Blockchain & Cryptocurrency Regulation 2023 | 17 The emergence of DAOs: From legal structuring to dispute resolution covers subjects including:
1 Government attitude and definition
2 Virtual currency regulation
3 Sales regulation
4 Taxation
5 Money transmission laws and anti-money laundering requirements
6 Promotion and testing
7 Ownership and licensing requirements
8 Mining
9 Border restrictions and declaration
10 Reporting requirements
11 Estate planning and testamentary succession
1 – What are DAOs?
When defining Decentralised Autonomous Organisations (DAOs), one must begin by looking at the facts as they always precede the law or any other formal template. Therefore, we commence with Christoph Jentzsch’s white paper describing the first implementation of DAO code to automate organisational governance and decision-making. On the one hand, Jentzsch states that “corporate entities of all kinds are governed by rules that describe permitted and proscribed conduct. These rules may exist as private contracts (like bylaws or shareholder agreements) between corporate owners. They may also be imposed by law in addition to or in the absence of a written agreement between participants”.[i] On the other hand, Jentzsch adds that “(1) people do not always follow the rules and (2) people do not always agree what the rules actually require”.[ii]
We note that DAOs are focused on improving the aforementioned, i.e. guaranteeing the application and functioning of organisational rules, whilst also boosting their members’ trust and access to the entity’s information (transparency). These significant improvements are also doubled by the speed and security that the specific blockchain technology brings to DAOs. By adding these DAO-specific characters, we define it as a high-tech form/entity intended to improve the organisations’ life and functioning, including their mechanisms, transparency and trust.
Interest in DAOs has continued to grow since 2016 when the first functional DAO was created,[iii] with an important number of institutional, academic and business analyses (and definitions) on the matter. Among the many analyses, we use the World Economic Forum June 2022 white paper, Decentralized Autonomous Organizations: Beyond the Hype, to provide another DAO definition: “Decentralized autonomous organizations (DAOs) are entities that leverage blockchains, digital assets and related technologies to deploy resources, coordinate activities and make decisions. DAOs attempt to decentralize the operation of firms and other collective entities by making functional and financial information transparent and empowering token-holding members to propose, vote on and enact changes.”[iv]
In the US, the Lummis-Gillibrand bill proposes a comprehensive framework for virtual currencies, and provides the following definition of a DAO: “[A]n organization—
which utilizes smart contracts to effectuate collective action for a business, commercial, charitable, or similar entity,
governance of which is achieved primarily on a distributed basis, and
which is properly incorporated or organized under the laws of a State or foreign jurisdiction as a decentralized autonomous organization, cooperative, foundation, or any similar entity.”[v]
Hence, at the core of qualifying a DAO lies the inherent use of smart contracts for a community that achieves its decision-making via distributed decision-making. It is highly important to note that, in the eyes of a legislator, a DAO needs a “legal wrapper” in order to be recognised – namely, proper “incorporation” under the laws of a US state or other nation, mainly for three reasons: tax; opposability/transparency towards third parties; and ensuring that the limited liability protection that a state provides for normal corporate entities is transferred to DAO members as well (discussed further below). The main purpose of a DAO is very broad and thus covers any activities that are legal and regulatory compliant for any other non-DAO business entity in the US.
DAOs are defined by several positive characteristics, while also having several downsides, both briefly described in the table below:[vi]
Benefits- Decentralisation
The decisions taken by the organisation belong to the members of the organisation, in contrast with the decisions taken by company CEOs or boards (with the exception of DAOs where one entity owns the vast majority of the votes).[vii]
Downsides - Inefficiency
The rights provided to each participant can make each decision difficult, slowing down the entire effort.
Benefits - Publicity
Within a DAO, votes are cast via the blockchain and made publicly available.
Downsides - Security
Of utmost importance to the entire blockchain environment is the security of the operations performed, as any breach not only leads to financial loss but also to diminished trust (another element of a DAO’s essence).
Benefits - Community
DAOs bring together individuals from all over the world, joined by a common interest.
DAOs are a result of the work of communities and entrepreneurs and are not yet governed by regulation. The concept hails from professionals that perform in the field, with regulators failing to fully understand the entire concept and/or fearing the new technological wave of improvement. Presently, DAOs do not have regulation to govern the field, with the exception of three US states (Tennessee, Vermont and Wyoming).
2 – Legal wrappers for DAOs
So, what exactly is a “legal wrapper”? In a nutshell, a legal wrapper is a non-automated, human-negotiated contract or filing needed by a DAO to interface with government or other business actors. DAOs allow people who share an economic interest to coordinate effectively through the blockchain protocol and tools, and utilise smart contracts to automate decisions and govern members’ relationships with each other. Many DAOs choose to operate without any legal wrapper and while this does not violate any laws, it does create potential legal consequences for a DAO’s members. There are currently nearly 200 active DAOs that manage a total of approximately €14 billion in cryptoassets, so it is fair to assume that soon enough DAOs will be heavily regulated. DAOs are being commonly designed to confer a “legality” of the blockchain, yet the vast majority of DAOs by their very nature exist outside any legal framework. This dichotomy creates challenges for the DAOs and their participants; in short, a DAO cannot properly operate in the business world without having a legal identity because:
it needs to interact with other parties: a DAO cannot sign contracts or enter into agreements without a legal identity;
it must protect the liability of its members: if a DAO is unincorporated, it will most likely be considered a general partnership and as a consequence, all its contributors will be liable in the event of a lawsuit or any other legal issue;
it cannot hire talent: a DAO will require a legal wrapper to be able to legally hire talent and remunerate it legally without risking tax evasion; and
it needs to pay taxes: a DAO will need a legal identity in order to be taxable.
Overall, a DAO needs a legal wrapper to act as an insurance policy against the future of digital assets and cryptography regulations. However, such wrapper comes in many forms, and a DAO must carefully choose the adequate form that will properly protect its members, activities and assets. Particular attention should be geared towards tax and regulatory requirements, and founders should operate in ways that preserve the integrity of the DAO. For instance, members need to make sure that they respect all corporate formalities so as to avoid mixing their personal assets with those of the DAO in order to avoid the risk of the court disregarding the wrapper and piercing the “corporate veil”.[viii] The types of legal wrapper vary according to the DAO’s purpose and the country in which it is founded. In the US, for instance, DAOs can be organised as: an unincorporated non-profit association (UNA); a limited cooperative association (LCA); or the well-known limited liability company (LLC). These legal wrappers are imperfect for they do not take into consideration the subtleties and corporate dynamics that give a DAO its uniqueness. LLCs are interesting for DAOs because they are well suited to decentralised governance LLCs, allowing their members to waive fiduciary duties to each other and to the company and providing flexibility for arranging decision-making in a decentralised fashion. In summary, when deciding whether to “wrap” a DAO, the founders need to carefully assess whether or not the activities of their DAO bear potential litigation risks and whether the DAO’s activities create any tax liabilities. An LLC structure, for instance, may not be suited for DAOs with flexible memberships as the LLC structure is designed for an immutable body of members. Similarly, DAOs with fluid and decentralised structures will be hard pressed to fit well in the current available wrappers that imply a centralised governance.
3 – What rights does a DAO participant hold?
There are two main types of DAO – legal DAOs and DAOs that are not covered by any legal framework. Legal DAOs are those incorporated in the US states of Tennessee, Vermont or Wyoming, states that can regulate various aspects regarding the DAO’s quorum or certain cybersecurity requirements.[ix] In contrast, DAOs that do not fall under any legal framework are common, and grant their token owners the rights decided by their own governance act and will. In the following paragraphs, we address the rights granted by some of the most important DAOs in existance.
DAOs are organisations formed out of token holders, with these tokens being at the centre of the stakeholders’ rights. Tokens are issued by each DAO and compared with company shares, the basis on which the holder obtains his rights within the organisation.
Broadly speaking, tokens provide holders with organisation ownership rights, which can take various forms, including the following:
Right to propose organisational actions/modifications – a token owner has the right to propose new aspects of interest for the DAO or even changes regarding its day-to-day activities.
Voting rights – notwithstanding, the right might be subject to quorum and voting thresholds, as in the case of the Decentraland DAO. Herein, governance proposals have a three-stage roadmap, commencing from a pre-proposal poll (a submission threshold of 100 voting powers (VP) and a passage threshold of 500,000 VP), a draft proposal (a submission threshold of 1,000 VP, a passage threshold of 1 million VP and simple majority (51%) of participating VP) and a governance proposal (a submission threshold of 2,500 VP, a passage threshold of 6 million VP and simple majority of participating VP (or needed acceptance criteria for their category)).
Return on investment – there are two main types of benefit in this respect (whilst token owners can vote on the benefit distribution or reinvestment):[x] (1) the token owner can receive different types of benefits – discounts, additional tokens or even cash; and (2) the owner can resell its token and thus obtain additional amounts of cryptoassets (or even fiat), should the value of the token (which, in general, is freely traded) increase.
Some DAOs are limited in the rights provided to their token holders – a good example (despite failing to achieve its purpose) is the Constitution DAO, a single-purpose DAO targeting the acquisition of a rare US Constitution. The DAO was successful in raising $40 million yet it did not win the Sotheby auction selling the respective valuable, regarding which, according to the DAO website, “the tokens possess no rights, governance, or utility other than redeeming them for ethereum from the smart contract held in Juicebox at a ratio of 1,000,000:1—the same ratio at which contributions were made to the initial crowdfund to buy the Constitution”.[xi] Therefore, whilst the Constitution DAO website also states that “it is also an option to keep your $PEOPLE tokens and do with them as you please—it is clear that there are parts of the community who wish to incorporate them into future projects”, it is clear that such other projects can incorporate the tokens, yet are distinct from the existing DAO.
4 – DAO obligations and liabilities
There are critical unresolved questions regarding the application of equitable principles, such as the law of fiduciary obligations, to DAO relationships. For example, it is unclear whether there is sufficient trust and confidence in relationships between DAO members, and between DAO members and managers (if they are not also members), to justify imposing fiduciary obligations. There is also ambiguity about how other corporate law concepts, such as the rules of agency, apply where DAO members or external advisors act on behalf of DAOs. There is also ambiguity about how other corporate law concepts, such as the rules of agency, apply where DAO members or external advisors act on behalf of DAOs. Many DAOs fall into partnership status because they cannot be incorporated, imposing unlimited liability on their members. As long as DAOs are not legally recognised, they also do not have limited liability protection. This means that contributors to a DAO can be held personally liable for the debts and obligations of the DAO, deterring many potential contributors from participating. The lack of limited liability also makes it difficult for DAOs to raise capital since most investors would be unwilling to put their assets at risk. Another concern with DAOs is the risk associated with distributed governance. Because DAOs have no central authority, they are often governed by rules embedded into smart contracts. There is a potential for these rules to be hacked or manipulated, leading to disastrous consequences.
The Ooki DAO case and the Commodity Futures Trading Commission (CFTC) imposed liability on founders of a DAO.[xii] The CFTC filed a federal civil enforcement action against Ooki DAO and its founders for illegal commodity transactions performed by the Ooki DAO platform. The view of the CFTC is that even if one transfers control over an activity to a DAO, this does not mean that the founders or managers of a previous centralised activity are free of any liability after the control being offered to a DAO. The CFTC relies on a state law doctrine of unincorporated association whereas its members (associates) are fully liable to the actions of the association if the association is for profit. As long as the founders were active members, shaping the strategic path of the DAO, then they may become liable for any of the DAO’s violations. Second, once a DAO violates any rules and/or regulations, then the liability is passed on to the “owners” of the DAO, namely the stakeholders who form the governance of the DAO. This means that DAO voters may also be liable in such situations, even if they were not managing or leading the DAO’s operations.
On the other hand, CFTC Commissioner Mersinger had a dissenting opinion. She dissents from using an overly broad umbrella on DAO members’ liability, namely determining liability for DAO token holders based on their participation in governance voting,[xiii] for the following reasons: (i) the liability theory used by the CFTC is a state law theory stemming from torts and contract disputes – the liability of the unincorporated association lacks predictability and might hinder the efforts of good governance in the web 3.0 world of DAOs; and (ii) the creators and organisers of an unlawful DAO might be charged by the CFTC by using the aiding and abetting liability, already used by CFTC in other cases, without geopardising the actors involved in a DAO but whom do not have any role in a rules violation. The aiding and abbetting standard requires:
there being a violation of the Commodity Exchange Act or CFTC rules;
the aider-and-abettor having knowledge of the wrongdoing underlying the violation (which does not necessarily require knowledge that the conduct is unlawful); and
the aider and abettor intentionally assisted the primary wrongdoer.[xiv]
5 – DAO use cases
The number of DAOs has skyrocketed since the first appearance in 2016: “4,228 DAOs in operation, ranging from large communities with multiple aims14 to applications that are nothing more than “group chat[s] with a shared bank account””,[xv] while “the total combined value of DAO treasuries increased roughly fortyfold (from $380 million to $16 billion) from January to September 2021”.[xvi]
Among these DAOs, we focus below on some examples that are representative and explain their practical use and utility, including disputes between shareholders and the startup dynamic equity method. An interesting use case for DAOs could be syncing the model of dynamic equity splits of startups with the self-enforcing nature of smart contracts upon which a DAO is built.
The dynamic equity split is “a simple formula based on the principle that a person’s % share of the equity should always be equal to that person’s share of the at-risk contributions. At-risk contributions include time, money, ideas, relationships, supplies, equipment, facilities or anything else someone provides without full payment of it’s fair market value. Every day people contribute more and more to a company in hopes that it will someday generate a profit, go public or sell. Because contributions are constantly being made, the model is dynamic. It self-adjusts to stay fair”.[xvii] It is also a helpful method for a leaving shareholder to be bought out by the other shareholders at a commonly agreed price that is based on objective and quantifiable criteria.
The main issue with dynamic equity split is the will of the founders to transfer the shares based on the method. Founders sign pre- and post-incorporation agreements to set the rights and obligations stemming from the inputs/efforts/resources of each founder, but what if a dispute arises or one of the founders acts in bad faith? The other founders can only recourse to justice and sue the bad faith founder.
However, for DAOs, a sort of operating agreement and the contribution of each founder/member of the DAO can be enforced on-chain, together with other governance decisions of the DAO. The inputs can be accounted for on-chain (for inputs such as token transfers, code writing, and basically any digital contribution) or off-chain and then accounted for by an oracle to the DAO’s on-chain environment. Third-party intervention could be minimised, including the recourse to judiciary means to enforce the parties’ agreement in a pre-agreed joint venture.
6 – Governance
The Decentraland DAO, according to its website, is “a decentralized virtual reality platform powered by the Ethereum blockchain. Within the Decentraland platform, users can create, experience, and monetize their content and applications”.[xviii] The Decentraland DAO “is the decision-making tool for MANA, NAMES and LAND holders in Decentraland’s virtual world. Through votes in the DAO, the community can issue grants and make changes to the lists of banned names, POIs, and catalyst nodes. The DAO also controls the LAND and Estate smart contracts”.[xix]
In short, the Decentraland DAO is used for two general types of proposals: (1) proposals with direct binding actions; and (2) governance proposals.[xx] Whilst we discussed above the governance proposal steps and thresholds, we continue below with examples of proposals with direct binding actions available for Decentraland DAO participants:
Funding a community project by transferring a portion of the DAO’s resources to grant a vesting contract.
Adding a catalyst node to the network of servers that host and run Decentraland’s virtual world.
Adding or removing points of interest (POIs), or highlighted locations within the virtual world, to a list that is shown to users. This list helps users to find popular and interesting locations to explore.
Banning certain names from Decentraland. This proposal ensures that avatars cannot be given offensive and harmful names.[xxi]
7 – Funding/crowdfunding
Another important use of DAOs is funding various projects and investments, such as the Constitution DAO (discussed above) and BitDAO.[xxii]
In contrast with the single purpose that defines the Constitution DAO, BitDAO appears similar to the big investment banks/funds/asset managers with its target of open finance and a decentralised tokenised economy, and describes itself as “a collective of builders, products, and mutually beneficial ecosystems governed by $BIT token holders, whilst emphasising its focus”, i.e. that it can “provide grants for development of decentralized technologies including DeFI, governance, layer 1 or layer 2, privacy, NFTs, etc.”.[xxiii]
As such, BitDAO is used as a complex financing entity, open to participants and granting BIT token holders the right to “propose and vote on the direction of BitDAO and the use of BitDAO treasury assets, under the benefit of being governed by a set of smart contracts on the blockchain”.[xxiv]
8 – How to structure a DAO
As discussed above, a DAO can be structured in number of ways, such as a UNA, an LLC or an LCA. These legal forms each come with benefits but are also burdensome and indifferent to the nature and intent of DAOs. Currently, many DAO funders are tempted to avoid giving any legal status to their DAO in order to maintain its decentralised character and the freedom of its members to change their roles or forgo their position in the DAO altogether. For those that wish, and for a good cause, to operate in a legal framework, the options below are available at the time of writing. We are confident that the regulators will come up with a better-suited legal solution that will afford DAOs a proper legal structure designed for DAOs only, preserving their characteristics while protecting all involved parties.
In the US, three states are serious about finding a legal solution for DAOs. These states are Vermont, Wyoming and most recently Tennessee. The Vermont blockchain-based LLC (BBLLC) was established in July 2018, making Vermont the first US state to enact LLC legislation designed for such companies. While the law does not explicitly mention “DAOs”, it generally applies to companies that “utilize […] blockchain technology for a material portion of its business activities”. BBLLCs are also subject to the provisions of Vermont’s standard LLC law. A company that registers as a BBLLC must include in its operating agreement a summary of the company’s mission or purpose, information about the blockchain technology to be used, protocols for responding to security breaches, voting procedures to address certain types of matters, the procedure for becoming a member, and the rights and obligations of each group of participants. A BBLLC participant must comply with any applicable fiduciary duties (e.g. the duty to refrain from competing with the organisation).
The Wyoming DAO LLC followed suit in July 2021, when the state enacted the nation’s first law giving mention to DAOs – the “Wyoming Decentralized Autonomous Organization Supplement” – which was subsequently amended in March 2022. DAO LLCs are also governed by Wyoming’s standard LLC law. In Wyoming, an organisation electing to be a DAO LLC must specify in its articles of organisation “how the decentralized autonomous organization shall be managed by the members, including to what extent the management will be conducted algorithmically”. As a default rule, Wyoming’s statute provides that members do not owe any fiduciary duties, such as the duty not to compete, to each other or to the organisation unless the organisational documents say otherwise. A Wyoming DAO LLC dissolves if the DAO “failed to approve any proposals or take any actions” in a one-year period.
Furthermore, the Tennessee DO LLC was created in April 2022. Tennessee, similarly to Wyoming, passed its own DAO legislation. Tennessee’s statute, however, refers to the entity type as a “decentralized organization”, or “DO”. So, why not including the word “autonomous”? This is most likely to reflect the reality of how most DAOs actually function. According to Chainalysis, fewer than 1% of governance token holders have 90% of VP, which does not seem particularly decentralised, or autonomous. DO LLCs are also subject to Tennessee’s standard LLC law. A DO LLC dissolves upon failure to take action or approve proposals in a one-year period.
In other parts of the world, the DAO has seemed to gain traction. For instance, in the Republic of the Marshall Islands (RMI), the law enables DAOs to register as legal entities. RMI legislation, known as the “Non-Profit Entities Act”, allows DAOs to legally register as corporate entities and the legislation “grants DAOs the same privileges as limited liability corporations”. However, DAO LLCs are only recognised in the RMI and as a result, if a DAO LLC decides to invest in other jurisdictions, it would be subject to foreign investment laws, which can be even more complex than the corporate legislation that DAOs are seeking to avoid.
DAOs have employed various foreign wrappers in jurisdictions in order to help align operational structures with DAO attributes. In the not-so-distant past, Swiss foundations were employed by various early projects. Today, one of the most frequently used and internationally recognised structures is the Cayman Foundation Company, which allows an independent legal entity and limited liability associated with a typical corporation. Foundation Companies can be created in just a day and do not require any owners or shareholders; simply put, they are not owned by anyone and can still achieve important functions for DAOs, including hiring talent, being a vehicle for early-stage funding, and holding funds. Foundation Companies have a flexible structure, allowing any member (director or not) to exercise control. These DAOs may also be structured to afford favourable tax treatment in the Cayman Islands. However, such foundations can be difficult and expensive to implement. It is important to note that this structure does not “wrap” the DAO, but rather acts as an affiliate or independent entity of the DAO that is directed by the DAO’s token holders for a specific purpose, creating potential liability for the DAO’s members and its directors.
Another method of organising a DAO is via the Guernsey Special Purpose Trust, which separates a person’s ownership of property from the right to benefit from that property. It allows a person or entity (the settlor) to transfer property to another (the trustee), who is then charged with holding the asset for a specific purpose. Guernsey Special Purpose Trusts are governed by trustees, who have general fiduciary duties to act in the best interest of the trust and are subject to removal by other trustees, which can in turn be directed by vote of DAO token holders. The advantage of such trust is that it does not require any governmental filing to be formed; a contract between the grantor and the trustees is sufficient.
These laws burden DAOs without conferring any real benefits as the statutes are flawed as a result of a misunderstanding of how DAOs really function. For instance, the existing legislation fails to resolve conflicts between the operating agreements and smart contracts or set a realistic default quorum requirement (DAO votes typically have very low participation, especially on matters of minimal impact for the DAO – in fact, it would be irrational for the majority of guild members to participate in every on-chain voting, which costs gas). Tennessee and Wyoming both require any smart contracts to be capable of being upgraded or amended despite the fact that, by their very nature, smart contracts are immutable. LLCs pose significant challenges for blockchain-based DAOs with fluid, constantly changing participants who seek to stay anonymous. Typically, adding new members to LLCs requires amending the LLC’s operating agreement, and transferring membership interests can also be restricted (amendments are often necessary to operating agreements in order to reflect new members in an LLC).
In order to address this legal vacuum, a number of international experts from the legal and technological field are focusing on drafting a model law aimed at helping states to modernise their legal framework on company law by adopting rules of substantive law applicable to DAOs. The proposal would be to break away from existing forms of companies, take into consideration the unique characteristics of blockchain technology and, in essence, create an independent and national legislative model based on self-regulation whose rules would only be adopted by the blockchain community, thus offering a unique legal regime to DAOs.
9 – How to solve disputes in the decentralised economy
The decentralised economy is characterised by simple, non-bureaucratic and formalist-free procedures and we therefore believe that classic litigation would not be compatible herein. In contrast, arbitration appears to be much more suitable due to the following characteristics:
Delocalised – parties have the power to choose their own rules (ad hoc arbitration) or resort to the rules of arbitral institutions. There is no specific situs in which to solve arbitration, apart from the place set by the parties that regulate how procedures have been dealt with by the arbitrators. Basically, a Romanian and US party may solve a dispute solely by meeting online with the chosen arbitrator.
The parties’ right to appoint the arbitrators – as in DAOs, where the token owners can vote on aspects of interest for the respective DAO, in arbitration, too, those involved can choose who shall decide on their dispute.
Confidentiality – in contrast with ordinary court litigation, the arbitration, its procedures and ruling are secret and thus provide a higher degree of protection to those involved.
Speed – arbitration works on a specific schedule and is not bound by the limitations and number of additional cases that are regular in ordinary litigation.
The arbitrators are qualified – in contrast with ordinary judges, arbitrators are specialised in specific areas and thus provide a higher degree of understating in complex matters.
Less expensive – arbitration is (usually) less expensive than court litigation for complex matters.
The ruling is definitive – thus, the interested party can request its enforcement (while avoiding additional appeals).
Additional characteristics include, specifically for on-chain arbitration:[xxv]
Arbitral or expert dispute resolution in very short periods.
Arbitrators implementing decisions directly on-chain using a private key.
Optional anonymity of the parties.
Worldwide enforcement is another means of solving disputes, as arbitral awards are globally recognised by national courts by virtue of the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (the New York Convention, 1958), which was signed by more than 168 countries. In a nutshell, a local court will recognise an arbitral award, irrespective of where it was issued, with very finite exceptions, which have been interpreted in a somewhat standard manner across national jurisdictions.
The novel example of enforcing smart contracts in a leasing contract took place in Mexico based on a decentralised arbitration clause. The leasing contract was governed by Mexican law and was a standard clause where parties appointed an arbitrator and set the arbitration rules in a traditional “New York Convention” way.
The novelty of this particular arbitral clause was that the parties instructed the arbitrator to use the Kleros protocol to govern the substance of the award, underpinning a sort of hybrid concept of arbitration, according to which it is possible to have “traditional arbitrators” conducting the proceedings while using decentralised protocols and technological tools (cyberjuries, artificial intelligence, or any other technology that could be used to facilitate dispute resolution) to actually settle the substantial controversy.
In this case, when a dispute arose, the parties commenced the arbitral proceeding, both presenting their respective claims and evidence.
The appointed arbitrator drafted and sent a procedural order to Kleros, which ran its protocol and delivered a decision about the substance of the litigation, deciding in favour of the landlord. This decision was used as the crucial criterion for the arbitral award rendered and signed by the arbitrator and sent to the parties in a traditional fashion.
The local court had no precedent for this. Fortunately, the court did a remarkable job of going through the legal nature of the arbitral award with which it was presented and, having checked that neither the arbitral clause nor the proceedings were in any way opposed to any statute, it recognised the award and ordered its enforcement by means of public force.[xxvi]
On-chain arbitration
The novelty for on-chain organisations (DAOs) is the use of justice-as-a-service. The best model for this type of service for now is arbitration-as-a-protocol, which should be a service integrated in any DAO infrastructure. This is a type of dispute resolution characterised by a high degree of automation. Herein, the software code can incorporate the automatic election of an arbitration procedure in specific cases, the type of proofs accepted and their direct provision, as well as the automatic enforcement of the ruling (thus having reduced human intervention). Therefore, such arbitration involves the use of smart contracts.
On the arbitrability of on-chain disputes, the legal standards point in the direction that on-chain arbitration agreements are valid: “Arbitration agreements implemented in the respective executing SMART CONTRACT (eg as ‘comment’) may be agreed upon between businesses. Such arbitration agreements may also agree upon a dispute resolution ON-CHAIN.” This is not only the opinion of European experts across jurisdictions[xxvii] but also of the UK.[xxviii]
One of the seemingly last gaps in the interpretation of the validity of an on-chain arbitration is the generally accepted condition for an arbitration agreement to be “in writing”. Would a bitcode embedded in the blocks of the blockchain contained in the arbitration clause qualify as “in writing”? The European Law Institute mentions this issue: “Problems might arise when a particular legal system demands that arbitration agreements are to be concluded ‘in writing’ and the question arises whether a Smart Contract or a transaction on a blockchain can be qualified as fulfilling the ‘in writing’ requirement.”
We consider that a Ricardian contract embedded in the blockchain’s informational package, or a specific text code pre-agreed by parties, communities, or DAOs, respects the “in writing” requirement. One can argue that recourse to oracles in relation to input information of whether arbitration agreements related to the transfer of information, ownership, or access through that blockchain should amount to a pre-agreed, consented arbitration agreement.
However, even without the help of oracles, we argue that the condition of “in writing” is met by looking at its interpretation within the New York Convention, which states that an agreement in writing includes “an arbitral clause in a contract, or an arbitration agreement, signed by the parties or contained in an exchange of letters or telegrams”. Both parties will sign up to be part of a smart contract transaction, either with a click or by introducing data that will enable the use of the smart contract that is embedded. Parties agree before the self-execution of the smart contract on the effects of adhering to a smart contract. The signature requirement may be met by accessing the wallets or providing the wallet address, or by using the private keys that would allow the transfer of digital assets onto the blockchain.
It has also been clarified that the exchange of letters or telegrams can be replaced with other documents, as the technology has evolved since 1958: “[I]t is widely accepted that article II (2) [of the New York Convention of 1958] covers any exchange of documents and is not limited to letters and telegrams. Most courts recognize that an arbitration agreement contained in an exchange of documents or other written communications, whether physical or electronic, satisfies the requirement of article II (2).”[xxix]
New protocols and on-chain solutions are on the rise, such as DAOs becoming interoperable with a juror-based dispute resolution model – namely, independent jurors who decide online on a DAO-related dispute submitted via the blockchain to such juror-based[xxx] “tribunal”.[xxxi] Furthermore, Snap and Kleros[xxxii] can be described as follows: “As an open and neutral arbitration system, Kleros can be a useful tool to integrate with the governance of DAOs that want to ensure that their process is fully decentralized. It can be used in conjunction with other tools to enforce the correct execution of governance proposals on-chain by resolving disputes related to proposal enforcements in an unbiased manner.”
Jur.io is another blockchain that proposes a new protocol of dispute resolution and enforcement for the entire digital economy to which DAOs will be able to adhere. Jur wishes to empower an entire new digital society where rules and laws based on lex mercatoria shall become the new framework for digital activity and courts shall be transformed in digital/decentralised arbitration centres. On DAOs, they focus on the dispute resolution front: “DAOs are today generating transactions that need external dispute resolution services.” For example, the following disputes are covered:[xxxiii]
DAO grants.
DAO contribution.
DAO and sub-DAO cooperation agreements.
Gaming DAOs’ internal processes.
Vitalik Buterin accurately summed up the essence of DAOs as follows: “DAOs = automation at the center, humans at the edges.” It is inherent in human activity that conflicts shall arise. Such conflicts will be solved on- or off-chain depending on the facts and the claims made, namely if damages satisfaction/compensation shall be required on- or off-chain. Hence, both dispute resolution worlds shall have a place to coexist. Nevertheless, we sense that there will be a strong push for whatever can be solved on-chain to be solved on-chain, as part of the philosophy of decentralisation and the need for fast, binary decisions for less complex issues. This is a fast-developing space where decentralisation and more competitors are required in order to provide various models of dispute resolution for private and commercial matters, taking into account technology, cultural differences and the various nuances of the sense of justice, applied to an entirely digitised universe.
10 – The metaverse – the future of DAOs
DAOs are now functioning as global businesses that fundraise and/or empower communities,[xxxiv] and are here to stay, as evidenced by business emerging in the metaverse – Decentraland, Meta, etc.
The shaping of the concept and use cases for the metaverse lies again in a big market trend: centralised or decentralised metaverses. It is commonly agreed in this space that we are facing the prospects of a multiverse (more than one metaverse, with each communicating to the other via an interoperable infrastructure). The key question is whether such metaverses will be centralised or decentralised (as is the case with current social media platforms). Banking on a decentralised version of the metaverse, blockchain technology is poised to play a key part in the development of the metaverse for various reasons: “Blockchain-based cryptocurrencies could serve as a payment method in metaverse transactions. Proponents argue that blockchain use in the metaverse could facilitate fast, secure, trusted, and transparent online transactions without a centralized oversight body.112 Moreover, those who advocate for a decentralized metaverse (i.e., one not owned and controlled by a handful of companies) argue that blockchain could also serve as the technological backbone to build decentralized and distributed applications, services, platforms, and communities in the metaverse.”[xxxv] The best way to operationalise ownership of digital assets in the metaverse is through the use of blockchain technology (think of fast payments, the ownership of digital assets in encrypted wallets and the wide use of non-fungible tokens as forms of owning digital plots of land, avatar forms of identity expression, etc.).
Against this background, the governance of a metaverse and enforcement of policies and rules is expected to be performed by DAOs. A DAO could be a very good mechanism for stakeholders’ decision-making in this new area of human activity. “The question of whether DAOs are efficient enough to compete with centralized service providers can be answered by the view that DAOs are very good at managing treasury globally. I think it really depends on what a DAO is doing, what the objective is, and what it tries to achieve. In my opinion, DAOs are very good at governing public goods or infrastructure that have a greater base than one particular company. But when it comes to actually building something efficient, perhaps a DAO might not be very suitable. However, we’re still in the early stages. We might see, actually, a very efficient way of building things through DAOs soon.”[xxxvi]
We expect that the future shall bring a regulatory framework for DAOs as a foundation of their future and secure development. Until such regulation appears, at least at a US (federal) and EU level, stakeholders will provide proposals in this direction. The Coalition of Automated Legal Applications in its Model Law for Decentralized Autonomous Organizations has provided a DAO definition (“…refers to smart contracts (i.e. blockchain-based software) deployed on a public Permissionless Blockchain, which implements specific decision-making or governance rules enabling a multiplicity of actors to coordinate themselves in a decentralized fashion. These governance rules must be technically, although not necessarily operationally, decentralized”), as well as requirements in order for the DAO to obtain legal personality, among which we indicate the following:
The DAO must be deployed on a permissionless blockchain.
The DAO must provide a unique public address through which anyone can review the DAO’s activities and monitor its operations.
The whole software code of the DAO must be in open-source format in a public forum to allow anyone to review it.
The software code of the DAO must have undergone quality assurance.
There must be at least one graphical user interface (GUI) that will allow a layperson to read the value of the key variables of the DAO’s smart contracts and monitor all transactions originating from, or addressed to, any such smart contracts. The GUI will also specify whether members are able to redeem their tokens without restrictions and if not, the GUI will clearly mention the restrictions that are in place.
The DAO must have by-laws that are comprehensible to a layperson.
Therefore, this proposal appears to be focused on accessibility, transparency and security, elements of maximum importance for the DAO’s success that should be taken into consideration by the regulators.
On September 2, 2022, KlimaDAO announced that it is collaborating with politicians to provide a legal framework for DAOs in the Lummis-Gillibrand Responsible Financial Innovation Act.[xxxvii] The bill intends to bring clarity to the digital assets industry, outlining how these assets should be taxed and how they should be regulated by different government agencies. The bill also includes definitions for what virtual currencies are, as well as for other terms that have not yet been established by lawmakers, including DAOs. DAO operators hope that the legislation will help provide a legal framework for DAOs. Under the framework, DAOs would be classified as business entities, adding to the Internal Revenue Code 1986. The proposed legislation would extend the classification to DAOs effective from 2023. The definition also clarifies what actions undertaken by a DAO would not count as a form of business activity and be tax-exempt, which includes raising funds for charitable purposes and the staking and mining of digital assets, effectively giving a new meaning to UNAs.