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DAOs: A note of caution

01 Apr 2022

The cryptocurrency sector tends to follow trends. Once a high-profile project announces something or takes an approach, many others seek a similar model, including new entrants. Some might see this as mania.

The current trend is corporate decentralised autonomous organisation (DAO) structuring. If you’re reading this, you’re already familiar with the concept of a DAO.

Corporate DAO structuring involves establishing corporate vehicles which can perform functions on behalf of or provide services to a DAO. These can include engaging with third party service providers, being the legal entity by which the DAO contracts with the world, disbursing DAO treasury funds or acting as an enforcer vehicle. Project requirements vary - some want to wrap the DAO entirely in a corporate structure and operate through it, others want the corporate structure to be a vehicle entirely separate from the DAO yet capable of acting on instruction from the DAO an ad hoc basis.

Few jurisdictions are equipped to facilitate efficient DAO structuring and those that do offer various solutions. The Cayman Islands is particularly popular as it is one of the few jurisdictions which has the foundation company model, a corporate vehicle which is not required to have members and is therefore “ownerless”, can have non-charitable purposes such as supporting a protocol or DAO, and its constitutional documents can be drafted so that it can take instructions from the DAO through the relevant government mechanism. This makes the foundation company a popular vehicle for corporate DAO structuring as this moves somewhat closer to the philosophical ideal of decentralisation.

This is a novel and fast-developing area in a sector that is currently the focus of heavy regulatory scrutiny amidst an evolving legal and regulatory landscape. There is currently no consensus (ironically given the nature of blockchain) on how to approach or optimise corporate DAO structuring, and little legal, regulatory or judicial consideration or treatment in any jurisdiction. Some of the risks, liabilities and exposure with any corporate DAO structure are known, some are unknown. Therefore there is no guarantee that any structure proposed will survive regulatory or judicial challenge and changes in law and regulation may adversely affect the viability of any structure.

A few important points to consider before engaging service providers to assist in DAO structuring in any jurisdiction:

  • Why do you want a DAO structure?: be very clear as a project as to why you want a DAO structure. Not all DAO operations require a corporate structure, and as noted below a DAO structure (corporate or otherwise) may not fully protect the project or certain stakeholders from liability or legal and regulatory obligations;
  • Plan and be realistic on sequencing and timelines: a DAO corporate structure underpins the entire project. Founders, teams and projects leaders have parallel workstreams and competing demands for their time, with understandable investor and market pressure to move quickly. However, we strongly suggest that corporate structuring is prioritised as one of the first elements of any project inception. Service providers, particularly law firms, need to commit the time, thought and appropriately experienced lawyers to analysing and advising on a project’s DAO structure, which is always bespoke. We and numerous other law firms are already at maximum capacity advising existing clients on DAO structuring. Engaging the right service providers early and being realistic on timing expectations ensures the project meets launch deliverables and timelines and helps manage investor relations;
  • Be very careful copying other projects: we always caution against assuming a consensus just because other participants in the market do or don’t follow a certain approach – their legal structure, advice, risk appetite and roadmap are not always clear. Even if these are known, another project’s approach may not align with your objectives. A high-flying project’s structure may be seen as the example but may also be the subject of regulatory action in future, and if you’ve simply copied their approach without further thought or detailed legal advice and analysis, that potentially makes you a target too;
  • DeFi projects need to be particularly cautious, especially around sanctions: DeFi protocols can (but don’t necessarily) include activities which would ordinarily be subject to registration or licensing under financial services regulation if they were run through a company in the relevant jurisdiction. Subject to the intended structure and functions of corporate DAO structuring, there is a risk that the corporate DAO structure may be challenged as seeking to evade regulatory obligations or be deemed to be the entity subject to some form of registration or licensing even if the entity itself is not directly undertaking those activities.

Further, DeFi projects are strongly recommended to screen wallets and users against sanctions, PEP and other relevant databases. Breaching sanctions laws can carry criminal and civil penalties, the latter on a “strict liability” basis in some jurisdictions (ie if it happens, a fine is levied and there is no defence). Should this occur, we would not be surprised if authorities look straight to the identifiable humans behind all layers of a corporate DAO structure (whether directors or trustees) for enforcement action. There will always be at least one identifiable human. There are free tools available for sanctions screening for DeFi projects and the arguments that “it’s non-custodial/decentralised” or “our competitors don’t do it” won’t absolve you. In practice, many DeFi protocols are permissioned in some way, such as through requiring KYC or IP blocking and the ability to manually block wallets/users – that’s just the reality of the world we’re in right now Pure decentralised finance is technically possible but practically extremely high risk for certain stakeholders.

Sanctions regimes don’t just apply to DeFi projects, they also apply to DAOs engaging or disbursing funds or grants to sanctioned individuals or entities. Protections should be a key consideration for any DAO project.

There’s no excuse not to screen other than philosophical reasons that won’t protect the structure or certain stakeholders if enforcement action occurs. Competing projects which do not may expose themselves to risk that may be unacceptable for your project and unsustainable in the medium to long term. Further, you may also find some service providers are unwilling to engage with or provide certain services to clients who refuse to undertake even basic sanctions checks on wallets and users for purely philosophical or commercial advantage reasons – the risk to their reputation and regulatory obligations may be too great;

  • Know your exposure: regardless of the jurisdiction and preferred structure, ensure you fully understand the liability exposure your team, DAO participants and those appointed to roles within the structure may face. For example, the directors of a Cayman Islands foundation company are subject to the duties of directors under Cayman Islands law. Further, the Financial Action Task Force states in paragraph 68 of its updated guidance on a risk-based approach to virtual assets and virtual asset service providers: “In cases where a person can purchase governance tokens of a VASP, the VASP should retain the responsibility for satisfying AML/CFT obligations. An individual token holder in such a scenario does not have such responsibility if the holder does not exercise control or sufficient influence over the VASP activities undertaken as a business on behalf of others.” Conversely, if an individual token holder does exercise control or sufficient influence over the activities of the DAO, and that DAO would be a virtual asset service provider if it a legal or natural person, that individual token holder may be deemed responsible by authorities for satisfying AML/CFT obligations that would otherwise be placed on the DAO. Personal exposure is very good at concentrating minds and ensuring considered rather than rushed structuring. Ensure that your legal counsel provide you with a detailed advice note on potential exposure of stakeholders in the corporate DAO structure;
  • Take local advice: do take local advice on the tax implications of a corporate DAO in particular. The most relevant jurisdictions will be those where any existing company that instructs service providers to form the structure is based and where the key principals are located. It’s also important that DAO participants take tax advice on the implications of their participation in a DAO;
  • The DAO structure may be subject to local regulation: if a Cayman foundation company is undertaking activities which make it a “virtual asset service provider” under the Virtual Asset (Service Providers) Act (as revised), it will need to register or be licensed as such with the Cayman Islands Monetary Authority before it can commence those activities and will be subject to obligations under that law. Our note on this topic provides an overview of the virtual asset service provider regime. The same may apply in respect of other financial services regulations, and the position may apply for other structures in other jurisdictions, either now or in the future when virtual asset service provider and other relevant laws and regulations are introduced (and they will be in time);
  • Engage experienced and knowledgeable service providers: DAOs as a concept and their operations are complex enough, and optimal structuring requires careful consideration on a case-by-case basis. Evaluate your proposed service providers to ascertain their depth of knowledge of the sector and experience. Carefully review any proposal or engagement to ensure they understand what you need and are offering services that meet your requirements. Ensure all fees are fully set out for both the initial engagement and on an ongoing basis so that you have a degree of cost certainty. Also communicate realistic expectations around timing so that you and your service providers are aligned.

If you are looking to issue platform or DAO tokens in the US or provide the platform’s services in the US, you absolutely must engage experienced US legal counsel to advise you on the treatment of the token and the obligations of the DAO structure under US law. The SEC is currently particularly active in monitoring and taking enforcement actions in this sector, and you may find some service providers unwilling to be engaged or act unless you have or will instruct US counsel if there is a US nexus to the project.

Considered structuring is essential to the success and longevity of any project. The digital assets sector is very competitive and projects move quickly, but in our view it is important to take the time and allocate the resources to get the structuring right at the outset, as the time, cost and adverse effects on the in project trying to reverse engineer a structure after it is launched could well exceed any cost and time savings rushing this crucial element of the project.

Authors

Matt Taber Harneys front portrait image on a grey background
Marc Piano Harneys front portrait image on a grey background