A legal wrapper for a DAO might be one of the necessary steps of decentralized project legal structuring. This step is often considered unnecessary by Web3 founders, or simply overlooked. In reality, the DAO legal wrapper helps facilitate the relationship between the tokenholders, and enables the users of the web3 project to exist safely in a decentralized community of people, with decentralized governance and a treasury–which is also managed in a decentralized way–all without risk to any individual in the form of unlimited liability or risk of fines from regulation violations.
In answering the question “does my DAO need legal structuring?”, we’ve addressed 8 of the most commonly asked questions that web3 founders have about the legal aspects of launching and operating a DAO.
1. When should I set up a DAO for my web3 project?
Usually, once an idea has been created, investors have been found, tokenomics has been decided and the tokens have been issued, a final step for a web3 founder might be to turn it into a DAO. Alternatively, there are some cases where you could proceed to setting up a DAO when you only have an established community and are simply looking for a way to decentralize the decision-making process and have the ability to manage the community’s Treasury.
It’s important to note that there is no obligation for web3 projects to set up a DAO. A DAO is also not obligatory for any legal structuring of the project. There are a lot of Web3 projects with no plans to decentralize their governance & ownership and as a result don't plan to launch DAO. Whether you wish to set up a DAO is a business decision, not a legal question.
2. Are DAO members at risk if there is no DAO Legal Wrapper in place?
Yes. DAO members can be at risk of all kinds of unlimited liability. Most DAOs are called ownership-free entities or ownership-free organizations, which means that all assets that are inside the DAO are owned by the whole community. As a consequence, some web3 founders mistake the ownership-free aspect to mean that DAOs do not have any legal requirements that help or permit the DAO’s operation. Many web3 founders would argue that the smart contract rules are implemented into the protocol of the project and that it is enough to build trust, create transparency within the project, and satisfy any “legal” requirements. Unfortunately, having a smart contract and transparent governance practices is simply not enough to exempt DAOs from legal obligations. An unregistered DAO, which some web3 founders may consider as a truly ownership-free entity, can have legal implications that are quite dangerous for DAO members, founders, and investors.
The most important consequences to address–and that all web3 founders should be wary of–is the unlimited liability that arises in cases of unregistered–or incorrectly registered–DAOs. This unlimited liability can be split into different types; unlimited judicial liability, unlimited tax liability, and unlimited financial liability. Additionally, an unregistered DAO might be recognized by some regulators as a General Partnership. In general partnerships, each member (each general partner) has unlimited legal liability for all activities conducted by the organization.
One of the recent legal cases that illustrates this is CFTC vs Ooki DAO. The DAO in question doesn't have a legal entity, therefore, CFTC (Commodity Futures Trading Commission) finds that DAO is liable as unincorporated association for illegal asset trading and other violations. In the CFTC’s view, "every voting participant in a DAO can and should be held individually liable for any illicit activity conducted by the DAO".
3. What happens when DAO members face unlimited judicial liability in a DAO?
This type of liability might arise in situations where a DAO is involved in some kind of lawsuit. There are two main types of lawsuits against DAOs:
- lawsuits initiated by regulators (if there is a non-compliant DAO). A lawsuit of this kind may result in fines and even criminal liability for DAO members. The above CFTC vs Ooki DAO example falls into this category;
- lawsuits initiated by investors (in cases of investment-related misconduct and violation of investor's rights). A lawsuit of this kind might result in DAO members being obligated to return all collected funds and pay additional compensation to the investors.
The court may search for the people who are involved in, or are behind the creation of, the DAO. An unregistered DAO that does not have the proper legal rules in place limiting liability for DAO members puts the DAO members at great risk. Each DAO member may be required to respond to the court and may become involved in the lawsuit, with serious repercussions.
4. What happens when DAO members face unlimited tax liability in a DAO?
The same applies in a situation where tax liabilities arise. For example, if a DAO collects some money or earns some income and then doesn’t pay the correct taxes for these earnings, any DAO member could be liable for these tax violations if the DAO is not registered. In other words, without a correctly registered DAO, any unpaid taxes and penalties may have to be paid for by the DAO members.
5. What happens when DAO members face unlimited financial liability in a DAO?
In situations where verification procedures have not been correctly followed, for example the KYC requirements set out by a jurisdiction have not been met, certain fines for violations of AML regulations may be issued by the regulator. If the DAO itself does not have the correct legal structure, it may fall to the DAO members to pay for the fines. The DAO members may have unlimited liability for such penalties, and consequently are at risk of having to pay an unlimited amount out of their personal pocket.
6. What is a DAO legal entity?
A DAO legal wrapper is a legal entity that is much the same as all other legal entities but with some very important characteristics. The first is the entity ownership. Regular companies have their shareholders centralized and they also have directors, and generally a centralized form of governance and ownership. In the case of a DAO, governance is decentralized. Decentralized organizations still need some form of decentralized government and decentralized ownership of the treasury, and so a DAO legal entity can be described as a kind of ownership-free type of legal entity. There are–currently–no ideal legal solutions for such types of entities. The closest example to an ownership-free type of entity includes different forms of trusts, such as foundations.
7. What are the different types of a DAO legal entity?
There are DAO LLC, DAO foundations, and DAO associations, all of which could also be for-profit and not-for-profit organizations.
There are several countries where these types of legal entities can be registered. For example, it might be that your DAO can be registered as an association or a foundation in Switzerland. Recently, Wyoming has passed specific regulations for DAOs, making it possible for a DAO LLC to be set up in that specific US state. There is also the option of a foundation entity in the Cayman Islands and an LLC in the Marshall Islands, the latter of which has seen new specific regulation for non-profit LLCs passed quite recently.
Web3 founders who wish to turn their web3 project into a DAO, can choose between creating a DAO LLC, DAO foundation or DAO association and with a growing number of options for creating a DAO legal wrapper, founders should not overlook the necessity of limiting liability of the DAO members and creating a proper legal structure for their DAO.
8. How can decentralized governance work from a legal perspective?
After you have designed your decentralized governance system, you should list all the details of it in your DAO constitution. This is a document, like a state constitution, to which all the DAO members should agree to, and which outlines the rules for their decentralized governance system.
To make your decentralized governance system legally binding and provide more legal protection to DAO members, you should include the most important details of your DAO Constitution in the statutory document of your DAO legal entity (i.e., your DAO foundation or DAO LLC).
If you have found this useful and would like to learn how Legal Nodes could help your project, request a demo call with an expert from the Legal Nodes team. We've helped all kinds of Web3 projects with things like their business model, their tokenomics, Token Cap Table, plans for token distribution and fundraising, ultimately helping them to build a proper legal roadmap for creating an effective legal structure to protect their project and their DAO community.
Disclaimer: the information in this guide is provided for informational purposes only. You should not construe any such information as legal, tax, investment, trading, financial, or other advice.
Nestor is a Co-founder & Head of Web3 Legal at Legal Nodes. Having over seven years of legal consulting experience, Nestor loves working with innovative startups and Web3 projects, helping them navigate the regulations and scale on global markets.