The Legal Structure of DAO: Starting from the CFTC's Lawsuit Against DAO in the United States

Summary

Recently, Ooki DAO faced a lawsuit, and the members who participated in the voting may need to share responsibility. This situation, although shocking, has long been anticipated by legal professionals. DAOs are not above the law, and when legal responsibilities arise, a non-entity DAO poses significant risks to its members. Many DAOs are seeking to establish more mature legal structures, with limited liability companies, foundations, non-profit associations without legal personality, and special purpose trusts becoming common choices based on different business characteristics.

Part One

The U.S. Commodity Futures Trading Commission (CFTC) announced enforcement action against the DeFi protocol bZx on September 23. The CFTC alleges that the protocol illegally offered leveraged and margin futures trading, engaging in activities that only registered futures commission merchants (FCMs) are allowed to conduct, and failed to implement financial regulatory requirements such as KYC. As a result, the CFTC has filed a lawsuit against bZeroX, LLC and the two founders of the bZx protocol, proposing a settlement penalty of $250,000 for each party.

At the same time, the CFTC decided to file a civil lawsuit against the DAO behind bZx, because on August 23 last year, the bZx team transferred control of the protocol to bZx DAO (later renamed Ooki DAO) to evade regulation and promoted this practice within the community as a way to escape regulatory oversight. The purposes of the lawsuit include seeking damages, restitution of illegal gains, civil penalties, trading and registration prohibitions, and prohibiting other actions that violate the CEA and CFTC regulations.

This action has sparked widespread criticism in the Web3 community, even within the CFTC there are divisions. CFTC Commissioner Summer K. Mersinger publicly expressed her opposition and published her opinion on the CFTC's official website. She believes that the actions taken by the enforcement agency against DAOs and their members are venturing into uncharted legal territory, that this decision lacks a clear legal basis, and that it has not widely sought input.

This article does not delve into whether bZx is violating regulations or how it might be violating them, but rather focuses on the legal structure of the DAO and the corresponding responsibilities.

The CFTC's action has caused a huge stir in the DAO space, mainly because the DAO members behind the bZx protocol may need to bear legal responsibility directly. Currently, the standard for determining whether someone is a member is whether they have participated in voting within the DAO, as voting represents an influence on the operation of the organization. Although this seems outrageous, countless legal professionals have warned in the past that this situation could occur, namely, if a DAO lacks a legal entity, it could be deemed a general partnership when responsibility needs to be assumed, resulting in all DAO members facing unlimited joint liability. This is one of the most important reasons why various DAOs are actively pushing for entity registration.

Despite the fact that most people were aware of this risk beforehand, hardly anyone believed that DAO members would actually bear joint liability. On one hand, most community-type DAOs have not even established basic operations and believe that the risks are minimal, thus lacking a sense of urgent risk awareness. On the other hand, it is extremely difficult to enforce penalties against DAO members. Most DAO members are anonymous and only have one address. How to track them, and how high are the law enforcement costs? Unless it involves major cases requiring FBI intervention, who would spend a lot of effort chasing down thousands of anonymous addresses scattered around the world for a small fine? Even if only the addresses that voted are pursued, generally, after summarizing several proposals, there are also hundreds of them. Everyone believes that the law does not punish the many, and they all feel morally justified.

Although this incident has set a dangerous precedent, I personally judge that it may be more about hype than substance, mainly intended to serve as a deterrent. The primary aim is to warn operators of DeFi protocols not to think that transferring operational authority to a DAO will absolve them of responsibility, while also reminding the community not to easily take the blame. The CFTC also mentioned in its statement, "These actions are part of CFTC's broader efforts to protect American customers in the rapidly evolving decentralized finance environment."

This incident has made everyone more clearly aware of a fact: under the current legal system, DAOs need to, and will be required to, assume corresponding legal responsibilities.

Therefore, for DAOs, forming a more complete organizational legal structure at the right time (the sooner, the better) has almost become a necessity. (Of course, there will definitely be some DAOs that pursue pure crypto-nativity, refusing to accept regulation, and achieving censorship resistance through various designs. These types of DAOs will certainly exist in the crypto world for a long time, but they may not become the mainstream form.)

Once again, let's review the drawbacks of not registering an entity. If this is not your first time focusing on this direction, you may have seen similar explanations in several places, primarily three points:

1. A non-entity DAO may be recognized as a general partnership, and members may be required to assume unlimited joint liability under certain circumstances. This is precisely the situation that bZx is currently facing.

2. Tax risks, in the absence of a physical entity, members may be required to assume tax liabilities that do not actually belong to them under certain circumstances, even if the individual has not received any benefits.

3. Off-chain activities are limited, and it can sometimes be difficult for entities without a physical presence to interact with traditional entities, such as signing contracts. A large number of DAOs have already expanded beyond on-chain activities into the off-chain world.

Any of the above issues will have a significant impact on the long-term development of the DAO.

Part Two

So, if I want to register, where should I register and what type should I register for?

The following lists common solutions for reference:

Limited Liability Company ( LLC )

In the United States, a DAO can be registered as a limited liability company (LLC), making it fully compliant with U.S. laws and subsequent tax requirements. In the U.S., limited liability companies can be member-managed without the need for a board of directors, managers, or leaders, which makes LLCs very convenient for DAOs. States like Delaware and Wyoming have already explicitly accepted the registration of LLCs in the form of DAOs.

An LLC can be registered for profit, and those who choose to register an LLC are mostly investing in a DAO. Although there are no clear regulatory guidelines yet, they mostly require members to be accredited investors and limit the number of members to 99. This way, even if they face regulation in the future, compliance can be maximized.

Some investment groups also register as LLCs but define themselves as an investment club ( Investment Club ). This can be seen as a simplified version of a Venture DAO. This name is not used arbitrarily; the SEC has clear regulations on what constitutes an investment club. If an investment collective meets the criteria of an investment club, it may be exempt from SEC regulation. However, there are trade-offs; investment clubs have a maximum limit of 99 members, and the most troublesome requirement is that all members must actively participate in every investment decision. Even if just one member does not participate in a particular investment matter, it could be deemed a violation by the SEC.

Recently, another institution proposed the concept of sDAO, which will allow the member cap to be raised to 499 people and to make specific category investments under compliance, but it requires all participants to be U.S. citizens. In contrast, LLCs have no nationality restrictions on members. Currently, this plan is still in the verification process, and there are not many details available yet.

At the beginning of this year, the Marshall Islands revised the Non-Profit Entities Act, allowing any DAO to register as a non-profit limited liability company in the country while enjoying tax exemptions. The law permits registration in cases where an individual is solely responsible for the entire DAO. This is an offshore version of the U.S. structure, but it is not subject to U.S. federal law. Although the Marshall version of the LLC can conduct normal business operations, it cannot allocate income or profits to DAO members, making it unsuitable for investment-type DAOs.

Overseas Foundation

Compared to registering a DAO as a limited liability company, more are currently choosing to register foundations in different locations around the world. The advantage of a foundation is that it can be "ownerless", which reduces the legal liability of the founding team in case of unforeseen circumstances. Popular onshore locations for foundations are Switzerland and Singapore. They offer good legal protection, but DAOs are required to pay taxes on income. Offshore registration locations are often the Cayman Islands, BVI, and others. Among them, the Cayman Islands are relatively friendly to token issuance, which is also the choice of quite a number of DAOs. The main difference between onshore and offshore is that offshore has tax exemptions. Foundations are managed by a council or board of directors, which sacrifices a certain degree of decentralization; however, token holders can guide the council or board of directors to take actions through voting. Foundations were widely used by blockchain-related organizations even before the popularity of DAOs, and people are relatively familiar with this model.

Limited Cooperative Association (LCA)

LCA is a hybrid of traditional cooperatives and limited liability companies ( LLC ), offering greater flexibility than traditional cooperatives, especially in terms of investment. LCA can effectively structure the governance agreements of DAOs and the bylaws of associations, accepting voting governance rights from different types of participants while adhering to cooperative principles. Colorado has a relatively complete set of laws for LCA, which has gained recognition from numerous DAOs.

Unincorporated Nonprofit Association (UNA)

UNA is a new form that everyone has been exploring intensively in the past year. UNA allows for very flexible membership recognition, permits member anonymity, and facilitates easy mobility, features that fit well with existing community-like DAOs. UNA can operate profit-making businesses, but the entire organization must remain non-profit, as there can be no profit distribution. However, UNA is a relatively new practice, and the understanding of UNA varies across different states in the U.S., lacking corresponding case law, which may lead to UNA not being recognized in specific situations, causing risks. Additionally, UNA is more suitable for DAOs whose main personnel and business activities are based in the U.S., and the organization must pay taxes in the U.S.

special purpose trust

The form of a special purpose trust generally involves the DAO transferring part or all of its assets to a trustee, and entrusting the trustee to carry out business activities through a trust agreement. This not only resolves issues for offline entities but also provides limited liability protection for both DAO members and trustees. One of the main issues with introducing a legal structure into a DAO is that adhering to norms designed for traditional organizations may undermine the decentralization and freedom of the DAO. In particular, the vast majority of legal structures require government approval to be completed. However, special purpose trusts established under Guernsey law eliminate this issue. They do not require government approval and do not need to maintain reporting. The trust becomes effective when asset transfers occur according to the trust agreement. However, the application scenarios for special purpose trusts mainly involve representing committees or SubDAOs within the DAO to carry out specific business activities, and packaging the entire DAO as a trust structure is still to be explored.

All the solutions discussed above address the three initial problems presented. However, each has its own characteristics based on this foundation. The legal structure of a DAO often needs to adapt to complex situations in actual design, with factors to consider including the countries or regions where the main participating members are located, the desired governance structure, the degree of decentralization, the main business direction, the scale and sustainability of the DAO members, the token strategy, the SubDAO strategy, registration costs, and so on.

The legal structure and related practices regarding DAO are a very new field, and there is still no general consensus or best practices, which require further exploration.

The author is not a legal practitioner, and this article does not constitute any legal advice; some content may contain errors.