The Law Commission has recently been looking at how new commercial practices and structures driven by emerging technologies fit with the existing English legal system.
Earlier this year we commented on their consultation process relating to digital assets. Other recent exercises have also looked at smart contracts, and electronic trade documents.
The latest initiative focuses on Decentralised Autonomous Organisations (DAOs).
Law Commission public call for evidence
On 16 November 2022, the Law Commission launched a public call for evidence relating to DAOs. This requests information about how DAOs can and should be characterised and how the law in England and Wales might best accommodate them.
What are DAOs?
DAO is not a legally defined term. Fundamentally, it is a community of participants, whose interactions are governed by rules set out in computer code, and which is not directly regulated by any government body. It does not operate on the same basis as traditional commercial organisations which have a clear decision-making hierarchy.
The Commission notes that in simple terms “a DAO is a novel type of technology-mediated social structure or organisation of participants.”
The concept of the DAO is fundamental to the use of blockchain in particular. It is the network of DAO members, or “nodes”, which collectively ensures the integrity of the blockchain.
There are thousands of DAOs in existence and these have been set up for a variety of purposes, including investing in crypto-tokens and NFTs, for fundraising and lobbying/advocacy.
Whilst DAOs are becoming increasingly common, they do not take on a particular or uniform organisational form or structure.
This creates questions as to the proper legal treatment of DAOs including questions around the rights and obligations of participants and the rules and regulations to which they are subject.
Legal characterisation – the starting point
As a starting point for considering the best characterisation of DAOs, the Commission considers whether DAOs should be categorised as unincorporated associations or general partnerships.
The Commission recognises the following criteria for an organisation to be classed as an unincorporated association:
- Two or more persons with a common purpose (other than profit – persons working together for profit are more likely to be regarded as a partnership).
- Contractual relations between those persons.
- The organisation must be governed by rules, be non-temporary and not have separate legal personality.
As unincorporated associations do not have separate legal personality, their contracts must be entered into by one or more members on behalf of the organisation. Similarly, any assets must be held by one or more members on its behalf, and as there is no legal person for any liabilities to attach to, liabilities of the unincorporated association will attach to some or all of the members personally.
Broadly speaking, for an organisation to be classed as a general partnership, the following criteria must be met:
- There must be a business.
- The business must be carried on by persons acting in common.
- The persons must have a view to profit.
Like an unincorporated association, a general partnership does not have legal personality. Although the specifics are different, this has a similar effect in that all contracts have to be entered into by partners on behalf of the partnership, and assets and liabilities of the partnership will be the partners’ personal responsibility.
Is either classification satisfactory?
Whether or not a DAO satisfies the criteria for an unincorporated association or general partnership will be a question of fact and law.
The Commission notes that a DAO may potentially be classed as either, but whilst this is a starting point for the analysis it is not entirely satisfactory since it fails to reflect the realities of how most DAOs are structured and operate in the market today.
Centralising structural elements
The Commission goes on to explore the ways in which this starting point may be modified and how a DAO may mitigate the risks associated with it by adopting ‘centralising structural elements.’
The Commission recognises that some DAOs may choose to use an incorporated entity as part of its structure (such as a private limited company, unlimited company or limited liability partnership) in order to deal with “off-chain” issues, for example engagements with third parties to deal with elements of the DAO and the risk of a subsequent hack to the network (which could lead to litigation and concerns around personal liability).
Whilst a DAO may adopt a particular legal form or entity as part of its structuring in order to mitigate risk, the Commission recognises that a DAO may also rely on certain ‘decentralising structural elements’ (either in substitution or in addition to the use of centralising structural elements).
Examples given by the Commission include:
- The design and creation of governance mechanisms to prevent the concentration of control (to encourage participation);
- The use of smart contracts; and
- Opting for transparency in “off-chain” activities in order to minimise confidential / non-public information.
The Commission’s preliminary view is that the law is sufficiently flexible to allow for the use and implementation of such arrangements with a high degree of certainty however, given that the use of such techniques (in isolation) by DAOs in England and Wales is relatively uncommon, the Commission invites stakeholders to submit their views on the efficacy and use of such tools and how these techniques could be “refined, clarified and applied” under the law of England and Wales.
Practicalities of operating a DAO
In the final chapter, the Commission briefly explores some of the issues that may arise in the operation of a DAO. Examples include:
- The potential for participant disputes: Since DAOs are likely to use different organisational structures; their governance structures will often vary which may result in differences in the rights and powers of participants. This may create conflict if, for example, participants do not have the same voting power and feel they are being outvoted in decision-making.
- Taxation issues: Different entities are subject to different tax regimes. There is, for example, a difference in the tax regimes applicable to general partnerships (tax transparent and partners liable to pay tax on profits) and limited companies (liable to corporation tax). It may therefore be the case that a DAO is subject to multiple taxation regimes which may create uncertainty.
Conclusion and next steps
Within its paper, the Commission arrives at the preliminary view that the law in England and Wales is sufficiently flexible in terms of the tools and principles that may be relied upon when it comes to structuring a DAO.
The deadline for submitting responses to the public call for evidence is 25 January 2023. Once this deadline has passed, the Commission will produce a scoping paper in order to further explore this area and identify any areas in need of potential reform.