DeFi and the DAO: How the Law Needs to Change to Accommodate Decentralized Autonomous Organizations

14 December 2021 Foley Launch Blog
Authors: Louis Lehot Patrick D. Daugherty

Originally published in LegalTech News on December 14, 2021.  Reprinted with permission.

As financial markets wrap up the year 2021 and launch into 2022 at warp speed, the “DeFi” world has a new star called the “DAO.”

Decentralized finance, short-handed as “DeFi”, refers to peer-to-peer finance enabled by Ethereum, Avalanche, Solana, Cardano and other Layer-1 blockchain protocols, as distinguished from centralized finance (CeFi) or traditional finance (TradFi), in which buyers and sellers, payment transmitters and receivers, rely upon trusted intermediaries such as banks, brokers, custodians and clearing firms.

DeFi app users “self-custody” their assets in their wallets, where they are protected by their private keys. By eliminating the need for trusted intermediaries, DeFi apps dramatically increase the speed and lower the cost of financial transactions. Because open-source blockchain blocks are visible to all, DeFi also enhances the transparency of transactions and resulting asset and liability positions.

Although the proliferation of non-fungible tokens, or NFTs, may have gathered more headlines in 2021, crypto assets have become a legitimate, mainstream and extraordinarily profitable asset class since they were invented a mere 11 years ago. The Ethereum blockchain and its digitally native token, Ether, was the wellspring for DeFi because Ether could be used as “gas” to run Layer-2 apps built to run on top of Ethereum. Since then, Avalanche, Solana and Cardano, among other proof-of-stake protocols, have launched on mainnet, providing the gas and the foundation for breathtaking app development which is limited only by the creativity and industry of development teams.

DeFi apps require “DAOs,” or Decentralized Autonomous Organizations, to operate. DAOs manage DeFi apps through the individual decisions made by decentralized validator nodes who own or possess tokens sufficient in amount to approve blocks. Unlike joint stock companies, corporations, limited partnerships and limited liability companies, however, DAOs have no code (although, ironically, they are creatures of code). In other words, there is no “Model DAO Act” the way there is a “Model Business Corporation Act.” DAOs are “teal organizations” within the business organization scheme theorized by Frederic Lalou in his 2014 book, “Reinventing Organizations.” They are fundamentally unprecedented in law.

Just as NFTs have been a game changer for creators, artists and athletes, our legal system will need to evolve to account for the creation of the DAOs that govern NFTs and other crypto assets. (NFTs are a species of crypto asset.) Adapting our legal system to account for DAOs represents the next wave of possibility for more numerous and extensive community efforts.

A DAO is fundamentally communitarian in orientation. The group of individuals is typically bound by a charter or bylaws encoded on the blockchain, subject to amendments if, as and when approved by a majority (or some other portion) of the validator nodes. Some DAOs are governed less formally than that.

The vast majority of Blockchain networks and smart contract-based apps are organized as DAOs. Blockchain networks can use a variety of validation mechanisms. Smart contract apps have governance protocols built into the code. These governance protocols are hard-wired into the smart contracts like the rails for payments to occur, fully automated, and at scale.

In a DAO, there is no centralized authority—no CEO, no CFO, no board of directors, nor are there stockholders to obey or serve. Instead, community members submit proposals to the group, and each node can vote on each proposal. Those proposals supported by the majority (or other prescribed portion) of the nodes are adopted and enforced by the rules coded into the smart contract. Smart contracts are therefore the foundation of a DAO, laying out the rules and executing the agreed-upon decisions.

There are numerous benefits to a DAO, including the fact that they are autonomous, do not require leadership, provide objective clarity and predictability, as everything is governed by the smart contract. And again, any changes to this must be voted on by the group, which rarely occurs in practice. DAOs also are very transparent, with everything documented and allowing auditing of voting, proposals and even the code. DAO participants have an incentive to participate in the community so as to exert some influence over decisions that will govern the success of the project. In doing so, however, no node participating as part of a decentralized community would be relying upon the managerial or entrepreneurial efforts of others in the SEC v. Howey sense of that expression. Neither would other nodes be relying upon the subject node. Rather, all would be relying upon each other, with no one and no organized group determining the outcome, assuming (as noted) that the network is decentralized. Voting participants in DAOs do need to own or possess voting nodes, if not tokens.

As with NFTs, there are limitless possibilities for DAOs. We are seeing a rise in DAOs designed to make significant purchases and to collect NFTs and other assets. For example, PleasrDAO, organized over Twitter, recently purchased the only copy of the Wu-Tang Clan’s album “Once Upon a Time in Shaolin” for $4 million. This same group has also amassed a portfolio of rare collectibles and assets such as the original “Doge” meme NFT.

In addition to DAOs that are created as collective investment groups, there are DAOs designed to support social and community groups, as well as those that are established to manage open-source blockchain projects.

As is true with any emerging technology, there is currently not much regulation or oversight surrounding DAOs. This lack of regulation does make a DAO much simpler to start than a more traditional business model. But as they continue to gain in popularity, there will need to be more law written about them. The state of Wyoming, which was first to codify the rules for limited liability companies, recently codified rules for DAOs domiciled in that state. So a DAO can be organized as such under the laws of the State of Wyoming. No other state enables this yet.

DAOs are a path-breaking form of business “organization” that are not well understood. They are not corporations. Should they nevertheless file and pay taxes, open bank accounts or sign legal agreements? If so, then who would have the power or duty to do that for a decentralized autonomous organization whose very existence decries the need for officers, directors and shareholders?

What we need are a few workable principles or standards (emphasis on “few” and “workable”) that define the decentralization that is at the core of legitimate DeFi and the consumer use of tokens that are not investment contracts.

Futuristic DAOs are a decentralized break from the centralized past and present of business organization. It’s time for legislation and regulation to follow where the technology is taking us.

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