How not to structure a DAO: case studies of Arbitrum and Hector

As DAOs gain momentum, it becomes clear that having a formal legal structure is vital for their long-term success. However a poorly implemented structure can do more harm than good, ranging from potential power usurpation by management to regulatory problems whose consequences threaten the very existence of the organisation.

On the main mistakes that DAOs make in this area, illustrated by the Arbitrum (ARB) and Hector (HEC) cases, as explained by Sergei Ostrovsky — co-founder of DAObox and partner at the law firm AURUM.

Arbitrum DAO

This case is interesting from the perspective of structuring a very large and diverse decentralised autonomous organisation. Moreover, it’s an excellent example of how the DAO managed to reject the founders’ proposal to steer the treasury, which forced them to change the governance mechanism.

Participants in Arbitrum decided to structure themselves on the Cayman Islands in the form of a controlled DAO ownerless foundation company — a legal entity that has no owners or shareholders and is created to achieve specific aims, for example the development of a blockchain protocol. One feature of such a structure is its durability — it can outlast changes to the project and the team, including founders and key contributors departing.

An ownerless foundation company can be a compelling option for structuring a DAO; however, the governance procedures and mechanisms laid out in the charter documents of the Arbitrum Foundation raise many questions. We note the following:

• Lack of subordination. Both directors and the foundation’s supervisors can be appointed and removed without the DAO’s consent. Such an approach, in our view, deprives the Arbitrum DAO of adequate oversight over the foundation’s management. Moreover, the board of directors was given the power to replace supervisors at its discretion, and the latter must ensure that directors act in the interests of the organisation and in accordance with its goals. Thus, a situation has arisen in which the foundation’s management may replace the supervisors if, for example, they “start asking questions”. This should raise serious concerns within the community, because it opens the door to abuse of power and the subsequent usurpation of control over both the foundation and its assets. A decentralized autonomous organisation in such a case would not have real mechanisms to defend its own interests.
• Non-recognition of DAO resolutions by the foundation. In such a situation, participants cannot make governance decisions over their own foundation company, set its aims and objectives, or influence the board of directors. The lack of direct recognition means that the foundation company is not obliged to follow decisions made by the DAO, nor to seek its consent for certain deals and transactions. This effectively allows the appointed management to ignore the views of the participants, which, in turn, may lead to a pronounced divergence between the DAO’s goals and vision and the actions of the foundation’s leadership.
• Reserved matters. The foundation’s charter documents did not include a list of “reserved matters” requiring prior approval by the DAO. This mechanism obliges the foundation to obtain the agreement of the participants for actions that could have substantial consequences for the DAO: significant transactions, transfer of IP, disposition of assets, provision and receipt of loans, etc. Such a procedure is, in effect, a checks-and-balances mechanism designed to prevent the foundation’s directors from undertaking the most consequential actions affecting the entire organisation without discussion and approval by the DAO, in whose interests they act.
• Lack of protective mechanisms. The proposed Arbitrum Foundation structure does not provide mechanisms by which the DAO could protect itself from misconduct by management, including in situations where it refuses to perform tasks defined by the organisation or acts against the interests of the organisation. Such procedures should be detailed in the foundation’s charter documents.
• Governance shortcomings. The governance mechanisms described in the charter documents were not adapted to the particular dynamics of the relationship between the DAO and the foundation. Governance procedures did not take into account the peculiarities of relations between Arbitrum DAO and the foundation as its legal wrapper.

These problems were identified shortly before the planned vote on the creation of the Arbitrum Foundation. DAObox published a post on the Arbitrum DAO forum in which we proposed ways to address these shortcomings.

Our recommendations, unfortunately, did not receive the attention and response we had hoped for. Subsequently, Arbitrum DAO participants approved the foundation’s structure with all the gaps described above.

Hector DAO

As with Arbitrum DAO, a structure was proposed for Hector DAO that involves using a Cayman foundation company as a legal wrapper for HEC.

After reviewing the draft charter documents we found many of the same issues as in the Arbitrum Foundation. The identical set of concerns demonstrates that very different DAOs face very similar problems when structuring legally:

• Centralisation of power. As with the Arbitrum Foundation, the core problem for Hector DAO was that much of the authority concentrated unchecked in the hands of a closely connected group. As discussed above, this approach contradicts the decentralisation principle at the heart of any DAO, and creates significant risks for the organisation itself.
• Lack of oversight. In the proposed Hector DAO structure the foundation is effectively not under the influence of the DAO; there is no subordination of management to the participants. In such a situation, there can be serious problems in defining the foundation’s aims and in controlling management actions.
• Right to admit shareholders. We found that the foundation company’s charter documents allow it to admit shareholders. This is a crucial point, because a shareholder would gain full control over the company and its assets, which clearly does not align with the aims and tasks of creating a legal wrapper for a DAO. In the absence of adequate checks and balances, such a decision could be taken by the board without any approval from the participants.
• No reserved powers. As in Arbitrum DAO, this creates conditions in which the foundation’s directors have unrestricted ability to undertake significant deals and dispose of the organisation’s assets.
• Governance procedures. Analogous to Arbitrum, the foundation’s structure also did not envisage any mechanisms that a DAO could use to safeguard its interests should management abuse power or act against the organisation’s interests. The governance procedures did not account for the specifics of the relationship between Hector DAO and the foundation as its legal wrapper.

Immediately before the planned Hector AMA session, when the community would discuss the questions around creating Hector Foundation, DAObox published its comments and proposals in the community’s Discord channel. One of the project’s founders later replied that the project planned to discuss our proposals with lawyers involved in setting up the company.

How to structure a DAO and create its legal wrapper: 8 recommendations

The issues described above and their possible consequences show how important it is for any DAO to create a robust and transparent legal and corporate structure.

It may be that many of the gaps described in this article were introduced deliberately, for example to guarantee founders and the core team full power over the foundation. But such an approach completely undermines decentralisation, as it implies control over the foundation by a narrow group of insiders.

To create a high-quality and balanced legal structure for a DAO, and to avoid the mistakes described in this material, a few basic recommendations should be followed:

1. Clearly define the goals and objectives of the legal wrapper. They form the foundation of the organisation, and their precise formulation will align the DAO and the management of the structure around a common vision. We also recommend instituting a prohibition on changing the goals of creating the legal wrapper.

2. Prioritise the DAO’s control over the legal wrapper. In the charter, include provisions obliging the management to recognise and implement the resolutions adopted by the participants of the organisation (via Snapshot or other mechanisms).

3. Avoid centralisation of power in the hands of a few people or one group. The uniqueness of a DAO lies in its decentralisation and direct access of members to governance, which should be reflected in the charter documents of the legal structure.

4. Introduce a system of checks and balances, which allow some stakeholders to control others and vice versa, creating a balance of power and a fair distribution of authority within the organisation. For example, undertaking significant deals and the most consequential actions, such as appointing and dismissing directors and supervisors, disposition of IP and substantial assets, may require the DAO’s consent. This will help prevent power abuse by management and ensure that such decisions are taken in the organisation’s interests. The board of directors, in turn, may have the right to refuse to implement DAO resolutions in certain situations, for example if such decisions, in the board’s view and confirmed by a legal adviser, violate the law or could lead to other serious consequences.

5. Install protective mechanisms, with which the DAO can shield itself from potential abuses by management or actions contrary to the interests of the organisation. One can introduce a special dispute-resolution procedure and mechanism for taking urgent decisions. For example, consider appointing DAO representatives who can carry out enforcement.

6. Increase transparency. This may include open books, publication of decisions and meeting minutes, regular reporting to the DAO, etc. It should be noted that there are always issues and questions that should not be made public.

7. Work on precise definitions. Although not discussed above, you should avoid errors in terminology used in the legal wrapper’s charter documents. Carefully flesh out key definitions, such as “DAO”, “token”, “resolution” — they should be clearly defined with an eye to potential hard forks and technical changes.

8. Model negative scenarios. To enable the DAO to cope with governance challenges and organisational problems, during the creation of the legal wrapper one should thoroughly model plausible crisis scenarios and address them in the charter documents.

Conclusion

Legal structuring of a DAO is a complex and multi-component process that requires careful planning and consideration of various factors. By recognising common mistakes and understanding their potential consequences, decentralized autonomous organisations can create more robust, transparent and effective legal structures.

Such an approach not only ensures transparency and trust from the community, but also provides a solid foundation for the development and growth of DAOs, particularly thanks to a well-designed system of checks and balances.