The latest explosive trend in DeFi is distributed autonomous organizations, commonly known as DAOs. Hundreds of them have popped up in the last few years, and today they collectively control around $12 billion in assets and govern products with $98 billion in total locked value.
This innovation laid the groundwork for a transformative new form of human organization. The breakthrough is that DAOs ensure adherence to monetary and governance rules without the need for a judiciary or central government to enforce compliance.
The implications of this shift are hard to overstate. All established businesses and organizational structures — LLCs, corporations, partnerships, non-profits, and so on — require the threat of governmental force to ensure compliance with laws, contractual terms, and financial regulations. DAOs, on the other hand, enable coordinated, collective financial activity free from the oversight of a functioning judiciary or law enforcement body. This may seem like a minor development to those of us living under the rule of law, but it represents a sea-change for much of the world.
Sometimes, minor innovations can have a massive impact. For instance, few saw the transistor as a world-altering invention when it was invented in 1947. Put simply, each transistor acts as a switch representing a one or a zero in computer code; today’s transistors can turn on and off hundreds of billions of times per second. But without transistors we wouldn’t have computer chips, which means we wouldn’t have personal computers, the internet, or mobile phones.
This helps explain why we have seen so many DAOs bloom, from investor DAOs to developer DAOs building products collaboratively, art DAOs and activist DAOs, DAOs overseeing DeFi protocols, and more. With the monetary and governance rules baked into the blockchain rather than into bylaws enforced by state bodies, peoples from across cultures, countries, and continents can work together, safe in the knowledge that their funds are secure and cannot be tampered with.
Of course, this requires well-written code audited by security experts, just as corporate entities need well-written bylaws and contracts drafted by qualified lawyers. Thankfully, DAO code quality has come a long way since 2016 and has been battle-tested with billions of dollars in deposits.
Precisely because they have no need for government enforcement of bylaws or contracts, many DAOs choose not to declare themselves as a specific legal entity. But every member of every DAO lives in the physical world, which means that despite its counterculture appeal, opting not to incorporate as a legal entity is a bad idea for DAOs.
Why? First, unincorporated DAOs are likely to be deemed unincorporated partnerships. Remember, the original purpose of a corporation was to limit personal liability. Before corporate entities, everybody had unlimited liability for anything that happened to one of their ventures. If an investor owned a ship that smashed into a dock, for instance, the dock owner could sue the shipping company and its owners for damages. Such high risk deterred investors and dampened employment and economic activity, until the advent of corporations and limited liability ensured they would avoid personal bankruptcy.
DAOs without a corporate entity expose all their members to unlimited liability, turning back the clock on centuries of risk management. If a DAO is hacked or crashes, users could conceivably sue every identifiable member for damages and hold them liable for the lost funds, just like with that ship in the days of old. Let’s say a crashed DAO had 3,230 members and held $4 billion worth of cryptocurrency. Each member would be liable for $1.2 million — Hello, bankruptcy!
Even more worrisome, most DAOs are not governed entirely on-chain. This is because it’s nearly impossible to code for all possible related activities, from sending funds to publishing new code and posting updates on Twitter. Instead, many DAOs have a few more active members who handle these off-chain actions. For example, funds are often held in what’s known as a multisignature, or multisig, wallet. These more active members approve DAO transactions using their individual cryptographic signatures, or keys.
These wallets are called multisig because more than one of the signers is required to authorize any transaction; in some cases two of the three keys are required, in others, three of five, and so on. Nearly every major DAO has a multisig wallet that holds digital assets, executes grants and pushes code live. This means the multisig signers have the most liability of all. Imagine if three of these members published code that resulted in another member losing an enormous amount of money. That member could then sue the three signers for damages. This may not have happened yet, but it’s probably only a matter of time, and with $90 billion at stake, the risk is massive.
To sharply reduce this risk, the above DAO would be wise to become a legal entity. The hurdle, of course, is that existing legislation and regulations regarding legal entities do not mention blockchains. Some statutes apply seamlessly, like taxes and employee rights, but many others do not. Some DAOs have attempted to force-fit themselves into the more pliable legal structures of places like Panama and the Cayman Islands. At least one jurisdiction, meanwhile, has attempted to embrace the DAO concept, but Wyoming’s DAO legislation, while worthy, falls short of enshrining the DAO, particularly because the Cowboy State cannot rewrite federal laws that may also apply. As of November 2021, no sovereign nation has enacted effective DAO legislation.
For instance, legal entities often require bylaws filed with the government in a particular format, but DAO bylaws are usually written on the blockchain, and often unalterable. Another example is that many legal entities track membership by registering names in corporate records. DAOs, meanwhile, typically track membership with bearer-tokens that require no personal identification. The laws that define our various legal entities never imagined an on-chain vote of members who need never be named to prove their right to register their opinion.
This is why DAOs need the creation of a legal corporate entity.