The Right Legal Wrapper Can Protect a DAO and Its Members

The decentralized autonomous organizations landscape has evolved significantly over the past few years. Since DAOs emerged in 2016, they have expanded across finance, non-profit, media, science, and creative sectors—and beyond.

It’s estimated that, in February 2023, over 11,000 DAOs were operating, 6.4 million people held tokens in DAO projects, and total treasury exceeded $12.5 billion.

Although conversations around DAOs are optimistic, a storm is approaching. Many DAOs operate without a clear legal structure recognized by governments, regulators, and tax authorities, creating legal, tax, and compliance liability risks with potentially serious consequences for DAOs and token holders.

However, a suitable legal entity, or “wrapper,” can protect a DAO and its members against many of these risks, allowing token holders to reap the advantages of DAOs while legal frameworks catch up.

Legal, Tax, and Compliance Risks

In 2022, members of a DAO, bZx, brought a class action lawsuit against its founders and investors, alleging liability for a security breach leading to theft of $55 million in cryptocurrency.

The final judgment is pending but a recent US federal court ruling stated if a jurisdiction deems the DAO has general partnership status, owning a token could make individual members personally liable.

Personal liability aside, a recognized legal structure is just as important for tax and compliance liability. If a non-incorporated DAO is found to have failed to meet its tax liabilities, its members face risk of higher fines and penalties. Tax authorities can also look at previous years, making tax liability risk even more concerning.

In addition, if a jurisdiction considers tokens issued by a DAO to be securities and therefore subject to securities law, there’s a risk of sanctions or fines for any individuals deemed a responsible DAO creator.

As DAO members are pseudo-anonymous and can reside anywhere in the world, there’s risk of non-compliance with anti-money laundering and know-your-client regulations that apply when raising capital. That makes litigation more likely in the case of a dispute, and could discourage serious investors from unwrapped DAOs.

On- and Off-Chain Worlds

A wrapper can create valuable opportunities for a DAO. Having a clearly defined legal status can help DAOs attract investors, gain access to loans or government incentives, and expand into markets that require a formal legal identity.

Some in the Web3 community are suspicious of using formal legal entities, believing that counters Web3’s web-native decentralization philosophy. But at this stage of maturity, most DAOs also need to interact with the off-chain world.

For example, they may need to raise capital, pay and receive payments in fiat currencies, or enter working agreements with freelancers. Legal wrappers allow DAOs to bridge on- and off-chain environments and make the most of both.

Wrappers are typically existing corporate forms, such as a corporation, limited liability company, foundation, association, or cooperative, or a new, DAO-specific form such as a DAO LLC, DAO limited cooperative association, DAO cooperative, or DAO foundation.

Both forms have pros and cons. Traditional forms offer the reassurance of well-established legal frameworks, practice, and case law, and are available globally. But they also often involve complex tax and governance requirements, formal off-chain governance features, such as a board of directors, or limits to operational control.

In contrast, new legal forms are customized to the specific properties of DAOs and have been designed to encourage DAO creation and activities. But they are only available in a limited number of countries with significant variation in how they work. There is also little to no existing legal or case-law practice to address the uncertainty and cost of any legal disputes.

Risks Remain

To examine the appeal of DAO-specific wrappers, it’s useful to look at Wyoming, where legislators have amended the LLC law to permit blockchain-based automated governance. Members of a Wyoming DAO LLC benefit from limited liability protection for the debts and obligations of the DAO entity—so long as the DAO complies with additional rules.

Some of these rules could be seen as restrictive. For instance, a Wyoming DAO LLC can’t be “manager-managed,” which prevents it from delegating authority to a group of members. Members may not always be able to transfer ownership interests, which some DAOs may feel adds friction into their governance. Finally, a DAO can’t assume DAO LLC formation rules are the same in different jurisdictions.

An alternative for a for-profit DAO could be to form a DAO cooperative, which is possible in the Netherlands among several other countries. A DAO cooperative provides “full legal personality”—where equity of the DAO is separated from the equity of participants—and an ownership structure that distinguishes between voting and non-voting interests.

Choosing the Right Legal Wrapper

Each DAO needs to consider which options best suit its unique aims, membership, and operations. The obligations and liabilities of a large financial DAO with many members and frequent off-chain interactions differ from those of a smaller non-profit DAO, for example.

It’s important to think carefully about where a DAO is incorporated. This critical decision stays with the DAO for the long term and underpins its legal framework. The stability of a jurisdiction’s policies and government matters, as does whether the jurisdiction has any DAO-specific regulatory innovations to leverage.

Navigating the complexities of this landscape can seem daunting, but it’s worthwhile and achievable. It helps to become familiar with regulations and requirements of the legal jurisdictions where a DAO operates. Legal professionals with domain expertise can ensure a DAO is compliant with applicable laws, and provide clarity on the tax implications and reporting obligations for the DAO and its participants.

This knowledge of the legal landscape can aid in establishing governance and legal frameworks that safeguard a DAO’s interests, protect its participants, and ensure its long-term success.

The case is Sarcuni v. bZx DAO, S.D. Cal., 3/27/23

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Dennis Post is EY’s global blockchain tax leader. He focuses on tax implications of blockchain and digital assets, and Web3, and the metaverse, and leads the EY Metaverse Tax Center of Excellence in the Netherlands.

Jeff Wong is EY’s global chief innovation officer and spearheads EY Global Innovation team’s remit to research and explore new technologies.