DAO and the Law: Lawyers on the Experience of Decentralization. Part 2

DAO Politics — a series of Forklog podcasts, in which we, together with invited experts, examine how decentralized autonomous organizations are structured, and discuss their conceptual and technological foundations. In this episode we continue discussing the legal aspects of DAOs with lawyers Baseley&Partners Elizoy-Tatyana Vasilyeva and Bogdan Popovchenko. The first part of the podcast can be accessed here.

1. A DAO without well-thought-out rules is child’s play. Contractual arrangements in a decentralised system are as variable as in a centralised one: both sides require careful rule-setting. Creating a DAO object without well-considered rules means we are at a infant stage, not yet able to find a common language with others.

Frequently used smart contracts are overly simplified and do not account for all aspects. They should be more complex and anticipate a wide range of possible developments. Alternatively, they should be combined with paper and electronic contracts that include all unaccounted aspects.

2. Lawyers are working on a common standard for DAOs that would satisfy regulators’ claims. The Howey test was developed by the US Supreme Court in 1946 to determine which assets fall under securities and which do not. In 2019 the SEC issued guidance on how to use it to classify virtual assets. It applies basic rules: a buyer can expect a share of profits, freely transfer and sell the asset, the purchase is considered an investment. In the European Union there is a similar test enshrined in the directive MiFID II. It has its own criteria: a crypto asset must belong to the class of securities, be traded on capital markets, and not be used as a payment instrument.

Regulators are trying to apply these tests to decentralized autonomous organizations. Many DAO projects promise investments but are not enterprises and may fall under securities classification. Hence arises a regulatory chaos.

We as lawyers are building a matrix of regulatory claims and look at how DAOs were classified for each configuration. For each configuration we apply the appropriate regulatory wrapper. We determine what constitutes an investment platform, a fund, and what is truly a decentralised project capable of answering any potential regulator claims. We are currently refining this matrix mathematically to present to the community as a standard for such organisations.

3. DAOs do not emerge from a void; we must take into account the heritage of philosophy, psychology, and law. It is absurd to think that one must abandon all old concepts and create everything from scratch. Yes, we need to rethink a lot. But we will craft a new decentralised philosophy not out of nothing.

We recommend small DAO projects:

• build a minimal legal infrastructure;
• align the tokenomics and positioning of the project with legal requirements;
• prepare for a serious fight, and remember those who push unfair regulation and file obviously unjust lawsuits against projects.

The future belongs to decentralisation. The generation of children who are now seven to eight years old communicates more in the virtual space. This will contribute to decentralisation with public regulation, agreements through tokens, high-quality smart contracts, and artificial intelligence able to resolve disputes automatically.

4. Blind reliance on AI is dangerous, so DAOs need moderators. The role of intermediaries in a decentralised world will be as important as in a centralised one. Improving smart contracts will allow in automated fashion to resolve all deadlocks, but there will remain questions that cannot be solved without a human.

AI may prove unsuitable where people can sit at the negotiating table. It is important that in such situations there are moderators who help regulate AI decisions in light of universal human values, principles of justice and balance.

5. If you determine each participant’s share, regulating a DAO becomes much easier. Practical advice: do not mix responsibility for regulatory questions with issues of ownership. Assets are one thing; activity is another.

In classical corporations there are two main ownership models:

• the work-for-hire principle — everything we create belongs to the company because it pays the salary;
• the contracting mechanic — what was asked to be developed for the company belongs to it.

In a DAO the following model is possible: a participant contributes, the community decides what portion of this work constitutes of the total, and then a fixed percentage is recorded. The key is to properly formalise the contractual relationships: smart contracts, electronic documents, monetisation of ownership.

6. Anonymity is maintained until tax payments are due. In a DAO, identification of the rights holder is carried out by unique tokens. This allows anonymity, but exactly until the moment when it is time to meet tax obligations. If a participant earned from a DAO investment, there arises a question of declaring income. Supervisory authorities, of course, will want to de-anonymise all participants of the organisation. A similar situation with marketplaces in Europe, which were obliged to provide tax information about those who earn on them.

Admittedly, for blockchain this is detrimental. A corporate structure with compliance with TAAR can in some cases reduce the tax burden (do not take this as fact; each case should be discussed with advisers in the involved jurisdictions).

7. Upon confiscation of a fragmentNFT you can receive compensation. Let us consider a private scenario. A DAO participant faces criminal charges; their property is confiscated, including a fragment in an NFT. As a result the token loses value. This will not deprive other participants of the opportunity to exhibit the artwork in a virtual gallery, but instead a black spot forms where the missing fragment used to be. Distribution may be blocked, or the funds from it may go to the state body that confiscated the property.

In the case of NFT fragment confiscation within one jurisdiction, citizens of other states will have a chance to recover it. The regulator does not care that the work loses value.

The only thing a participant can do is seek compensation. Here the following logic may apply: for example, when during searches container trucks are opened and the value of their contents is lost because the storage technology was breached. The government body that organised the search is obliged to compensate for the lost benefit. A full return of value is unlikely, but partial compensation may be possible.