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THE DAO DILEMMA: IS PROGRESSIVE DECENTRALISATION THE FUTURE OF CORPORATE GOVERNANCE?

[Alka Nanda Mahapatra and Anjali Sunil are third year law students at National Law University Jodhpur.]


A Decentralised Autonomous Organisation (DAO) is a newly developed type of corporate structure where all members strive to act in the organisation’s best interests; however, what sets them apart is the lack of a central governing body. Popularised by blockchain technology and cryptocurrency enthusiasts, DAOs use a bottom-up management approach to decision-making. With the help of self-executing rules placed on a public blockchain, this blockchain-based system allows people to coordinate and govern themselves in a decentralised manner.

 

How are DAOs governed?


Meticulously constructed smart contracts are essential to the functioning of DAOs. Decision-making procedures are dictated by these agreements and codes, which derive information from the activities taking place on a blockchain. To demonstrate, let us assume that a decision’s outcome causes a particular piece of code to run. This code might make it easier to carry out operations like increasing the number of tokens in circulation, regulating the number of reserved tokens, or rewarding tokenholders who are already a part of the ecosystem.


Voting inside DAOs is transparently documented on this blockchain. Users are typically given options that are mutually exclusive. Voting power is frequently distributed in direct proportion to each user’s token count. In a DAO, for example, a user with 100 tokens would have twice the voting power of a user with 50 tokens.

 

Understanding the Wyoming DAO Supplement


As of April 2021, the state of Wyoming made history by enacting Senate Bill 38 (Wy. Stat. § 17-31-101-115), also referred to as the DAO Supplement. This legislation marks the first time DAO has been given official recognition and is regulated as a Limited Liability Company (LLC).


The DAO Supplement’s primary purpose is to offer liability protection to members of DAOs organised as Wyoming LLCs, safeguarding them from personal liability for the actions and obligations of the DAO. This legal shield effectively prevents DAOs from being treated as general partnerships in legal disputes, a crucial safeguard in an emerging field where regulatory clarity is paramount.


One notable distinction is that while members of a typical LLC typically have fiduciary duties to the organization, members of a DAO are subject only to the implied contractual covenant of good faith and fair dealing. This characteristic highlights the unique nature of DAOs, where trust and governance rely primarily on smart contract code. This is something that is also reflected in the actual functioning of a DAO; even in the ConstitutionDAO, Jonah Erlich had clearly stated that the model worked on trust and good faith, serving as a basic premise for this model.


Another feature favoured in DAO’s is anonymity. However, in the state of Wyoming, with the introduction of this supplement, the Corporate Transparency Act that applies to LLCs would also simultaneously apply to LLCs, compromising the anonymity of members. But the supplement still manages to keep intact certain aspects of the DAO, such as more flexible management and the intrinsic role of the smart contract as the primary governing document.

 

Liability of Individual Members and Reading DAO Into Existing Organisational Structures


Before the introduction of the Wyoming Supplement and the recent Utah Law, DAOs have largely operated in a legal grey zone. There have been scarce legal provisions assigning responsibility to individuals, and there haven't been any prior judicial rulings on this matter. The situation changed with the case of Sarcuni v. bZx DAO.


Considering that the very concept of DAO’s governance is largely dependent on blockchain technology and smart contracts, the issue arises as to who the liability ultimately falls on.


In May 2022, users of a decentralised finance platform bZx filed a class action lawsuit against bZx in a United States federal court in California to seek damages for negligence arising from a hack of the protocol that resulted in losses amounting to USD 55 million. The cause of this was not an elaborate hack but a simple phishing scam on one of bZx’s developers, which permitted access to key passphrases that then permitted the hackers to drain Plaintiff’s accounts. The protocol had not implemented security measures yet. The plaintiff held that since the protocol was hacked as a matter of negligence, the Defendants were jointly and severally responsible for compensating the Plaintiffs. The Plaintiff’s argued that because a bZx lacks any legal recognition, it would be considered a general partnership.


The court in this case mentioned a threefold test: firstly, to determine that it is an association of two or more persons; secondly, to check that it is carried on by the persons as co-owners, and thirdly, to determine that it is a business of profit. The courts did find that a general partnership existed.


This case held that, in the absence of specific legislation, a DAO is likely to constitute a general partnership. A general partnership insinuates that there is no separate legal existence, and the court failed to understand how a smart contract would avoid legal accountability for the actions or omissions of a DAO. Members of a DAO cannot essentially avail themselves of the benefits of a limited liability partnership or company without incorporating as such. Being a general partnership narrows down the liability of the members, thus exposing their claims for damage.


This raises the question of how a DAO would be read into the Indian legislative framework. Going by the rationale of the judgement in Sarcuni, the Indian courts would also be likely to adopt a similar understanding of an unregistered DAO. Pursuant to Section 4 of the Partnership Act, 1932, a partnership is the relationship between persons who have agreed to share the profits of a business carried on by all or any of them acting for all. Section 5 of the act further stipulates that the partnership must always arise from a contract. Considering that DAOs are governed primarily by smart contract, the members can be construed as a relationship between persons who have agreed to share the profits arising from the DAO. It can be held that within the current legal framework, a DAO not registered as a Limited Liability Partnership can be considered as a “partnership” within the ambit of the Partnership Act, 1932.


However, looking into the inclusion of DAO’s being read into the ambit of a Limited Liability Company’s through legislation such as the Wyoming Supplement raises the question of whether, in the Indian context as well, DAOs can be read into the ambit of a Limited Liability Partnership.


Applying this perspective to the Indian legal framework, the principles outlined in the Partnership Act, 1932, appear applicable to unregistered DAOs. The contractual nature of DAO interactions and the profit-sharing aspect align with the essence of partnership relations described in the Act.

 

Limitations & Potential Challenges:


Although immutability and a blockchain’s consensus mechanism protect the governance rules of DAOs, the human-written code that underpins these rules is still prone to error. Blockchain’s immutability can be a benefit, but when human error occurs, it can also cause issues. The deliberate restrictions placed by Satoshi Nakamoto on smart contracts on the Bitcoin blockchain prove this. Platforms like Ethereum, which allow the execution of smart contracts via Turing complete languages like Solidity, made the introduction of Decentralised Apps feasible. This flexibility does have a cost, though, as programmers occasionally design apps with weak smart contracts that jeopardise money. To reduce these risks and audit smart contracts, initiatives such as Quantstamp have been developed. But for businesses, particularly those who are just starting to create a DAO on smart contracts, a cautious approach towards the current technology is recommended.


Moreover, the immaturity of the technology gives rise to additional vulnerabilities. On the Ethereum blockchain, the first open crowd-sale took place in 2016, and several projects that raised Ether through Initial Coin Offerings have not yet produced a working product. Furthermore, consensus algorithms' future is still unknown. There is ongoing discussion in the community about which approaches—Proof of Work, Proof of Stake, or other approaches—offer the best network security solution. This uncertainty is increased further by quantum computers, which could potentially make current cryptographic techniques obsolete due to their enormous processing power.


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