, who must be patron members, are required to file articles of organization with the Secretary of State. The LCA’s separate legal personhood ensures limited liability for its members, providing a layer of protection.

Catawba Digital Economic Zone

The Catawba Digital Economic Zone (CDEZ) has enacted regulations enabling DAOs to register as either Limited Liability Companies (similar to Wyoming DAO LLC law) or unincorporated nonprofit associations. The regulations, akin to those in other states, mandate the issuance of a certificate of organization by DAOs, which includes stating their DAO status, disclosing member rights distinctions from traditional LLCs, and providing information on voting rights, member duties, and amendment procedures.

Also, organizations may offer an operating agreement as a supplement to the smart contract, governing principles, and certificate of organization.

Legal Wrappers in International Countries

These legal wrappers are internationally recognized structures that have been and are being adopted in other jurisdictions outside the US.

They include:

Coalition of Automated Legal Applications (COALA)

COALA has developed a DAO Model Law with the aim of reducing legal uncertainty and fostering the growth of DAOs. A major advantage of the Law is that it will provide uniformity, a model set of rules that could be implemented internationally, and legal certainty to DAOs and their members worldwide.

This Law, having 6 chapters addresses the kinds of activities DAOs can engage in, the requirements DAOs need to comply with in order to restrict the liability of its members, and the circumstances (fraud or failure to comply with regulations) that could lead to personal liability for members in chapters 1 to 4.

Chapter 5 addresses the unique features of DAOs and their legal implications. For example, what will happen in cases of a hard fork? Chapter 6 looks at the tax regime the Model Law seeks to implement.

Marshall Islands (Non-Profits & LLCs)

In a significant development, the Republic of Marshall Islands, an independent island state located in the Pacific Ocean officially enacted the Decentralized Autonomous Organizations Act by the end of 2022. This pioneering legislation enables DAOs to establish themselves as Limited Liability Companies (LLCs), provided they self-identify as a DAO LLC.

In the Act, both for-profit and nonprofit DAOs are permitted, as well as definitions and regulations for DAO formation, agreements, and smart contracts. Also, it explicitly recognizes DAO voting and tokenization as integral processes within the framework of the Act, further solidifying their legitimacy and importance.

The Cayman Foundation Company in the Cayman Islands

The Cayman Foundation Company of the Cayman Islands is an appealing choice for DAOs due to its flexible governance structure, and ability to function as both a trust and a corporation. Similar to a corporation, a legal wrapper allows the Foundation to operate as a distinct legal entity with limited liability for its members.

As well as providing definitions and regulations for the formation, agreements, and use of smart contracts, the Act accommodates both for-profit and nonprofit DAOs.ecisions in DAO must be made by the community.

Ownerless Foundations in the Bahamas, Panama, & Gibraltar

States like the Bahamas, Panama, and Gibraltar are international jurisdictions that provide DAOs with the option to establish ownerless foundations. These foundations operate under the guidance of a board of trustees or governors who hold a fiduciary obligation towards the foundation itself, rather than shareholders or DAO members.

Ownerless Foundations are appealing because of their structural adaptability and the associated limited liability. Nonetheless, setting this type of foundation can be both costly and complicated.

Swiss Foundations in Switzerland

Switzerland has not yet introduced specific legislation tailored for DAOs, but it remains a popular choice for DAOs to establish themselves as Swiss Foundations.

When setting up a foundation in Switzerland, it is essential for the organization to clearly define its purpose, governing bodies, and administrative procedures in its charter. These factors will determine the regulatory authority overseeing the foundation.

Swiss foundations possess their own legal identity, thus providing a limitation on personal liability. They also enable DAO members to exercise the rights granted to them through smart contracts and the organization’s charter. For instance, members of a DAO may have the right to participate in voting processes, with their decisions being implemented by a governing body established by the DAO foundation.

Private Trust Company In Liechtenstein

Liechtenstein has emerged as a favorable destination for blockchain projects. The country enacted the Token and Trusted Technology Service Provider Act for transparency in the registration requirements and liabilities for token providers. This legislation also provides clear definitions for various types of tokens and the associated rights they confer.

Although there is no specific legislation governing entity formation for DAOs, a DAO can choose to establish itself as a Private Trust Company (PTC). The PTC structure offers flexibility, allowing organizations to adopt either a corporation-like or a foundation-like model.

It’s noteworthy that a PTC can assume control over assets without incurring fiduciary duties, thus limiting member liability strictly to the assets held by the PTC.

How To Choose a Suitable Legal Wrapper

To choose a suitable legal wrapper, DAOs must carefully consider their structure, activities, and the advantages and disadvantages of establishing any of the above formal legal frameworks. This decision holds significant importance and should be guided by a clear and structured process informed and guided by experienced legal counsel.

When choosing a legal wrapper, the following factors should be carefully considered:

1. DAO’s mission and vision: Aligning the legal strategy with the DAO’s overarching goals is crucial for long-term success. The chosen legal wrapper should support and enable the DAO to fulfill its mission effectively.

2. Best suitable wrapper type: Considering the variety of legal wrappers available, DAOs should evaluate and choose the type that best suits their purpose, community, composition, and other relevant characteristics. Both traditional and bespoke wrappers should be considered in this evaluation.

3. Drafting legal documents: Thoroughly drafting legal documents that clearly define the rights, responsibilities, and governance structure of the DAO is vital. This should be done with the aid of an experienced legal counsel to ensure accuracy and compliance.

4. Registering the wrapper entity: Compliance with relevant registration requirements is necessary to establish the legal wrapper entity. DAOs should carefully navigate the registration process in accordance with the laws and regulations of their specific jurisdiction.

5. Integrating the wrapper with smart contracts: Seamlessly integrating the legal wrapper with the DAO’s smart contracts is crucial for maintaining operational efficiency and compliance.

6. Maintaining compliance: The legal wrapper’s ongoing compliance with applicable laws and regulations is paramount. DAOs must stay abreast of legal developments and adapt their compliance efforts accordingly.

It is worth noting that while legal structures offer operational advantages and legal protections, they also come with associated costs. Therefore, DAOs should carefully evaluate the benefits and drawbacks of each legal wrapper option in relation to their unique circumstances.

By following a well-informed and diligent approach, DAOs can navigate the regulatory maze, establish appropriate legal frameworks, and empower themselves with compliance and legal protection in an ever-evolving regulatory environment.