Legal Construction of DAO - Starting from the Lawsuit Against DAO by US Regulators

Summary

Recently, Ooki DAO has faced a lawsuit, and its members may need to share liability. This situation, while shocking, has long been anticipated by legal experts. DAOs are not outside the law; when legal liabilities arise, having no entity can pose significant risks to members. Many DAOs are seeking to establish more robust legal frameworks, with common choices including limited liability companies, foundations, unincorporated non-profit associations, and special purpose trusts, depending on the nature of their business.

Part One

The U.S. Commodity Futures Trading Commission (CFTC) recently announced an enforcement action against the DeFi protocol bZx. The CFTC alleges that it illegally offered leveraged and margined futures trading, engaging in activities that can only be conducted by registered futures commission merchants, and failed to enforce KYC and other financial regulatory requirements. As a result, the CFTC has filed a lawsuit against bZeroX, LLC and the two founders of the bZx protocol, proposing a settlement fine of $250,000 for each party.

At the same time, the CFTC decided to file a civil lawsuit against the DAO behind bZx, as on August 23 of last year, the bZx team transferred the control of the protocol to bZx DAO (later renamed Ooki DAO) to evade regulation, and promoted this practice in the community as a way to escape oversight. The purpose of the lawsuit includes seeking damages, the return of ill-gotten gains, civil penalties, a ban on trading and registration, and prohibiting other violations of the CEA and CFTC regulatory rules.

This action has sparked criticism from many Web3 practitioners, and there are also disagreements within the CFTC. CFTC Commissioner Summer K. Mersinger publicly expressed her opposition and released a statement on the CFTC's official website. She believes that the actions taken by law enforcement agencies against DAOs and their members are venturing into uncharted legal territory, that this decision lacks a clear legal basis, and that it has not widely sought input.

This article does not delve into whether bZx is in violation or how it might be in violation, but rather focuses on the legal structure of the DAO and the corresponding responsibilities.

The CFTC's action has caused a huge stir in the DAO space, mainly because the DAO members behind the bZx protocol may need to bear legal responsibility directly. Currently, the standard for determining membership is whether one has voted in the DAO, as voting represents an influence on the organization’s operations. While this may seem a bit absurd, countless legal experts have warned that such situations could occur in the past - if a DAO lacks a legal entity, it may be classified as a general partnership when liability needs to be assumed, resulting in all DAO members bearing unlimited joint liability. This is one of the most important reasons why various DAOs are actively pushing for entity registration.

Although most people were aware of this risk before, very few believed that DAO members would actually be held jointly liable. On one hand, most community-type DAOs have not even established basic operations, and they perceive the risks as minimal, thus naturally lacking a strong sense of urgency regarding risk. On the other hand, truly enforcing penalties on DAO members is extremely challenging. Most members of a DAO are anonymous, with only one address. How can they be tracked, and how high are the enforcement costs? Unless a major issue arises that requires FBI intervention, who would go to great lengths to trace thousands of anonymous addresses scattered around the world for a small fine? Even if only the addresses that voted are pursued, generally speaking, after compiling several proposals, there could be hundreds of them. Everyone believes that the law does not hold the masses accountable, and they all feel justified in their actions.

Although this incident has set a dangerous precedent, I personally judge that it is likely to be more of a thunderstorm than a downpour, mainly to deter the operators of DeFi protocols and warn them not to think they can evade responsibility by handing over operational authority to a DAO. It also serves as a reminder to the community not to easily take the blame. The CFTC also mentioned this in its statement, saying "These actions are part of a broader effort by the CFTC to protect U.S. customers in the rapidly evolving decentralized financial environment."

This incident has made everyone more clearly aware of a fact: under the current legal system, DAOs need to, and will be required to, bear corresponding legal responsibilities.

Therefore, for DAOs, forming a more complete organizational legal structure at the right time (the sooner the better) has almost become a necessary option. (Of course, there will definitely be some DAOs that pursue purely crypto-native approaches, rejecting regulation and achieving censorship resistance through various designs. These types of DAOs will certainly exist in the crypto world for a long time, but they may not become the mainstream form.)

Let's review the drawbacks of not registering an entity again. If this is not your first time focusing on this area, you may have seen similar explanations in many places, mainly three points:

1. A non-entity DAO may be recognized as a general partnership, and members may be required to bear unlimited joint liability under certain circumstances. This is exactly the situation that bZx is currently facing.

2. Tax risks, in the absence of an entity, members may be required to assume tax liabilities that do not belong to them under certain circumstances, even if the individual has not received a penny.

3. Activities in the off-chain world are limited, and it can be difficult for entities without a physical presence to interact with traditional entities, such as signing contracts. However, a large number of DAO's operations have already moved off-chain, entering the off-chain world.

Any of the above issues will have a significant impact on the long-term development of the DAO.

Part Two

So if I want to register, where do I register and what type do I register for?

The following lists common solutions for reference:

Limited Liability Company ( LLC )

In the United States, a DAO can be established as a limited liability company (LLC), making it fully compliant with U.S. laws and subsequent tax requirements. In the U.S., limited liability companies can be managed by members without the need for a board of directors, managers, or leaders, which makes LLCs very convenient for DAOs to use. States like Delaware and Wyoming have already explicitly accepted the registration of LLCs in the form of DAOs.

An LLC can be established for profit, and those who choose to register an LLC are mostly investment DAOs. Although there are no clear regulatory guidelines, they mostly require members to be accredited investors and limit the number of members to 99. This way, even if they face regulation in the future, they can ensure compliance to the greatest extent possible.

Some investment groups also register as LLCs but define themselves as investment clubs (Investment Club). This can be seen as a low-tier version of a Venture DAO. This name is not used arbitrarily; the SEC has clear regulations outlining what constitutes an investment club. If an investment collective meets the criteria for an investment club, it may be exempt from SEC regulation. However, every advantage comes with a disadvantage; investment clubs also have a limit of 99 members, and the most troublesome requirement is that all members must actively participate in every investment decision. Even if just one member does not participate in a specific investment matter, it could potentially be deemed a violation by the SEC.

Recently, another organization proposed the concept of sDAO, which will allow the maximum number of members to be increased to 499 under compliance conditions and to make investments in specific categories, but requires all participants to be U.S. citizens. In contrast, LLCs have no nationality restrictions on members. Currently, this plan is still in the verification process, and there are not many details available.

At the beginning of this year, the Marshall Islands revised the Non-Profit Entities Act, allowing any DAO to register as a non-profit limited liability company in the country and enjoy tax exemptions. The law allows registration under the condition that a single individual assumes full responsibility for the entire DAO. This is an offshore version of the U.S. structure but is not subject to U.S. federal law. Although the Marshall version of LLC can operate normal business activities, it cannot allocate income or profits to DAO members, thus it is not suitable for investment-type DAOs.

Overseas Foundation

Compared to registering a DAO as a limited liability company, more are currently choosing to register foundations in different locations around the world. The advantage of a foundation is that it can be "non-entity", which alleviates the legal responsibility of the founding team in case of unexpected situations. Popular onshore locations for foundations include Switzerland and Singapore. They provide good legal protection, but DAOs need to pay taxes on income. Offshore registration locations are mostly the Cayman Islands, British Virgin Islands, and others. Among them, the Cayman Islands is relatively friendly to token issuance, which is also a choice for a considerable number of DAOs at present. The main difference between onshore and offshore is that offshore has tax exemptions. Foundations are managed by a board of directors or a council, which somewhat sacrifices the level of decentralization; however, token holders can guide the actions of the council or board through voting. Foundations have been widely used by blockchain-related organizations before the popularity of DAOs, and people are relatively familiar with this model.

Limited Cooperative Association (LCA)

LCA is a hybrid of traditional cooperatives and limited liability companies ( LLC ), offering greater flexibility than traditional cooperatives, especially in terms of investment. LCA can effectively structure the governance agreement of a DAO and the association's articles of association, allowing for voting governance rights for different types of participants while adhering to cooperative principles. Colorado has a relatively well-developed set of statutes regarding LCA, thus gaining recognition from numerous DAOs.

Unincorporated Nonprofit Association (UNA)

UNA is a new form that everyone has been focusing on exploring over the past year. UNA allows for very flexible member identification, permits anonymity for members, and facilitates easy mobility, which aligns well with the characteristics of existing community-type DAOs. UNA can operate for-profit businesses, but the entire organization must remain non-profit, as there can be no profit distribution. However, UNA is a relatively new practice, and the understanding of UNA varies across different states in the U.S., lacking corresponding case law, which may lead to UNA not being recognized in specific situations, thereby creating risks. In addition, UNA is more suitable for DAOs that rely on key personnel and business activities based in the U.S., and the organization needs to pay taxes in the U.S.

special purpose trust

The form of a special purpose trust generally involves the DAO transferring part or all of its assets to a trustee and entrusting the trustee to conduct business activities through a trust agreement. This not only addresses the issues of offline entities but also allows both DAO members and the trustee to enjoy limited liability protection. One of the main issues in introducing a legal structure to the DAO is that compliance with regulations designed for traditional organizations may undermine the decentralization and freedom of the DAO. In particular, the vast majority of legal structures require government approval to be completed. However, a special purpose trust established under Guernsey law eliminates this issue. It does not require government approval and does not need to maintain reporting. The trust comes into effect when the asset transfer occurs according to the trust agreement. However, the application scenarios of special purpose trusts mainly represent committees or SubDAOs within the DAO to conduct specific business, and wrapping the entire DAO into a trust structure is still to be explored.

All the solutions discussed above address the initial three problems. However, each has its own characteristics based on this foundation. The legal structure of a DAO often needs to adapt to complex situations in practical design, with factors to consider including the countries and regions of the main participating members, the desired governance structure, the degree of decentralization, the main business direction, the scale and sustainability of the DAO's members, token strategies, SubDAO strategies, registration costs, and more.

The legal structure and related practices of DAO are relatively new fields, and there is still no consensus or best practices formed, which require further exploration.