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DAO Legal: Examining the Pros and Cons of Regulatory Oversight

Balancing Innovation and Compliance in DAO Regulatory Discussions.

DAOs, or Decentralized Autonomous Organizations, are a novel type of blockchain-based system that enable people to self-govern themselves through a set of self-executing rules on the blockchain. DAOs operate autonomously through their members, removing the need for a central authority.  

Blockchain technology removes the barriers and constraints we have in the traditional world, allowing more participation. Furthermore, it celebrates skills and creativity and doesn't care about jurisdiction, religion, or skin color. What only matters is that you can build.  The implication of this is we must explore the potential of blockchain, Web3, and DAOs with appropriate regulations in place.

Why Are Regulations Important?

DAOs, being a novel organizational structure, are not regulated globally. The lack of regulation leads to non-compliance with the established principles of corporate and financial law. Further, owing to the lack of regulations, the party most at risk is the investors.

Since there is no precise categorization of DAOs as an organization due to their nature, they are deemed as general partnerships. This ultimately assumes unlimited liabilities for those involved. Meaning: One bad apple can burden a larger group of people with many legal issues. Hence, there is no investor protection in place that safeguards them from bad actors, scams, or rug pulls.

The lack of regulation causes many other problems as well. For example, in many cases, a decentralized organization becomes centralized when DAO founders assume arbitrary authority for themselves. In such cases, the parties that generally suffer are the community members.

In the past year we had issues with centralized platforms acting like they own the investors’ assets and thinking they can decide not to allow anyone to withdraw, or keep them as a method to pay off their mistakes. This might not directly seem like a ‘DAO issue’. However, let’s not forget that the holders are DAO members keeping their assets on centralized platforms. Since DAOs do not have legal standing, they cannot act on behalf of their holder and demand the centralized platforms release their funds.

Having regulations in place would allow DAOs to operate decentralized and autonomously, where the members are subject to limited liability. Hence, they are not reliant on a central authority for the operational and management decisions of the DAO. Also, they have the legal ability to protect their members’ assets towards centralized platforms and others when needed. 

Before we confuse having regulations in place with ‘enforcing’ centralization, the key is having regulations that do support the decentralized nature of the autonomous organization. Not at the expense of it. 

DAO Governance Centralization Challenges. 

Invisible to the law and subject to many unfortunate scams and bad actors, DAOs face challenges both on-chain and off-chain.

In my previous article, I discussed in more detail the centralization issues and how they can affect the industry as a whole.

There are a number of ‘DAOs’ that are just centralized environments in disguise, with the developers themselves not being educated on how DAOs actually operate and what they truly are. The effect is hindering the actualization of the true DAO potential. 

It is prevalent that initially, the DAO is structured in a pretty centralized manner and is ‘managed’ by a few. Then it cannot even be deemed a DAO -  it is a DAO in the making. A DAO needs a community, not a team of founders and initial contributors that developed smart contracts and published a whitepaper. 

Moving away from that initial centralization is the step towards making a DAO out of that initial founding team. In order to do it right, it takes time and involves testing what is good or not for the DAO, what framework responds well to community needs, and what mechanisms and tools support the project’s needs and growth. There is no ‘one solution fits them all’, even though many are convinced that it works that way.

It is essential to distinguish the governance from the operations of the DAO. While the governance is autonomous and embedded in smart contracts, the operations are human-powered. Hence this is the challenge - how to operate a DAO in a non-centralized manner. 

Ideally, the founding team is not ‘me, myself, I and one more person’ as having a decentralization mindset and building paths start from the very beginning. But, of course, that is not always the case and not always possible. So what matters is the decentralized governance framework, its roadmap, and the work done to achieve that decentralization.

Many fail to establish that from the very beginning for different reasons. The two biggest, in my opinion, are not knowing how DAOs work and the human-natured hunger power.

Both pose important issues for DAOs and the industry.

Lack of education and understanding of how DAOs work by founders lead to a significant risk of the organization being centralized for longer than it should or not decentralized at all. Why is this an issue? CEO-ing DAOs may easily end the industry and support strict and unfavorable regulations for DAOs. Further, aren’t we here because we don’t want centralization anymore? The answer is ‘yes’; but the actions of the industry builders say ‘no’. 

Besides not understanding decentralized organizations, another educational issue is the lack of sense of responsibility for the investors -  the DAO members. Hacks, rug pulls, and draining funds seem to surprise founders when they happen. I mean, if the security layers are budgeted and implemented on time, I would be surprised too. This on-chain lack of accountability easily translates into the off-chain world. 

The liability issues associated with DAOs. 

Talking about offchain challenges, as I mentioned earlier, unlimited personal liabilities of the DAO members can lead to significant legal and tax issues. 

Suppose a DAO falls under regulated activities and there is no entity or necessary paperwork. In that case, the members may be deemed as active participants in the illicit activities in the eyes of the regulators and, as such prosecuted and liable alongside their personal assets. 

If we are less pessimistic, ‘simple’ tax and jurisdictional issues can leave a bitter taste when holding assets of your favorite DAO. However, a registered entity that represents the DAO could help its members and offer at least some protection.

Many of us are aware that being able to communicate and interact with Web2 without any legal risks and worries would support the scaling and growth of the industry.

DAOs, as non-legal structures, are unable to sign contracts, onboard, or partner up with Web2 businesses, which delays the business's scalability and, with that, the industry as a whole.

The founders often sign those contracts as individuals on behalf of the DAO. It is inappropriate because they risk centralizing all potential legal and tax issues on themselves and can be subject to AML.

Despite the uncertain regulatory environment and the challenges, DAOs lack the infrastructure that allows them to operate in a compliant manner where the investors are protected and efforts are taken to establish and maintain decentralization. However, due to the lack of education and awareness in the field, most DAOs operate non-compliantly.

‘Non-compliant’ onchain organizations operate in the gray area of law — unregulated, ‘illegal’ and waiting to see what the future regulations bring. Whether it’s a good tactic or not, we will find out soon.

It is essential to understand that those projects are not of less value, but are uncertain, and the community is at high risk.

DAOs need better Wyoming.

DAOs face a variety of challenges due to the lack of regulations concerning DAOs. However, another critical question is whether DAOs can be regulated. 

DAOs, being a novel and complex type of structure, are difficult to regulate because they are multijurisdictional. Also, it is difficult to understand legal and tax implications on DAOs and their members.

DAOs need to be regulated in the sense that they are seen, acknowledged, and recognized for what they are: decentralized organizations.

Giving DAOs legal recognition would limit the personal liabilities of the members and founders as they would not be seen as general partnerships. Furthermore, it would allow DAOs to interact with the traditional world without compromising their decentralized nature.

Regulating DAOs can be beneficial to the industry and support mass adoption. However, regulations must support DAOs as decentralized organizations, without compromising their nature.

The first country to recognize DAOs was Wyoming in the US, followed by the Marshall Islands and Panama. 

Due to the innovative legislation, Wyoming quickly became a popular place to register DAOs. However, the framework is not as supportive as one would hope. On the one hand, Wyoming LLC Law allows DAOs to register as LLCs without requiring members to reveal their identities. Hence, it can be filed anonymously. However, while legally recognizing DAOs as organizations is a great initiative, it has its downsides. A con is that it is mandatory to provide the name, contact information, and address of the registered agent and managers for registration. 

Another downside is that the Wyoming Act is unclear on how to treat smart contracts. For example, the statute requires that the smart contracts used by the DAO should be capable of being amended. However, by their very nature, smart contracts are immutable. Thus, to amend a smart contract would essentially mean to create a new smart contract altogether. 

In addition, the Wyoming act may still consider DAO tokens as “Securities” under some conditions. This requires filing Form 10 with the SEC, and the project becomes subject to federal securities law, which may further lead to the federal government scrutinizing the DAO’s operations.

Therefore, there is a potential cost of losing DAOs status as decentralized organizations built on the fundamentals we know them for today.

Despite the many challenges, DAOs have enormous potential to go mainstream. However, the adoption may take a long time. DAO is a novel type of structure even for those who are already building in the Web3 space. I believe it would take longer to grasp and implement in the off-chain world.

Once people understand the true power of decentralization and what a unified, decentralized unity can achieve, it will be the breaking point for the centralized environment.

Having that ability to safely and compliantly interact with the traditional world would drive the mainstream adoption of Web3 a lot more and faster and further aid the scalability of the environment.

Embrace the Rise of DAOs with me and embark on a journey into the intricate realms of DAOs, Web3, and decentralization. To delve deeper into this remarkable space, I invite you to listen to my podcast, DAO Today, where we passionately explore its inner workings, challenges, and potential. Tune in to engage with insightful discussions that navigate various aspects, with a particular focus on the legal and regulatory challenges shaping this industry. Listen now!

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