The idea for a decentralised autonomous organisation, where the rules are baked into its code with no management structure or board of directors, has emerged with the rise of blockchain technology. Andrew Godwin examines its legal status and the future that it may shape from the contemporary discussions

The recognition of limited liability in the early 19th century was a watershed moment in legal and economic history. The conferring of legal personality on companies – involving the right to own property, enter into contractual relationships, and sue and be sued – enabled companies to operate independently and to be accountable to shareholders, third parties and the broader community.

Although companies operate independently of their shareholders, who enjoy limited liability except in very limited circumstances, companies have traditionally been controlled, managed and operated by humans. These include human directors, who control the “corporate mind” of the company, and human employees, who manage the operations of the company.

The need to involve humans in the control, management and operation of companies has given rise to various challenges. These include the principal-agent problem – famously explored by scholars such as Berle and Means, which stems from the separation of ownership and control – and the resulting risk that a misalignment of interests or priorities arises between those who own companies and those who act on behalf of the companies. The resolution of this problem has been a big factor behind the development of corporate governance codes and rules.

In recent years, issues concerning corporate governance have become more complex as debate continues about the purpose of a company. It is now recognised that the purpose of a company extends beyond simply maximising shareholder value, and embraces broader purposes including the reputation of a company and its sustainable development.

Could the principal-agent problem be reduced (if not avoided altogether) if human agents were replaced with reliable and “neutral” computer code, and if decision-making were “democratised” such that shareholders could participate in all decisions concerning the company or, alternatively, agree to the basis on which decisions should be made autonomously by computer code?

This question, which was previously theoretical in nature and considered to be the stuff of fiction – alongside predictions of a cashless society and driverless motor cars – is now being answered in the affirmative through the emergence of decentralised autonomous organisations, or DAOs.

Rule of code

Put simply, DAOs are organisations that are governed by artificial intelligence (AI) in the form of smart contracts, and use blockchain technology to record transactions and interactions with and between their members and third parties.

Under a smart contract, the terms of a transaction are encoded as part of a computer program or algorithm, and are self-executing. In other words, the transactions are executed automatically without the need for human judgement or action.

An early example of a smart contract is a vending machine that dispenses drink products. With a vending machine, the terms of a written contract for the purchase of a drink product between the customer and the vendor are replaced by an automatic (or autonomous) process. Under this process, the customer’s act of inserting coins and selecting a particular drink product is converted into a product that is delivered to the customer by the vending machine dropping the drink product into the accessible bottom compartment.

The blockchain is a type of distributed ledger technology, under which a chain of transactions or interactions is recorded on a ledger that is distributed across a network of computer systems. Because all of the parties have access to a single database (or ledger), and because the data are held by (or distributed to) each party, the accuracy and the security of the data are considered to be guaranteed.

All the transactions or interactions on the ledger form a chain of blocks, and a new block is added to the chain each time a new transaction or interaction is verified. An important application of blockchain technology is the creation of cryptocurrencies such as Bitcoin.

DAOs are described as decentralised because they remove the need for centralised governance by humans in the form of boards of directors and managers. Accordingly, trust in humans is replaced with trust in technology.

They are described as autonomous because they operate in accordance with rules that are encoded in smart contracts, rather than in accordance with articles of association, shareholder agreements and written law. To a large extent, the “rule of code” replaces the “rule of law”.

Matters for debate

Two questions that are currently being debated in many jurisdictions is how DAOs should be characterised from a legal perspective, and how they should be regulated by the written law. These are important questions as the emergence of DAOs has created several challenges.

One challenge arises out of the fact that a DAO is decentralised and is therefore unlikely to have a board of directors or human managers. The challenge is how to ensure that the members can exercise appropriate governance over the DAO in areas such as the operation of the DAO, or the way in which its resources are distributed.

If decisions are made through a process of voting by members (known as participatory DAOs), how should this process be designed to enable members to participate in a meaningful way? On the other hand, if decisions are made not by members but entirely by algorithms (known as algorithmic DAOs), what should happen if unforeseen circumstances arise that require a revision to the smart contract code?

A second challenge relates to the question of the legal status of a DAO, and who is liable for its acts or omissions in a contractual context or otherwise. As noted above, the shareholders of traditional companies have the benefit of limited liability and are not liable to the creditors of the company except in very limited circumstances. On the other hand, if DAOs were considered to be akin to partnerships, this would expose their members to unlimited liability and would likely limit their usefulness and appeal.

A third challenge relates to the nature of the interest that members have in the DAO, which are often represented by tokens that are issued in initial coin offerings (ICOs). Are the interests of members proprietary in nature? Are the interests analogous to a share in a company, or to some other interest such as a unit in a managed investment fund? If so, should the interests be regulated in the same way, and should the holders be able to deal with those interests in the same way?

Even assuming that the above-mentioned challenges are resolved, a host of other legal and regulatory challenges await clarification in areas such as disclosure, consumer protection, taxation and cross-border dealings (including the question of applicable law and other private international law issues). The challenges are compounded by the reality that DAOs enable decentralised decision-making by, or on behalf of, members who are likely to be located in multiple jurisdictions.

That said, law and regulation have been able to cope with multinational companies without too many difficulties, so why should DAOs be any different? Can the existing framework be adapted to accommodate DAOs? In the US, for example, some states have taken steps to adapt the conventional regulatory framework to DAOs. For example, on 1 July 2021, Wyoming became the first state to recognise DAOs as a form of limited liability company, and to confer legal company status on DAOs.

Debate continues, however, about the most appropriate legal form for a DAO. Some argue that DAOs should be treated as analogous to unincorporated associations or unincorporated joint ventures. Others argue that they should have their own bespoke legal form. Still others say that labels should be avoided and, instead, that the focus should be on the way in which a DAO functions.

The concept of “functional equivalence” and the related concept of “regulatory equivalence” underpin the thinking behind the Model Law for Decentralised Autonomous Organisations (DAOs), which was prepared by the Coalition of Automated Legal Applications, a global multidisciplinary blockchain research and development initiative.

Under the concept of functional equivalence, an object such as a DAO token is regulated in the same way as a functionally equivalent object such as a company share. Under the concept of regulatory equivalence, regulations are applied to crypto assets by reference to the goal or policy objectives of the relevant regulations (e.g. disclosure or consumer protection).

A key question is whether it would be beneficial to work towards consistency or harmonisation in relation to the regulation of DAOs around the world.

Regional perspectives

Many jurisdictions in the region are considering how DAOs, and crypto (or virtual) assets more generally, should be regulated, and have adopted one of three approaches.

The first approach could be described as “regulation by analogy”, where DAOs and crypto assets are regulated by reference to the conventional regulatory framework, and on a functional basis. For example, if a DAO involves the issue of tokens that operate like securities, it will be subject to securities regulation.

This is the case in Australia, where the Australian Securities and Investments Commission has stated that regulation is based on the particular characteristics of the crypto-asset offering. It is possible, however, that there will also be law reform in Australia.

For example, the Final Report of the Senate Select Committee on Australia as a Technology and Financial Centre (published in October 2021) considered submissions concerning law reform in relation to the regulation of crypto assets and DAOs.

In recommendation 4, the committee recommended “that the Australian government establish a new Decentralised Autonomous Organisation company structure”. Although canvassing the submissions and options on this point, the committee did not make any specific proposals in relation to how the new company structure should be established. It is expected that the Australian Department of the Treasury will initiate a consultation process on this and related questions later this year.

Similar to Australia, the Hong Kong Securities and Futures Commission regulates tokens and ICOs “by analogy” under the Securities and Futures Ordinance if the activities involve securities or futures contracts (as defined). Intermediaries conducting regulated activities in relation to securities or futures contracts must also comply with the applicable licensing or registration requirements, and with the rules governing anti-money laundering and counter-terrorist financing.

The Hong Kong Monetary Authority has said that it does not regulate cryptocurrencies such as Bitcoin, which it regards as a virtual “commodity” and not as legal tender or a means of payment or money. Hong Kong’s banking laws and regulations therefore do not currently apply to entities accepting or dealing in cryptocurrencies.

The second approach involves developing a bespoke regulatory framework. Japan began to develop a bespoke regulatory framework for cryptocurrencies in 2014, and is developing specific guidelines for ICOs. In Singapore, the Monetary Authority of Singapore is taking active steps to build a strong distributed ledger technology ecosystem. Thailand began to develop its own regulatory approach to ICOs in 2017.

The third approach involves the imposition of bans. For example, in September 2021, the People’s Bank of China declared that trading in cryptocurrencies was illegal and banned related activities, including fundraising through ICOs. In mainland China, therefore, it will be difficult to establish and operate DAOs until the ban may be removed and a permissive regulatory framework may be set up.

In South Korea, a ban on ICOs has also been in place since 2017. However, the government is reported to be considering removing the ban and bringing ICOs within the regulatory framework.

India is an interesting jurisdiction to examine. In 2018, the central bank – the Reserve Bank of India – issued a circular prohibiting banks from providing services in connection with cryptocurrencies. This ban was later set aside by the Supreme Court in 2020. In November 2021, the government introduced the Cryptocurrency and Regulation of Official Digital Currency Bill into the parliament.

If enacted, the legislation would provide a framework for the creation of a central bank digital currency. It would also prohibit all private cryptocurrencies in India, subject to certain exceptions, “to promote the underlying technology of cryptocurrency and its uses”. It is uncertain what the prohibition and its exceptions would mean for the development of DAOs and ICOs in India.

As jurisdictions in the region continue to discuss and debate DAOs, now is an opportune time to hear from practitioners and others on the relevant challenges and issues, including the following:

  • How important is it to reform the regulatory framework to accommodate DAOs?
  • How should DAOs be regulated in terms of their legal form or structure?
  • What are the key challenges in regulating DAOs?
  • Are DAOs becoming more relevant in corporate and commercial transactions and, if so, how?
  • Should jurisdictions work towards regional or global co-ordination and harmonisation in the regulation of DAOs?
  • How should jurisdictions in the region move the law reform process forward?

Although it remains uncertain how widespread DAOs will become, and to what extent they will operate as an alternative to the conventional company form, previous experience with technology suggests that they will become part of the mainstream more quickly than we expect.

Andrew Godwin

Andrew Godwin is a co-editor of Technology and Corporate Law – How Innovation Shapes Corporate Activity (Edward Elgar Publishing, August 2021) and contributes a regular column called Lexicon to China Business Law Journal subscripton ad red 2022