A Decentralized autonomous organization (DAO) is an internet-native, digital entity with no central leadership. DAOs are based on smart contracts that are deployed on a blockchain. DAOs are managed by their token holders who decide the actions DAOs take by voting on governance proposals.
The founders of a DAO set up the entity by creating a set of rules for it by using smart contracts. The founders then usually ‘raise capital’ by issuing tokens that give the owners voting rights in all issues regarding the governance of a DAO. After issuing the tokens, the DAO is deployed on the blockchain after which the founders pass on the power to decide on the future of DAO to the token holders.
DAOs are becoming increasingly more prevalent in virtual currency projects, which is why this article focuses on certain legal standpoints regarding DAOs and on categorizing DAOs in the Finnish legal system.
Tokens – securities or not?
Due to their novelty and unique nature, DAOs are currently in a legal vacuum. When issuing DAO tokens, one must consider how to categorize this transaction. In light of standard IPOs (Initial Public Offering), the transaction would presumably fall under the applicable securities regulations (Finnish Securities Markets Act (746/2012) in Finland). DAO tokens do not, however, particularly fit under any definition found in the Finnish legal system and categorizing the asset must be done by interpreting the current legal framework surrounding the topic. The question is: are tokens securities or a cryptocurrency?
The current market standard dictates as a general rule that all tokens issued in the EU are cryptocurrencies and, as such, depending on the member state, the legal issuing of a token may require registration to the relevant authorities. In the United States, however, the situation is more complex, and the matter is solved using the so-called Howey test, which you can read more about in our Bitcoin analysis. It is worthy to mention that the United States Securities and Exchange Commission (SEC) deemed in its 2017 report that the tokens issued by an organization called “The DAO” were securities according to the Howey test.
Since the issuing of both cryptocurrencies and securities requires registration or a permit, DAOs invoke an interesting question: If DAOs are not seen as legal entities and the law does not recognize them as a legal person with certain rights and responsibilities, does the issuing of DAO tokens require registration or a permit and if so, how could such a requirement be enforced?
The Legal Status of a DAO
As stated above, new emerging legal phenomenons, such as DAOs, may be regarded to have an unclear legal status at the moment. Since the Finnish legal system (generally) requires that an organization must register in order to achieve legal personality, a decentralized organization such as a DAO cannot per definition satisfy these demands. This means that a DAO cannot by itself have ownership rights, do legal actions or gain rights or responsibilities. However, nothing prohibits a company from incorporating the use of a DAO in their business, although this might corrode the decentralized aspect of it.
In theory, DAOs could be categorized as unregistered associations according to the Finnish Associations Act (503/1989). For this to happen, a DAO would need to be a non-profit organization and all economic activities would need to be written in its rules. A DAO’s rules are etched to the blockchain but the requirement of non-profitability is probably not met in the majority of these projects.
As the situation stands, DAOs must be understood as coalitions of natural and legal persons that are acting on the basis of a blockchain based agreement to achieve a common goal. Therefore, it can be concluded that DAOs should be first and foremost be interpreted in light of basic principles of contract law.
Legal impact on DAO token holders?
The current Finnish legal system seems unable, at first sight, to direct and/or impose any legal effects on DAOs themselves, but is it possible to extend these effects on DAO token holders?
DAO token holders can either be natural or legal persons. The token holders agree together on the legal transactions they wish to do, after which one or several of them approach a third party with the intent of conducting a business transaction. For example, this could mean the trade of tangible property which is governed by the principles of contract law. In certain situations, the token holders who participated in the trade can be held jointly liable for the therein related obligations, for example when a breach of contract or a debt is at hand.
If DAO tokens are viewed as a cryptocurrency according to the Act on Virtual Currency Providers (572/2019) or obligations are imposed on them by securities market regulations being applicable, it is difficult to find joint liability justifiable – a DAOs’ minority token holders with little to practically no influence on the outcome of the votes would have to carry the same responsibility as large token holders regarding the decisions that the latter essentially makes. On the other hand, holding DAOs’ large token holders accountable for the decisions made could be better justified since they have an actual effect on the governance of the DAO. During the funding phase of a DAO, before deploying it on the blockchain, it would in theory be fair and possible to extend liability to the founders a DAO without having to assess the relative ownership of the token holders.
The above interpretation can find support in the guidance of the Financial Action Task Force (FATF). According to FATF, a DAO and the possible obligation to register as a virtual currency provider should be determined with the so-called owner/operator test. The test helps to ascertain whether a DAO has a (centralized) party involved that has effective control over a DAO, thus making it less decentralized – such a party might in theory be obligated to register as a virtual currency provider.
Because of the novelty of DAOs as a phenomenon, liability questions surrounding the topic are very much subject to interpretation. Projects that are considering including DAOs as a part of their business should always evaluate the planned DAO and its possible governance token on a case-by-case basis and assess the distinct features of it in advance, which consequently helps to identify the applicable regulation.
A DAO is to be regarded as a blockchain and smart contract based decentralized decision-making body that allows its token holders to decide together on the actions of the DAO by making governance proposals on the blockchain. The Finnish legal system does not currently recognize DAOs as legal entities and utilizing DAOs as independent tools will most likely lead to token holders’ personal liability.
The above being noted, DAOs unarguably offer very interesting and unique instruments essential to the so-called web3 development. Companies can use DAOs to diversify their fintech-structure, and DAOs can also be regarded to offer a viable modern alternative to the traditional Venture Capital and Private Equity investment models.
As a law firm specialized in projects evolving around fintech and blockchain technology, we at Nordic Law are happy to assist you in any DAO related matters.
Our Associate Trainee Patrik Anthoni took part in writing this article.