DAO Limitations

In 2020, DAOs are still subject to significant limitations. Such limitation’s origins can be summarized as path dependencies, regulatory uncertainty, lingering suboptimal incentive designs, public policy, as well as market-, economic-, and technical limitations.

For example, a public policy problem would arise if DAOs are used for illicit or otherwise undesirable purposes. The anonymous nature of DAOs opens up the possibility of a DAO being used for undesirable purposes, such as to evade federal regulations, or coordinate social resistance and terrorism.[1] However, the vast majority of blockchain-driven projects are aimed to serve the common good.[2]

Economic problems that may be associated with DAO concepts include the consequences of decentralized decision making and impact on corporate culture. Decision making driven by consensus can cause problems.[3] For example, majority voting may lead voters to compromise the lowest common denominator level amongst the group, resulting in mediocre outcomes.[4] Decentralized business entities may negatively impact corporate culture.[5] On the market side, the efficiency-driven nature of DAOs could create hypercompetitive markets which would benefit consumers, but if DAOs outperform human-run companies, they could not only become monopolies or oligopolies, but could also skirt regulations prohibiting price fixing or collusion.[6]

Technical vulnerabilities of DAOs include cyber security, voting procedure, and voter manipulation.[7] The immutable nature of blockchain ledgers could also make the DAO vulnerable to attacks because it is so difficult to alter the essential construction of the DAO once the system is in operation, should a bug in the code arise.[8]

1. Path Dependencies

The original DAO has a lasting impact on emerging DAO designs. It creates core commonalities and associated path dependencies in futures generations of DAOs. The core common denominator for all DAO token members is the unifying desire to optimize the DAO token value. Accordingly, performance assessment in the DAO structure is based on value optimization not on hierarchical or political processes. On the upside, token holders and contractors work towards a common goal of optimizing the DAO and the token value and non-performance reputational penalties are free from racial or cultural biases and associated implications as the token holders are unlikely to even know each other. Yet, the focus on the value enhancement of fungible tokens can lead to short termism and may ignore ethical and governance issues.

DAO developers are also subject to path dependencies which undermines the evolution of decentralized DAO designs. The communication structures in organizations will invariably influence future designs. While groups of DAO developers certainly influence DAO designs with their collective assumptions about how their intended DAO users will engage with the DAO, the inherent structure and approach of a group of developers building a software solution typically has an even larger impact on DAO design. The collective reasoning process of DAO developers is based largely on their prior experiences with DAO software solutions which form path dependencies. The impact of such path dependencies became apparent in the Ethereum developer community and their attempts at upgrading Ethereum 1.0 to 2.0 in the late 2010s.

2. Regulatory Uncertainty

Regulatory uncertainty is holding back the development of DAOs and the optimization potential of DAOs for digital assets. For example, the original DAO claimed to be a crowdfunding contract and made unregistered offers and sales of DAO tokens in exchange for Ether.[9] However, the SEC began an investigation and determined that, although the DAO claimed to be a crowdfunding contact, it did not meet the SEC’s requirements for a Regulation Crowdfunding exemption because the DAO is neither a broker-dealer nor a funding portal registered with the SEC and the Financial Industry Regulatory Authority.[10] In July 2017, following this investigation, the SEC issued an investigative report stating that virtual coins or tokens may be securities and subject to securities laws, depending on the facts and circumstances including the economic realities of the transaction. The SEC stated that federal securities laws apply to those who offer and sell securities in the United States, regardless of whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless of whether securities are purchased using fiat or virtual currency, regardless of whether they are distributed in certificated form or through distributed Ledger technology. Federal securities laws provide disclosure requirements and regulatory scrutiny aimed at investor protection.[11]

Perhaps the most common and the broadest legal issue associated with DAOs pertains to the selection of an applicable jurisdiction. Jurisdictional issues for DAOs include the government’s ability to enforce relevant regulations and DAO accountability through civil liability.

DAO participants can be held personally liable for the DAO’s liabilities if the DAO is not properly legally formed. DAOs historically did not incorporate or officially create a corresponding legal entity off-chain for their on-chain existence. The lack of legal recognition of DAOs creates uncertainty as to how they would be treated by a court should they be sued. That is, the average DAO participants might not expect to be held liable for liabilities or obligations of the DAO. However, a very serious risk is associated with DAO membership in the sense that if the DAO members do not formalize a structure for their human-created entity, courts are very likely to impose one for the members of the DAO.[12]

It is possible that a DAO can be legally construed as a general partnership or joint venture.[13] Under US law, DAOs are most likely to be treated as partnerships. A partnership is “an association of two or more persons to carry on as co-owners a business for profit.”[14] Such basic action legally forms a partnership, regardless as to whether or not the persons intend to form a partnership.[15] If no legal entity is involved, partnership rules are default rule that apply to all interactions between parties trying to achieve a common goal.[16] No US statute authorizes the creation of a legally distinct entity in the form of a DAO.[17] Many courts and lawyers would describe the relationship between members of a DAO and their investors as the default general partnership which puts every stakeholder of a DAO as liable for any debts or legal actions that the DAO may face.[18] Even not-for-profit DAOs can run into legal gray areas where participants may individually face legal liability for the activity of the organization if a court were to consider them partners should a litigation ensue.[19] The original DAO was arguably a partnership — a public, permission-less community-based, with on-chain governance, and a very specific investment purpose.[20] By interacting with a smart contract, DAO members unite their efforts and resources to achieve a certain goal, which satisfies the legal definition of a simple partnership.[21]

As partners, DAO participants are potentially liable jointly and severally for all debts, obligations, and other liabilities of the partnership.[22] That could mean that any known participants in the DAO may be targets for regulatory enforcement or civil actions.[23] However, some believe that the way in which people come together to fund, participate, and interact with a DAO is significantly different than that of a general partnership.[24] By contrast, a limited liability company is the only party that is liable for debts, obligations, or other liabilities of the company.[25]A member or manager is not personally liable, directly or indirectly, by way of contribution or otherwise, for a debt, obligation or other liability of the company solely by reason of being or acting as a member or manager.[26] In order to form an LLC, a certificate of organization is filed with the Secretary of State.[27]

The application of the legal concept of fiduciary duties is less clear in DAOs. Fiduciary duties may require a fund manager to act in the best interests of their client.[28] In the traditional regulatory infrastructure fiduciary duties often function to overcome the corporate governance problems associated with the separation of ownership and control.[29] However, in a DAO, because of the value-to-effort focus of workflows in the DAO structure, supervision and imposition of legal duties are less clearly applicable. DAO token holders optimize the DAO together according to their individualized value propositions in accordance with their unique skillsets, backgrounds, and training.

Another legal risk associated with DAOs pertains to the legal recourse for third parties who contract with a DAO. In lieu of partner liability, it is less clear who a liable party may be in a DAO. Without clearly defined liability rules, third parties and investors in DAOs may have less clearly defined legal recourse.[30] While DAO dispute settlement is relatively predictable on-chain,[31] settlement off-chain is less predictable.[32] Parties may be able to limit remedies to DAO assets through private agreements. But, if the DAO should face a tort suit such an agreement is unlikely to be upheld.[33]

Applying a common legal anchor and traditional jurisdictional principles to cybernetic systems is near impossible because the status of the cybernetic system is constantly changing. Cybernetic systems are constantly changing and less amenable to jurisdictional reach. For example, Ethereum was launched as a foundation[34] in order to have sufficient funds to further promote[35] and propose the genesis block to the community.[36] After it launched, the community had to decide which version of the protocol they desired to adopt and use.[37] Such community choices make the application of jurisdictional principles and a legal anchor governance structure[38] less clear for cybernetic systems. Exacerbating things, cybernetic systems often involve counterparties that do not concurrently exist.[39] Therefore, web interfaces add centralization elements which make a legal anchor more critical because that is what traditional lawyers look for to analyze the system and apply jurisdictional principles.[40] For example, with The DAO, the financial markets authority in Switzerland did not look at the functionality of the smart contract but how the DAO was sold, promoted, and displayed.[41]

The application of securities laws is less clear for DAOs. Traditional organizations are subject to risk and compliance controls around fund withdrawal.[42] Under current laws, DAOs solely governed by smart contracts are restricted in their ability to pool assets and generate profit because securities laws limit their ability to fund ecosystem development and deploy capital efficiently.[43] The SEC published a report finding that the DAO’s tokens were securities, meaning that they were required to register with the SEC and be subject to federal securities regulations.[44] A security (“investment contract”) is defined as “an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”[45] This is a very fact-specific analysis, which requires thorough investigation or discovery in litigation to even determine whether a given token meets the definition of a security.[46] Certain ICOs have since been classified as securities offerings, but in addition to federal securities laws, state law may treat the issuance of tokens differently.[47] In essence, for participants in a DAO, all of these factors combined lead to uncertainty, and potential liability for failing to comply with federal securities regulations, which are designed to protect investors.[48]

3. Suboptimal Incentive Design

Despite the abovementioned seemingly optimized DAO governance structures, lacking decentralized governance solutions affect the application of decentralized systems on multiple levels. Decentralized networks depend on dynamic governance. As blockchains protocols evolve in a given market, they require updates. At the beginning of the 2020s, basic standards for the governance of digital assets were still missing. Efforts to provide more legal certainty through regulatory carve-outs were mostly tentative and lacked sufficient regulatory support or voting majorities in the regulatory agencies. The evolution of the digital asset market necessitates certainty for market participants. Without standards and governance, certainty and the associated market confidence cannot develop.

Chain forks with all their negative effects were still a reality and common practice for blockchain protocol upgrades in the early 2020s. While sometimes forks were merely used to test a process or upgrade, forking was most often used to implement new characteristics for digital asset or to create a fundamental protocol change. The bifurcation of nodes in a given decentralized network can lead to significant economic loss, errors, confusion, and bugs. For example, the bifurcation of network nodes can result in the reemergence of the double spend problem that the previous network had overcome. Users running the pre-fork code consider the post-fork code invalid, they cannot detect the spending on the post-fork code. Correspondingly, cryptocurrencies spent in a post-fork block could be spent again on a pre-fork block. Similarly, fork-related changes in protocol parameters such as the block size or the difficulty of the cryptographic puzzle can result in certain blocks being accepted by the post-fork protocol but rejected by the pre-fork versions of the protocol which may result in the loss of funds. The economic loss associated with such parallel existence can be quite significant. Finally, the fork that created Bitcoin Cash illustrates the risk of contention and the associated social and political turmoil post fork that necessitates blockchain reorganization. Post Bitcoin Cash fork, the Bitcoin community could not agree on the chain that provided the most survivable protocol. As a result of contention, two blockchains, e.g. Bitcoin and Bitcoin Cash compete in perpetuity with the resulting social and economic loss for each chain.

DAO governance lacked proper incentive designs at the beginning of the 2020s. At the beginning of the 2020s, most DAOs utilized centralized forms of master nodes to institute blockchain protocol and DAO upgrades. Human nature and any effective machine derivates of human engagements in institutional form require a duality of incentives in order to overcome attempts of rational and opportunistic internal and external constituents to game the governance design of a given DAO. The duality of incentives consists of a) incentives for actors to improve their own utility, while at the same time b) actors’ actions benefit the entirety of the institution and its constituents for the long run.

DAO designs at the beginning of the 2020s did not effectively master this duality. Moreover, then existing DAO designs did not effectively use non-fungible assets to overcome corruptive elements. When fungible assets are used as the dominant incentive design in the governance of DAOs with identifiable actors, rational and opportunistic internal constituents and external participants will typically attempt to corrupt the governance design of the DAO for their own gain. Similarly, the identity of actors in a DAO governance design creates typically corruptive elements. Merit identifiers other than individual identity remove the most corruptive influences. At the beginning of the 2020s, no then-existing DAO design had effectively conceptualized and applied an anonymous merit identifier with non-fungible decentralized assets.

[1] See, e.g. Kyung Taeck Minn, Towards Enhanced Oversight of “Self-Governing” Decentralized Autonomous Organizations: Case Study of the DAO and Its Shortcomings, 9 N.Y.U. J. of Intell. Prop. & Ent. L. 139, 165–67 (2019).

[2] See, e.g. forthcoming Kaal publication on Blockchain for Good (2021).

[3] William Mougayar, Cut the Consensus: You Can’t Run a Business Like a Blockchain, CoinDesk (Feb. 27, 2020), https://www.coindesk.com/cut-the-consensus-you-cant-run-a-business-like-a-blockchain.

[4] Mougayar, supra note 80; see also Philip Ball, ‘Wisdom of the Crowd’: The Myths and Realities, BBC Future (Jul. 7, 2014), https://www.bbc.com/future/article/20140708-when-crowd-wisdom-goes-wrong.

[5] Carla L. Reyes, If Rockefeller Were a Coder, 87 Geo. Wash. L. Rev. 373, 424–28 (Mar. 2019).

[6] For in-depth discussion, see De Filippi & Wright, supra note 69, at 154.

[7] Chohan, supra note 77, at 5.

[8] Chohan, supra note 77, at 5.

[9] Press Release, U.S. Sec. & Exch. Comm’n, SEC Issues Investigative Report Concluding DAO Tokens, a Digital Asset, Were Securities (Jul. 25, 2017) (citing to U.S. Securities and Exchange Commission, Report f Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (Jul. 25, 2017)).

[10] Id.

[11] Id.

[12] Stephen Palley, How to Sue a DAO, LinkedIn (Mar. 14, 2016), https://www.linkedin.com/pulse/how-sue-dao-stephen-palley; see also Reyes, supra note 82, at 398–400.

[13] See Laila Metjahic, Deconstructing the DAO: the Need for Legal Recognition and the Application of Securities Laws to Decentralized Organizations, 39 Cardozo L. Rev. 1533, 1554 (2018).

[14] U.P.A. §102 (11) (amended 2013).

[15] Id. at §202(a)

[16] MME Switzerland Token Summit, supra note 17 at 6:00–6:30.

[17] Amuial et. al., supra note 64, at 1.

[18] OpenLaw, The Era of Legally Compliant DAOs, Medium (Jun. 26, 2019), https://medium.com/@OpenLawOfficial/the-era-of-legally-compliant-daos-491edf88fed0.

[19] The LAO, supra note 33.

[20] MME Switzerland Token Summit, supra note 17, at 4:10–5:30. For full discussion of The DAO as a general partnership, see Metjahic, supra note 90, at 1546.

[21] MME Switzerland Token Summit, supra note 17, at 5:30–6:00.

[22] U.P.A., supra note 91, at §306 (a).

[23] Chohan, supra note 77, at 3.

[24] For full discussion of business organizations and DAOs, see Amuial, et al., supra note 64; see also Alexandra Sims, Blockchain and Decentralised Autonomous Organisations (DAOs): The Evolution of Companies?, New Zealand Universities L. Rev. (forthcoming 2019); on capitalization structures and DAOs, see Reyes, supra note 82 at 414–18, 419–22 (discusses DAO as business trust).

[25] U.L.L.C.A. § 304(a) (Unif. Law Comm’n 1997).

[26] Id.

[27] Id. at § 201 (a). For more on limited liability protection and blockchain, see De Filippi & Wright, supra note 69, at 141–42.

[28] Patrick Eha and Tanaya Macheel, What the Attack on the DAO Means for Banks, American Banker (Jun. 20, 2016) (quoting Kirill Gourov, Expand Research analyst and “early bitcoin adopter.”)

[29] Kaal, supra note 57, at 23.

[30] Eha & Macheel, supra note 105 again quoting Kirill Gourov; see also Chohan, supra note 77, at 4.

[31]Peter Van Valkenburgh, What Does It Mean to Issue a Token “On Top Of” Ethereum?, CoinCenter (May 10, 2017), https://www.coincenter.org/education/crypto-regulation-faq/what-does-it-mean-to-issue-a-token-on-top-of-ethereum/.

[32] Id.

[33] Ross Campbell, E-Commerce with Legal and Blockchain Security, Medium: Good Audience (Jan. 26, 2019), https://blog.goodaudience.com/e-commerce-with-legal-and-blockchain-security-6f2ba6c244a3

[34] MME Switzerland Token Summit, supra note 17 at 37:51–37:51.

[35] MME Switzerland Token Summit, supra note 17 at 40:21–40:34.

[36] MME Switzerland Token Summit, supra note 17, at 37:51–40:12

[37] MME Switzerland Token Summit, supra note 17, at 40:12–40:21

[38] MME Switzerland Token Summit, supra note 17, at 40:34–40.

[39] MME Switzerland Token Summit, supra note 17, at 42:40–43:00

[40] MME Switzerland Token Summit, supra note 17, at 43:00–43:30.

[41] MME Switzerland Token Summit, supra note 17, at 43:30–43:49.

[42] Eha & Macheel, supra note 105 (quoting Kirill Gourov).

[43] The LAO, supra note 33.

[44] Press Release, SEC, supra note 86.

[45] SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946).

[46] Timothy Nielsen, Note, Cryptocorporations: A Proposal for Legitimizing Decentralizing Autonomous Organizations, 2019 Utah L. Rev. at 8–9 (forthcoming 2019–20).

[47] Sven Riva, Decentralized Autonomous Organizations (DAOs) as Subjects of Law — the Recognition of DAOs in the Swill Legal Order (Oct. 2019) (unpublished master’s thesis, University of Neuchatel (one file with author) (citing SEC Spotlight on ICOs and Dewey Josias, USA, p. 479).

[48] See also Joel S. Telpner & Thomas M. Ahmadifar, ICOs, The DAO, and the Investment Company Act of 1940, 24 Investment Lawyer, 16, (2017); Amuial, et al., supra note 64, at § 4.5.

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