DAOs in English law: another (but not final) step forward

With so much focus on the regulatory treatment (and mistreatment) of blockchain related businesses, the benefits of commercial legal certainty for choosing a country or territory as a home of choice for these businesses is often overlooked. On 11 July 2024, the Law Commission of England and Wales published a scoping paper Decentralised autonomous organisations (DAOs): A scoping paper (the Paper) on the legal treatment of Decentralised Autonomous Organisations (DAOs) under the law in England (and Wales).¹

The Paper is useful in that it identifies how the current law is likely to apply to DAOs and, in this respect, is a useful further step towards legal certainty. The Paper also provides a useful primer on the legal basics as well as offering a definitional perspective which is likely to be adopted by law-makers, the courts and regulators in England.

No changes required (yet)

A main conclusion in the Paper is that there is no current need to develop an English law DAO specific legal entity , in part because there is no consensus on what that entity should look like. There is also a general desirability for organisational law to “remain technology neutral”. In other words and in keeping with the more incrementalist nature of the English common law, the law should not be changed solely to address new technologies where those technologies can be accommodated within existing general principles, adapted as necessary.

Why does the law care about what a DAO is?

The Paper provides a useful reminder of why the classification(s) of a DAO matter:

• Liability - who is liable where actions by or on behalf of the DAO give rise to liability in tort (such as negligence) or contract, or if there are any regulatory breaches or criminal conduct? (See our alerts) and for US perspectives on private law and regulatory liability.)
• Capacity – who represents a DAO where it enters into a contract or wishes to own property or hold funds, especially where the DAO has no separate personality?
• Roles and responsibilities - what duties do the various participants, including developers, token holders, and potentially miners/validators, owe each other, third parties and the world?
• Regulation and tax – who/what must apply for authorisation to carry on regulated activities and on what basis should the DAO and/or its participants be taxed?

A broad definition

The Paper highlights the point that the term “DAO” does not necessarily indicate a particular type of organisational structure and, therefore, cannot imply any specific legal treatment.

It seeks to define DAO broadly to refer to an online organisation using rules set out in computer code that is part of the “crypto ecosystem”. The Paper unpacks this further by explaining that a DAO will generally bring together a community of participants with a shared goal – whether profit-making, social or charitable – often with some control over governance matters distributed among participants through the use of distributed ledger technology (DLT), smart contracts and sometimes involving the issuance of “governance tokens” that allow DAO participants to take part in the governance of a DAO.

Three types of DAOs

The Paper considers three types of arrangements:

• Pure DAOs -  these are decentralised and “reject dependence on law and legal institutions for their existence.” A pure DAO may be found to include a general partnership or unincorporated association, or involve a collection of legally enforceable contracts between participants, or even a trust structure. These legal characterisations can arise under the law of England and Wales without the need for incorporation or registration.
• Hybrid Arrangements -  these intentionally combine smart contract based coordination, i.e. a pure DAO arrangement, with one or more legal forms or entities, sometimes known as a “wrapper”. Adoption of a legal wrapper can improve a DAO’s ability to protect its members from liability and interact with the off-chain world. For hybrid arrangements, key questions will be what type of legal entity or entities to use, and in which jurisdiction (although, few if any DAOs are currently set up under English law, the Paper cites the example of Wyoming which has a specific law for DAOs).
• Digital Legal Entities – these are incorporated legal entities which makes use of technology such as DLT and smart contracts in their formal governance and/or operational arrangements. An example of this is a private company limited by shares may wish to use various technologies to issue tokenised shares, substantially automate shareholder voting, or use DLT-based rather than centralised registers.

Some Pure DAO Legal Issues

The Paper highlights three issues for pure DAOs:

• DAOs as general partnerships or unincorporated associations? -   Characterisation as a general partnership, with members jointly liable for liabilities incurred by each other and with onerous duties to act in each other’s best interests, contrary to participants’ intentions, is a fear for DAO participants. The decentralisation of governance, nature of the activities of archetypal pure DAOs and the lack of means for making financial gains, may make it unlikely that a court would conclude that the participants agreed to carry on a business as a general partnership. The better characterization is as an unincorporated association, with participants interacting according to rules set out in smart contract code in order to carry out the non-business purpose of governing the DAO and only liable for their own acts or the acts of their agents.
• Other possible characterisations? - Participants in a DAO may have obligations to one another under contract, even if their relationship does not amount to a general partnership or unincorporated association. In this respect, the code in a smart contract can constitute a legal contract, therefore even if participants are only interacting with code or each other via code, this could be sufficient for a legally enforceable contract to exist. Any relationships will require other legal analyses and so participants may still have liability, for example, in negligence, or by way of fiduciary duties.
• Fiduciary duties of software developers? – a current question in the market, raised in Tulip Trading Limited v Van der Laan [2023] EWCA Civ 83, is whether software developers owe fiduciary obligations to users of their software and owners of cryptoassets manifested by that software (noted in our alert). The Law Commission take the view that there would be no policy or legal justification for characterisation as a fiduciary merely based on the act of open-source software development, whether in a DAO or otherwise, but note that there may be specific situations (although the Paper does not identify any) that give rise to fiduciary liability.

The challenge of jurisdiction and extra-territoriality

The Paper gives a clear reminder that individuals and entities participating within a DAO will have some choice as to which law applies for private law purposes to govern, for example, their contractual relationships with other private parties. However, that choice of law will not affect the regulatory regime that applies to the parties as a matter of public law, because parties cannot contract out of mandatory rules. On an application of existing English law principles, how these regulatory regimes will apply will depend on whether the rules also apply to things that happen outside England and Wales.

Regulation not ignored

Although the Paper’s focus is the private law aspects of DAOs, it also shines a useful light on financial services and securities regulatory considerations for DAO participants, including with respect to the following:

• Governance tokens - noting the comments of the Financial Conduct Authority (FCA) in its Guidance on Cryptoassets, PS19/22 (July 2019) [https://www.fca.org.uk/publication/policy/ps19-22.pdf.], whether governance tokens issued by a particular DAO are to be regarded as security tokens, subject to the rules on offers of securities, can only be determined on a case-by-case basis.
• Regulated activities - Even if the DAO’s governance tokens are security tokens, the FCA has noted that simply issuing security tokens is not necessarily regulated. FCA authorisation will depend on the other activities the DAO undertakes, e.g., for example, a DAO's treasury activities could involve managing and dealing in investments as could the business of selling and transferring security.
• A DAO as a collective investment scheme (CIS) - the definition of a CIS is technology neutral and the potential use of a DAO as a CIS, which requires an FCA authorized “operator” and is limited in the extent to which it can be offered to the public, has been recognized, at least, in the academic literature. (See Dan Awrey, ‘Artificial Intelligence versus Human Nature: Protecting Ourselves from the Perils of DAO-based Collective Investment Schemes’ (Oxford Business Law Blog, 12 July 2016).)

More work to come

The Paper identifies areas for further work to accommodate DAOs thought desirable, and to ensure that their activities are within the reach of the regulatory regime. The paper suggests:

• Review of the Companies Act 2006 – This would determine whether reform is needed to facilitate the increased use of technology in the governance of companies and other business organisations, such as limited liability partnerships.
• Introduction of a limited liability not-for-profit association? – This would have flexible governance options and could be a useful and attractive vehicle for non-profit DAOs (akin to foundations in, for example, the Cayman Islands).
• DAOs and the general review of English trust law – In general terms rather than in the DAO context specifically, this would consider the arguments for and against the introduction of more flexible trust and trust-like structures.
• A review of anti-money laundering regulation in England – This would consider whether the same policy objectives can be achieved in a manner more compatible with the use of DLT and other technology.

 

---

^[1] While the United Kingdom has a largely uniform system of public law, private law is considered separately as between (a) England and Wales, (b) Scotland and (c) Northern Ireland, even if the content of each may ultimately be the same. In this Alert, the term “English law” also includes the law of Wales.  

 

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee a similar outcome.