Syed Rahman and Rhys Evans consider the Commission’s just-published paper on decentralised autonomous organisations.
The Law Commission has produced a scoping paper on decentralised autonomous organisations (DAOs) which explores options for legal reform in order to clarify their status and facilitate their uptake.
One key issue is the difficulty in categorising DAOs within the current legal framework, which struggles to address the structure, creation or operation of them. As DAOs embody the ideas of decentralisation and little regulation, there is a risk that any potential changes may deter them from seeing the UK as a viable location.
This would be unfortunate for those who have come to view DAOs as an innovative alternative to traditional financial systems. But it should be noted that the law has proved itself to be adaptable to changes in the financial world – most notably in relation to a number of key judgements regarding cryptoassets.
While the development of DAOs has seen them branch out into the real world of tangible assets, they will (and to some extent already have) come under the scope of national and international laws. Yet the wide range of uses for DAOs means that any legal reform in relation to them may need to be equally far-reaching.
With this in mind, the Law Commission’s report identifies a number of issues that need to be addressed:
- Liability: If the structure is akin to an unincorporated partnership then the individuals involved would be legally liable whereas if the DAO is a legal entity, then it would be liable itself. In the context of criminal liability, there is also the matter of whether a mental element (mens rea) is required to establish criminal liability in relation to a DAO.
- Capacity: Who is entering into the relevant contract? i.e. is it an individual, or is it the DAO itself? If the latter, then again the structure of the DAO will need to be assessed. And who holds the property or funds?
- Roles and responsibility: What responsibilities do members of a DAO have to their fellow members? And do they have obligations to other parties (such as, for example, token holders)?
- Tax and regulation: Should every DAO require formal authorisation from a regulatory body? And how should the DAO (or individual members) be taxed?
- Jurisdiction: As a DAO has no head office, where is it registered or domiciled? And which domestic laws should apply to it?
The Range of DAOs
As the development – and resulting range – of DAOs has surpassed early expectations, they have become difficult to categorise.
In response to this, the Law Commission has put forward the idea of a ‘spectrum’ of DAOs. This is based on there being three distinct types of DAO:
Pure
These are described as “arrangements implemented through smart contracts with limited off-chain activity”, with a rejection of central governance, law enforcement and legal frameworks. The report says that established legal principles would likely still apply, but this would probably be done retrospectively i.e. in the context of applying already established legal principles to the DAO in the context of, for example, litigation, rather than having prospective analysis implemented through legislation.
Pure DAOs would be likely to be considered as an unincorporated association (or having characteristics similar to an unincorporated partnership), with participants acting in accordance with the rules set out in smart contracts. The code of smart contracts could be deemed to be a legally enforceable contract. Fiduciary duties are not likely to apply given the lack of dependency on participants - whether by other participants or third parties – and because such arguments have so far proved unsuccessful; as seen in the Tulip Trading case.
Hybrid Arrangements
These, according to the report, are “arrangements combining smart contract-based coordination with deliberate use of…legal entities”. They would seek to benefit from the technologies and (potential) independence of DAOs but would utilise the security offered by established legal principles.
Utilising the functions of a DAO within a legal entity – the process known as “wrapping” – would mean it would be within the scope of the current legal system. Yet there would be a need to consider and decide matters such as what legal entity is to be used, the relevant regulatory and tax requirements and jurisdiction.
Digital Legal Entities
These are described by the report as “arrangements where an incorporated legal entity adopts digitalisation through the use of smart contracts or DLT (distributed ledger technology) in its operations or governance”. Such an entity may be viewed as being some distance away from the independence and automisation associated with DAOs and reliant on traditional governance and law enforcement, while still looking to harness the benefits of the underlying technology.
Conclusion
There is plenty of food for thought in the Commission’s report. Arguably, the report has come at an appropriate time in relation to the development of DAOs.
There is certainly the possibility that a robust legal framework being applied to DAOs may force them to change their way of operating, which would go against the ethos of a DAO in conforming to a wider legal framework.
But while the report says there is no need for reform, it is quite clear that DAOs are not going to fit squarely into the current legal framework. Amendments will need to be made to prevent serious problems in the future. As has been the case with cryptoassets, we have the possibility that governance may become the task of the judiciary – with what appears to be a lack of willingness from central government to grasp the issue. Surely some amending of the law to promote the use of technologies would be a modest yet smart first step.
The scope of the possible legal implications in relation to DAOs is sizeable. This will be no easy task for those seeking to amend the current legislative framework in this context. But it is a task that seemingly must be addressed. As the paper suggests, there is work to be done on amending the Companies Act 2006, the introduction of a limited liability not-for-profit association and a review of English and Welsh trust law, as well as a need for a review of anti-money laundering regulations. This is clearly something that cannot be pushed through overnight and many will be keeping a close eye on the many arms of this situation.
