Discussion on the Legal Structure of DAO: Starting from the Lawsuit Against DAO by the Commodity Futures Trading Commission

Summary

Recently, Ooki DAO is facing a lawsuit, and members who participated in the voting may need to share responsibility. Although this situation is shocking, it has long been anticipated in the legal community. DAO is not outside the law, and when legal responsibilities arise, the lack of a physical entity for the DAO poses significant risks to its members. Currently, many DAOs are seeking to establish more robust legal structures. Depending on different business characteristics, several forms such as limited liability companies, foundations, non-profit associations without legal personality, and special purpose trusts are common choices.

Background

The Commodity Futures Trading Commission (CFTC) recently announced enforcement action against the DeFi protocol bZx. The CFTC accused it of illegally offering leveraged and margined futures trading, engaging in activities that can only be conducted by registered futures commission merchants, while failing to implement financial regulatory requirements such as KYC. As a result, the CFTC filed a lawsuit against bZeroX, LLC and the two founders of the bZx protocol, proposing a settlement penalty of $250,000 for each party.

At the same time, the CFTC decided to file a civil lawsuit against the DAO behind bZx. This is because on August 23 of last year, the bZx team transferred control of the protocol to bZx DAO (later renamed Ooki DAO) to evade regulation and had promoted this practice in the community as a way to escape regulatory oversight. The purposes of the lawsuit include seeking damages, restitution of ill-gotten gains, civil penalties, trading and registration bans, and prohibition of other actions that violate the CEA and CFTC regulations.

This action has sparked widespread controversy in the Web3 community, and there are even divisions within the CFTC. CFTC Commissioner Summer K. Mersinger publicly expressed her opposition and shared her views on the CFTC's official website. She believes that the actions taken by enforcement agencies against DAOs and their members are venturing into unknown legal territory, that this decision lacks clear legal basis, and that there has been insufficient consultation.

Legal Responsibilities of DAO

The CFTC's recent action has caused a huge stir in the DAO space, primarily because the DAO members behind the bZx protocol may need to bear legal responsibility directly. Currently, the standard for defining membership is whether one has participated in voting within the DAO, as voting represents an influence on the operation of the organization. Although this seems somewhat absurd, many legal experts have previously issued warnings, anticipating the occurrence of such situations. If a DAO lacks a legal entity, when responsibility needs to be assumed, it may be deemed a general partnership, leading to all DAO members being subject to unlimited joint liability. This is one of the most important reasons why various DAOs are actively promoting entity registration at present.

Although most people were aware of this risk before, almost no one believed that DAO members would actually face joint liability. On one hand, this is because most community-type DAOs have not even established basic operations and think the risk is low. On the other hand, enforcing penalties on DAO members is immensely challenging. Most DAO members are anonymous, with only an address. How do you track them, and what is the cost of enforcement? Unless it's a major case that requires FBI involvement, very few people would spend a lot of effort to trace anonymous addresses spread across the globe just for a small fine. Even if only tracking the addresses that voted, generally after a few proposals, there are usually hundreds of addresses. Everyone believes that the law does not punish the many, and they all feel that they have a clear conscience.

Although this incident set a dangerous precedent, I personally judge that it is likely to be a lot of noise with little impact. The main goal is to deter the operators of DeFi protocols, making them realize that transferring operational authority to a DAO does not absolve them of responsibility. Community members should also not easily take the blame. The CFTC also mentioned in its statement that these actions are part of the CFTC's broader efforts to protect American customers in the rapidly evolving decentralized finance environment.

This incident has made everyone more clearly aware of a fact: under the current legal system, DAOs need to, and will be required to, bear corresponding legal responsibilities.

Therefore, for a DAO, forming a more complete organizational legal structure at the right time (the sooner, the better) has almost become a necessity. (Of course, there will definitely be some DAOs that pursue pure crypto-native principles, refusing regulation, and achieving censorship resistance through various designs. These types of DAOs will certainly exist in the crypto world for a long time, but may not become the mainstream form.)

Looking back at the disadvantages of not registering an entity, there are mainly three points:

1. A non-entity DAO may be classified as a general partnership, and members may be required to assume unlimited joint liability under certain circumstances. This is exactly the situation bZx is facing now.

2. Tax risks, in the absence of an entity, members may be required to bear tax liabilities that do not belong to them under certain circumstances, even if the individual has not received a single penny.

3. Activities in the off-chain world are restricted, and it can be difficult for entities without a physical presence to interact with traditional world entities, such as signing contracts. Many DAOs have long since expanded their operations beyond the on-chain world and have entered the off-chain space.

Any of the above issues will have a significant impact on the long-term development of the DAO.

Choice of Legal Structure for DAO

So, if you want to register, where do you register and what type do you register for? The following lists common options for reference:

Limited Liability Company (LLC)

In the United States, a DAO can be registered as a Limited Liability Company (LLC), making it fully compliant with U.S. laws and subsequent tax requirements. In the U.S., LLCs can be member-managed without the need for a board of directors, managers, or leaders, which makes LLCs particularly suitable for DAOs. States like Delaware and Wyoming have already explicitly accepted the registration of LLCs in the form of DAOs.

An LLC can be established for profit, and most of those choosing to register an LLC are investment DAOs. Although there are no clear regulatory guidelines, they mostly require members to be accredited investors and limit the number of members to 99. This way, even if faced with regulation in the future, compliance can be maximized.

There are also some investment groups that register as LLCs but define themselves as investment clubs. This can be seen as a simplified version of a Venture DAO. The SEC has clear regulations outlining what kind of teams qualify as investment clubs. If an investment collective meets the criteria for an investment club, it may be exempt from SEC regulation. However, investment clubs also have a limit of 99 members, and the most troublesome aspect is that all members must actively participate in every investment decision. Even if just one member does not participate in a particular investment matter, it could potentially be deemed a violation by the SEC.

Recently, some institutions have proposed the concept of sDAO, which will allow the member cap to be raised to 499 people and make specific types of investments under compliance, but all participants need to be U.S. citizens. In contrast, LLCs have no nationality restrictions on members. This plan is still under verification and currently lacks many details.

At the beginning of this year, the Marshall Islands revised the Non-Profit Entities Act, allowing any DAO to register as a non-profit limited liability company in the country while enjoying tax exemptions. The law permits registration under the condition that a single individual bears full responsibility for the entire DAO. This is an offshore version of the U.S. structure, but it is not subject to U.S. federal law. Although the Marshall version of the LLC can conduct normal business operations, it cannot allocate income or profits to DAO members, thus making it unsuitable for investment-type DAOs.

Overseas Foundation

Compared to registering as a limited liability company, more DAOs are currently choosing to register foundations in various locations around the world. The advantage of a foundation is that it can be "ownerless," which reduces the legal liability of the founding team in the event of unforeseen circumstances. Popular locations for onshore foundations include Switzerland and Singapore. They offer good legal protection, but DAOs need to pay taxes on income. Offshore registration locations are mostly the Cayman Islands, British Virgin Islands, and others. Among them, the Cayman Islands are relatively friendly towards token issuance, which is also the choice of quite a few DAOs at present. The main difference between onshore and offshore is that offshore has tax exemptions. Foundations are managed by a council or board of directors, which sacrifices a certain degree of decentralization, but token holders can guide the council or board of directors' actions through voting. Foundations were widely used by blockchain-related organizations before the popularity of DAOs, and people are relatively familiar with this model.

Limited Cooperative Association (LCA)

LCA is a hybrid of traditional cooperatives and Limited Liability Companies (LLC), providing greater flexibility than traditional cooperatives, especially in terms of investment. LCA can effectively structure the governance agreements of DAOs and the bylaws of associations, accepting voting governance rights from different types of participants while adhering to cooperative principles. Colorado has a relatively comprehensive set of statutes for LCAs, thus gaining recognition from numerous DAOs.

Non-corporate Non-profit Association (UNA)

UNA is a new form that everyone has been focusing on exploring in the past year. UNA allows for very flexible member identification, permits anonymous members, and facilitates easy movement, which aligns well with existing community-type DAOs. UNA can operate profit-making businesses, but the entire organization needs to remain non-profit, as there can be no profit distribution. However, UNA is a relatively new practice, and the understanding of UNA varies across different states in the United States, lacking corresponding case law, which could lead to UNA not being recognized in specific situations, thus posing risks. Additionally, UNA is more suitable for DAOs that primarily rely on personnel and business activities based in the United States, and organizations must pay taxes in the U.S.

Special Purpose Trust

The form of a special purpose trust generally involves a DAO transferring part or all of its assets to a trustee, and entrusting the trustee to conduct business activities through a trust agreement. This not only addresses the issues of offline entities but also provides limited liability protection for both DAO members and the trustee. One of the main challenges of introducing a legal structure into a DAO is that complying with norms designed for traditional organizations may undermine the decentralization and freedom of the DAO. In particular, the vast majority of legal structures require government approval to be completed. However, a special purpose trust established under Guernsey law eliminates this issue. It does not require government approval or the need to maintain reports. The trust becomes effective when asset transfers occur according to the trust agreement. However, the application scenarios of special purpose trusts mainly involve representing committees or SubDAOs within the DAO to conduct specific business, while packaging the entire DAO as a trust structure is still to be explored.

All the solutions discussed above address the initial three problems. However, based on this, each has its own characteristics. The legal structure of a DAO often needs to accommodate complex situations in practical design, taking into account factors such as the countries or regions of the main participating members, the desired governance structure, the degree of decentralization, the main business direction, the size and sustainability of the DAO's members, token strategy, SubDAO strategy, registration costs, etc.

The legal structure and related practices regarding DAO are a very new field, and there is not yet a general consensus or best practices formed, which needs further exploration.