What is a Decentralized Autonomous Organization? (DAO)
A Decentralized Autonomous Organization (DAO) is an organization in which the traditional business management scheme is replaced by blockchain technology. While DAOs function like corporations in some ways, they replace board members with code and leave business decisions up to token-holders who exist as nodes along the blockchain. No single entity owns the DAO, and the organization’s day-to-day operations are executed via smart contracts. This note introduces readers to DAOs, provides insights into how major industry players and regulators are interacting with them, and speculates on how DAOs may influence the future of corporate law.
The first real-world example of a Decentralized Autonomous Organization was “TheDAO,” a venture capitalist firm run on the Ethereum Network (a public blockchainnetwork similar to Bitcoin). (Alyssa Hertig, CoinDesk). Investors could exchange ether, a form of cryptocurrency, for “The Dao” tokens. Once token-holders, investors were entitled not only to a return on their investment, but also to the right to vote on the projects in which “The DAO” could invest. Unfortunately, “The DAO” was hacked soon after its launch due to a developer error in a particular smart contract. Even so, its structure continues to be used as a model for new DAOs. (Andrew Hinkes, CoinDesk).
One company, Huobi Group, hopes to expand and improve upon “The DAO’s” blueprint with the launch of Huobi Chain Project (HCB) and Huobi Chain Superhero Championship Program (HCSCP). HCSCP is a competition that seeks to incentivize teams from around the world to build a new public blockchain. It will begin with one global DAO expert as the leader before the program is divided into ten global milestones, enabling people across the world to draft smart contracts for a better blockchain. Huobi believes that DAOs can use smart contracts to “cut out middlemen, reduce transaction fees, increase efficiency, and ensure that terms are met.” (Christina Comben, CoinCentral).
Can DAOs be used to further social justice aims? Several top Chinese universities think so. The universities plan to create a DAO called the Youth Education Chain (YEC) League, led by Tsinghua x-lab at Tsinghua University, with the goal of making higher education more economically accessible. The YEC League intends to allow university and research center participants to join the blockchain as distributed nodes that vote on future development and student applications. The distributed ledger of the DAO’s blockchain technology would also allow students and faculty at each university to exchange educational resources with one another, highlighting the increased interconnectivity that is now a hallmark of DAOs. (Wolfie Zhao, CoinDesk).
Courts still have yet to define precisely what a DAO is in a legal context. Washington, D.C.-based litigator, Steven Palley, predicts DAOs will be treated similar to general partnerships, meaning that a plaintiff could reach each individual participant in the organization for liability. This presents problems not only for DAO founders and investors, of course, but also for those who seek to sue such organizations. The law has not yet taken up the task of defining who or what qualifies as the authorized representative of a DAO. This combined with the fact that DAOs lack a single owner and are made up of investors spread out across an increasingly secure and anonymous blockchain, Palley says, will make suing DAOs extremely difficult. Plaintiffs’ attorneys will face an uphill battle identifying any individuals in the DAO, only then to potentially serve process on someone who is not an authorized representative, effectively jeopardizing the entire lawsuit. (Andrew Hinkes, CoinDesk).
Despite this persistent uncertainty about the type of entity best suited for DAOs, the SEC has made it clear that many DAO transactions, often referred to as Initial Coin Offerings (ICOs) or token sales, are subject to federal securities law. A July 2017 SEC Report stated that anyone participating in unregistered offerings of distributed tokens via DAOs will be held personally liable for violating federal securities laws. Stephanie Avakian, Co-Director of the SEC’s Enforcement Division, highlighted the Commission’s commitment to transparency: “The innovative technology behind these virtual transactions does not exempt [DAOs] from the regulatory framework designed to protect investors and the integrity of the markets.” (SEC, sec.gov). Despite their innovation, DAOs must either meet private placement offering exemption requirements, or be subject to the same federal securities laws as the biggest players on the New York Stock Exchange and NASDAQ.
DAOs are in a position to revolutionize the corporate governance world. Proponents of the DAO structure go as far as to say a DAO can “cryptographically guarantee democracy” because its code requires stakeholders to vote on decisions such as which projects to pursue, which rules to change, and whether to oust a fellow investor. (Alyssa Hertig, CoinDesk). However, “The DAO” found that awarding voting rights based on tokens held may also present problems. “The DAO” required 20% of investors to approve a decision before it could go through, but some investors held so many tokens that their votes alone would be enough to trump the voting rights of all others, resulting in a decision-making monopoly. (Andrew Hinkes, CoinDesk). Still, DAOs may provide other beneficial alternatives to traditional governance structures, like express disclosure of terms, conditions, and organizational structure. DAOs give investors a true say in business decisions by eliminating boards of directors, while increasing efficiency by having smart contracts automatically run day-to-day operations. (Alyssa Hertig, CoinDesk).
Decentralized Autonomous Organizations are still very much in their infancy. Despite their kinks, however, they may represent a viable solution to some of the problems that continue to plague traditional corporations: inefficiency, corruption, and human error, to name a few. One academic even stated that DAOs “are capable of enabling a global transition to a post-capitalist society.” (Zane Huffman, NullTX). While that remains to be seen, these organizations are certainly going to be an exciting topic to watch in corporate and securities law.