18 March 2022

What is a DAO?

Decentralised Autonomous Organisations (DAOs) are one of the more intriguing applications of distributed ledger technology (aka ‘blockchain’). They are self-regulating organisations comprising of members linked on a blockchain through NFTs and smart contracts which serve as a digital constitution. Like many concepts in blockchain and crypto, DAOs aim for maximum transparency, democracy and security.

If that sounds complex, think of a DAO as a virtual business, open to anyone prepared to comply with its rules, objectives and activities. In place of a traditional management structure, a DAO operates via a combination of smart contracts and membership votes, and, in place of a company secretary, all DAO’s actions are permanently recorded on a blockchain.

What can a DAO do?

The big promise of DAOs is to free modern commerce from administrative inefficiencies, centralised control and fraud. They are generally well placed to guard against these threats online but are likely to find things less easy whenever they have to interact with the real (analogue) world.

DAOs can also be extremely efficient at achieving mass participation in an enterprise, reaching large numbers of individuals worldwide who might not otherwise get involved. A good illustration is PleasrDAO, set up to acquire valuable NFTs and other items. In 2021 it effectively crowd-funded the US$4million needed to purchase the sole copy of Wu-Tang Clan’s ‘Once Upon A Time In Shaolin’. Investors will hope to benefit both musically and financially as access to this unique album is granted in accordance with PleasrDAO’s smart contracts.

Perhaps encouraged by this success, another DAO has recently been launched to buy the Denver Broncos on behalf of the team’s fans. With a putative price tag of US$4billion, this may seem ambitious, but it is only a question of scale!

What are the risks?

Running a business on pure blockchain principles may look great on paper, but the more a DAO entrusts its operation to automated coding and the ‘wisdom of the crowd’, the more it risks making mistakes or failing to adequately anticipate circumstances as they arise.

Common problems include ‘apathy attacks’ (where an adverse proposal succeeds in the face of insufficient scrutiny and opposition e.g. because it is advanced and voted on in the small hours of the morning) and ‘cartel attacks’ (where an interest group manages to garner enough support to effectively hijack the DAO to its own ends).

As with any business venture, it is also crucial for DAOs and their members to carefully assess the practicality and legality of their plans. Even as they push the frontiers of new technology, blockchain-based projects need to remember they remain rooted in the real world and are subject to real world market forces and laws. In 2021, for example, SpiceDAO purchased a rare copy of a screenplay adaptation of Frank Herbert’s ‘Dune’ with the intention of turning it into an animated series. However, as a matter of basic copyright law, this purchase did not include the rights needed to commercially exploit the screenplay, leaving SpiceDAO’s members with no easy way to recoup their investment of €2.5 million.

Disagreements concerning the spirit or the letter of the DAOs rules can also lead to disputes. An early case-study – known at the time as simply ‘The DAO’ – was set up in 2016 as a form of venture capital fund. It quickly attracted US$150million from investors, all of whom signed up on the basis of its open-source code, but collapsed almost immediately after several users exploited a vulnerability in the code to divert US$50million to their own accounts. While most investors cried foul at this apparent exploitation of a bug or loophole, the users in question asserted it was in fact a deliberate feature which they, along with all other members of The DAO, had signed up to in full knowledge.

This starkly illustrates the difficulty (perhaps the impossibility) of trying to condense the intricacies of a business operation to pre-programmed lines of code. Having no one in charge (because, in theory, everyone is in charge) means there may be no one to act as arbiter in the event of an unforeseen dispute or disagreement. More recent DAOs have therefore tended to retain an element of traditional governance and oversight in the form of confirmatory votes on important issues, or committees with powers to review decisions.

How do DAOs fit in with current law?

No jurisdiction has yet recognised DAOs as a distinct form of incorporated entity, with most countries attempting to shoehorn them into existing legal frameworks (although Wyoming now allows them to register as limited liability companies). In Australia (and other common law jurisdictions such as England), they are likely to be treated as a form of partnership or unincorporated association. This default position is less than ideal as it not only fails to take into account the unique features of a DAO, but also exposes individual members to unlimited personal liability for the DAO’s entire operation, regardless of any actual knowledge or control.

Acknowledging this issue, the Australian Senate is currently recommending that a new form of corporate structure be established specifically for DAOs and the Australian government is also reviewing regulatory and legal accountability for DAOs. As well as clamping down on fraud and clarifying the relationship between DAOs and their members, states have a clear interest in regularising how DAOs should be treated for tax. Is membership akin to a share in a company? Or is it more analogous to a loan? Or an investment in a managed fund?

The future

DAOs are complex, technical structures and will not be an appropriate vehicle for all business ventures. However, they can prove extremely efficient and cost-effective where an enterprise operates mostly or entirely online and can clearly benefit from being based on cryptographic principles. DAOs can also be useful where access is required to a broad pool of talent, liquidity or funding.

Until proper regulation and legislative clarity are implemented, DAOs will remain relatively niche and extremely high risk, and their commercial potential will therefore not be fully realised. For the time being putative investors and founders must proceed with caution and carry out detailed due diligence before committing their time or money.

If you would like to discuss any aspect of DAOs, blockchain or crypto in more detail, please contact Graeme Fearon 07 3367 6900.

This memo presents an overview and commentary of the subject matter. It is not provided in the context of a solicitor-client relationship and no duty of care is assumed or accepted. It does not constitute legal advice.

© Moulis Legal 2022