This post explores the legal standing of DAOs and provides insight on how to structure your DAO to minimize liability for its members. A DAO, aka Decentralized Autonomous Organization, leverages blockchain technology to empower a group of people to reach a consensus over the state of their organization. I originally coined the phrase “Decentralized Autonomous Company” in 2013 to describe Bitcoin. The thinking was that Bitcoin was autonomously achieving its purpose without reliance on any centralized infrastructure.
Since then the concept of DAO’s has gone viral and people around the world are starting DAOs powered by smart contract platforms. In the process, many have failed and people have started to file lawsuits under various legal theories. This uncertainty around the legal standing of DAOs may discourage people from participating.
*I am not an attorney and what follows should not be interpreted as legal advice nor relied upon when starting or interacting with a DAO. This is merely my personal interpretation of some of the many complex and ambiguous laws that might apply. It is my hope that this article can provide your attorney with a good starting point for answering your questions. In my research, I am reminded that there is nothing new under the sun (Ecclesiastes 1:10). When push comes to shove the courts will classify your DAO under existing laws and Common Law. Informal associations of people have existed for thousands of years so courts have a ton of precedent. *
In my opinion, unless a DAO explicitly officially incorporates, it will likely fall into one of two categories:
Of these two classifications, it is likely in the best interest of everyone involved to take the steps necessary to error on the side of the UNA.
In this article, I will explain what things are likely to trigger classification as a General Partnership and provide some strategies that may help achieve and maintain UNA status. The rules that govern UNAs vary from state to state and country to country and a UNA might be subject to any and all laws that any of its Members are subject to. Either way, it is in the best interest of everyone involved in a DAO to sign an agreement that leaves little room for ambiguity regarding the rights and obligations of the parties. Absent an agreement the courts are free to impute whatever serves their interests.
Are DAOs General Partnerships?
A recent lawsuit against bZx DAO is claiming that the organization is a General Partnership. This would make the Organization, its co-founders, and its Members jointly and severally liable for failing to adequately secure a decentralized finance (DeFi) protocol resulting in the loss of $55 million.
A General Partnership is the default arrangement any time two or more people associate to carry on a business for profit. They can be formed without any written agreements. Unlike officially incorporated entities such as an LLC or C-corporation, each business partner is fully liable for the debts of the business, even if the debt was incurred by the other partner.
A blockchain-powered organization could be interpreted as a modern accounting system that facilitates the distribution of the partnership’s books to its Members. The technology used is not relevant in defining a General Partnership.
The most important thing to understand is that you can accidentally form a partnership just by the manner in which you conduct business. Even without any written or oral agreements. So in the absence of any written agreements among the parties participating in a common venture the status of General Partnership may be imputed by the courts.
The vast majority of states have adopted the Uniform Partnership Act which governs General Partnerships. An interesting aspect of this act is that “a disclaimer of partnership status is ineffective to the extent the parties’ intended arrangements meet the criteria stated in this subsection”.
So acting as a General Partnership makes it a General Partnership regardless of what the parties subjectively claim it to be.
In order to have a General Partnership, it is critical to identify who is and who isn’t a Partner or Member. One potentially important “loophole” is the requirement that “all the partners” agree on who the partners are. Absent any written agreements, “all the partners” must agree to admit a new partner. If the number of partners cannot be ascertained because some are anonymous or pseudo-anonymous then it may be difficult to establish exactly who “all the partners” are and therefore make a “partnership agreement” impossible. More likely, the burden will fall on the more easily enumerated people who started the DAO.
That said, there is still an association among a number of known people and the courts will attempt to draw a line somewhere. If you don’t have a clear understanding of who is or who isn’t a Member/Partner then you might get caught on the wrong side of the line.
Who is a Member?
Whether a DAO is classified as a GP or UNA, the definition of a member is anyone who, under the rules and practices of the association, may participate in the selection of persons authorized to manage the affairs of the association or in the development of the policy of the association.
This definition appears to exclude those who profit but have no participation in the control. For example, an automated market maker may have many people pooling tokens for the purpose of providing liquidity and earning fees. If those that pool funds have no voting rights then they may have a solid argument that they are not Members of a UNA or GP. This would create a situation where the sole members of the “Smart Contract” Organization are those who control the keys that are able to update the contract code (aka defining policy).
This has a fascinating consequence of making the automated market maker “nonprofit” even though those who use the automated market maker may be clearly earning a profit. According to the Uniform Partnership Act “merely sharing gross revenues is insufficient” to form a partnership.
An association of people, whether for profit or not, may be imputed on any DAO and existing laws will apply. The only thing that is to be decided is who are the members and what liabilities those members have.
While General Partnerships have been around longer than anyone reading this, the ability to form large-scale partnerships on an international level is new and revolutionary. It brings the question of which jurisdiction should apply. If left ambiguous those who aim to sue the General Partnership have the opportunity to shop for the most favorable jurisdictions to the plaintiff and the least favorable to the Members.
How to Prevent a DAO from being classified as a General Partnership
As far as I can tell, the single most important fact required to establish a General Partnership is whether or not it is operating “for-profit”. The second most important fact is establishing who, if anyone, are the owners of the General Partnership where ownership is construed broadly to mean the ability to participate in choosing the managers or policies of the organization.
If you can prove the organization is not and cannot be operating “for-profit” then the DAO is clearly not a GP and would therefore fall under the Unincorporated Nonprofit Association (UNA).
The classification of a DAO as a General Partnership also depends upon how one defines a DAO. The term DAO was originally created to define organizations structured like Bitcoin. Clearly, Bitcoin has not been considered a General Partnership. So what makes Bitcoin different from an organization such as bZx DAO?
The primary difference is that DAOs, as originally defined, cannot hold title to property. Holding title to property would make the DAO “centralized” as said property can only exist in one logical place and would have one “legal” owner. In 2013, I stated that a DAO, such as Bitcoin, was like a company that cannot own property.
The idea that a DAO cannot own property has profound implications for the status of a General Partnership. In a General Partnership, there is an intention to make a profit by pooling resources and operating under a common brand name. The intellectual property is common property owned by both partners. The contracts the parties enter into on behalf of the organization create shared rights and obligations between the organization and 3rd parties. When people do business with the organization they are relying on the reputation of the entire organization and not just a single individual.
If an organization’s bylaws forbid it from owning property or entering into contracts then its Members are forbidden from doing business in the name of the organization. Any Member that subsequently signs a contract on behalf of the organization has done so without proper authority. This limits the liability for signing the contract to the specific individuals involved and not to every member of the organization. The mere act of signing a contract on behalf of the organization would be a fraud against the other Members and the other parties to the contract.
Imagine someone approached you and claimed that they represented Bitcoin and wanted to sign a contract as a representative of Bitcoin? That would be immediately recognized by almost everyone as fraudulent misrepresentation.
If a DAO cannot own property then it cannot generate revenue nor make a profit. Some may ask about service providers that own no assets, but the question becomes, how can the company receive and then own the profit if it cannot own property? How can the service provider sign a contract if the rights and obligations that the contract confers would be property? The lack of revenue and/or profit has huge implications for legal standing. All states I have looked at define a General Partnership with respect to an intention to carry on business for profit. Furthermore, without profit, the IRS doesn’t even consider the organization a business for tax purposes.
If your organization stays true to the meaning of a DAO, as I originally conceived it, then there is a strong argument against classification as a General Partnership. On the other hand, if your organization adopts the looser definition of “any organization that keeps its books on a blockchain” then you must carefully consider whether there is any “property” that is collectively owned by the DAO and whether or not profit for the Members is the goal of the organization.
Under my interpretation, the infamous “The DAO” on Ethereum and many other DAOs, such as bZx, are likely acting as unintentional General Partnerships.
What is Property?
The definition and classification of property have huge implications for whether or not a smart contract-powered organization is a General Partnership. For instance, are Ethereum tokens (ETH) property? If ETH tokens are classified as property, then a smart contract governing that property may be nothing more than the automated books of a General Partnership seeking to make a profit for its Members.
On the other hand, if ETH is not classified as the property of an individual or smart contract, then it would be difficult to argue that the smart contract is a general partnership in the business of earning a profit. The problem is, that most people claim and act as if ETH and BTC are their property that can be stolen. In a later section, I will present an alternative classification for community tokens that removes the characteristic of property. For now, it is easy to assume that ETH is property and therefore that smart contracts holding ETH for the purpose of making a profit may be General Partnerships.
Smart Contracts as Vending Machines
Suppose that the smart contract has no governance mechanisms at all. It is akin to a virtual vending machine that anyone may interact with. If the vending machine breaks and allows someone to walk away with the deposited coins and products, then it may be reasonable to hold the person who deployed the vending machine liable. It is therefore wise for anyone deploying a smart contract to have everyone who interacts with it sign a waiver releasing the deployer from liability.
Note that there is a distinction between the engineer who designed the vending machine and the person who took those designs, produced an operational machine, and made it available to the public. Open source code is typically licensed under conditions of no warranty nor fitness for purpose and the users of the open-source software waive all rights to sue the developers for bugs. That said, if someone takes open-source code, compiles it to a smart contract, and deploys it to a blockchain they may be taking responsibility for the performance of the software unless they also get their users to sign a release as a condition of their use.
Given a vending machine can be viewed as a template partnership agreement, those who manage its operation might be considered the Members. A common example would be automated market makers (aka Bancor relays) or NFT auction services. If these services operate on a for-profit basis then anyone participating in its governance may be a member of a General Partnership. Once again, the for-profit basis of these contracts is dependent upon the classification of tokens and/or NFTs as property and whether fees are designed to do more than cover costs.
Tokens that Aren’t Property
Property is a thing that belongs to someone. Tangible things are property. Positive contractual rights are property. The defining characteristic of property is that it is owned by someone and the test of ownership is the unilateral right to control. If someone allows you to drive their car it does not become your property. Use and temporary control do not constitute ownership unless the temporary control was a bargained-for right. For example, you may own the right to use a rental car for a defined period of time. In this case, you are the owner of a contractual right to use, not the owner of the car. The property remains with the person who has the title and who may revoke the right to use it at any time.
Property can be anything that has current or potential value; however, to realize this potential value one must have the ability to sell a clean title to the current or potential value to someone else. Without the right to sell the property you do not truly own it.
Opinions held by other people cannot be your property because their free will is inalienable. You cannot force someone else to hold a certain opinion. Your actions can certainly affect that opinion in ways that may create a profit or loss for you or others but your actions don’t entitle you to change their opinion or to the resulting profit.
With this foundation, a group of people can establish the principle that the person who is currently allocated tokens by community consensus is not the owner of those tokens. Instead, the token balance is merely the inalienable opinions of a multitude of individuals who may change their individual opinions at any time for any reason. In this way, the tokens are similar to the keys to a car which the owner(s) can reassign at any time. Possession of the keys and the power to drive the car where you like does not make the car your property.
That said, if you are the current possessor of the car keys you have the power to hand those keys to someone else in exchange for money. Doing so does not change the title to the car and does not make the new possessor the owner of the car nor does it transfer the right to use the car. The keys merely represent the ability to do something, not the right to do something.
When it comes to blockchains, signing a transaction to send tokens from one account to another can be viewed as a request to update the community’s opinion on the two parties’ balances. If this request constituted a contractual obligation of the community to update the balances in a particular way then the token balances might be property; however, if it is explicitly a request and not an obligation then the token balances are not the property of the requestor or the receiver.
A community wishing to minimize the risk of being classified as a General Partnership needs to minimize the risk of creating positive contractual rights and obligations among the parties. If the parties explicitly agree to treat all consensus states as an opinion subject to change at any time, then no property rights are created, allocated, or transferred on-chain. If your blockchain account is hacked or everyone else decides to zero your balance then you would have no legal right to a claim of theft. If there was a bug that caused the community opinion to change in an unexpected way, there is also no liability because each individual reserves the right to come to their own conclusion using whatever software tools they choose to use to interpret the events they have observed.
Under this model, individuals (not the association) can realize a profit when they receive money (or other property) in exchange for signing a transaction. This is income to the individual and not income to a partnership. The money is received in exchange for the service of using a particular private key to sign a specific message. The money was not received in exchange for the tokens the community now considers to be removed from your account and added to someone else’s account. This is because the community retained the inalienable owner of its opinion of the tokens before and after the transaction.
In reality, the community opinion is not a single thing, as each member of the community is entitled to have a different opinion on the consequences of a signed transaction. It just so happens that the vast majority of people share the same opinion.
Another way to view a signed transaction is as a “celebrity endorsement” which people are willing to pay for in order to sway the opinions of others in a manner that produces personal profit. Every token holder is a minor celebrity and their endorsement of others via a signed transaction has the impact of giving others more non-binding favor in the community.
This alternative view of the nature of blockchain tokens runs contrary to the way most people in the blockchain community act and feel. The movement of tokens from your account without your permission feels like theft. However, such feelings are merely the result of misguided thinking. Whether it is theft or not depends on whether or not a community declares those tokens to be the property of the individual or merely the opinion of the vast majority of the Members.
However, if the community opts to view tokens as property then the ramifications on the status of Smart Contracts relative to General Partnerships could be huge.
Ownership of Keys not Tokens
While individuals may not be able to claim ownership of the consensus state, they can certainly claim ownership of their cryptographic keys. Keys could easily be classified as intellectual property or trade secrets. The unauthorized reproduction and/or use of keys could still be prosecuted and the damages assessed could be linked to whatever money the copyright violator was able to realize in exchange for their use of the illegally copied keys.
This creates a material difference between one’s ownership interest in a balance on a blockchain and their ownership interest in the keys that enable them to influence, but not control, the communities shared opinions.
Smart Contracts as Smart Opinions
Given the new classification of tokens as opinions, a smart contract is merely a tool for generating a smart opinion given a set of signed statements. The opinion may be changed at any time by the community and is not the property of the users of the smart contract. The transfer of opinion tokens to or from a smart contract does not transfer property to or from the smart contract and therefore the smart contract cannot realize a profit. If no profit can be realized by the smart contract then it cannot be considered a General Partnership even if it generates a net increase in the shared opinion on the token balances of various parties.
This perspective on blockchain state as a non-binding consensus opinion and not property runs counter to the way most people act; therefore, it is crucial that everyone who interacts with the DAO explicitly opt-in to this interpretation of their interactions. Failure to explicitly agree to treat tokens as community opinion rather than individual property may leave room for courts to implicitly treat the tokens as property and therefore the smart contracts as for-profit General Partnerships. Ideally this explicit agreement is logged on the blockchain for every key that interacts with the chain.
Are DAO’s Unincorporated Nonprofit Associations?
For the purpose of this article, I will refer to Uniform Unincorporated Nonprofit Association Act (UUNAA) which has been adopted in one form or another by over 20 states. A “nonprofit association” is any unincorporated organization consisting of two or more members joined by mutual consent for a common, nonprofit purpose. This association is a legal entity separate from its members for the purposes of determining and enforcing rights, duties, and liabilities in contract and tort. In other words, the Members of a DAO classified as a UNA have some degree of limited liability even if they never file any paperwork with the government.
The fact that UNAs are legal entities means that they can sue and be sued. They can own property and real estate. They can even appoint a Member to register with the state for the purpose of receiving notices of lawsuits. That is if the party’s membership agreement permits these things.
Interestingly enough, the act requires that all UNAs keep correct and complete books and records of account for at least 3 years and that these books and records are made available to the members for inspection and copying. In other words, a blockchain is nothing more than the automated distribution of a UNA’s books to its Members as it is required to do by law.
It is my opinion that some of the most interesting and important use cases for DAOs are truly non-profit. In fact, the benefits one receives from decentralization are a public good (or club good) and there is really no practical for-profit way of providing these benefits to a population. Sound money is a public good and no centralized business should be in a position to profit from the issuance of money.
Legal Status of Immutable Smart Contracts
Proof of work blockchains put the governance power in the hands of those who choose to perform the required calculations. This creates an interesting challenge for legal classification given that technically everyone in the world is able to participate in governance. This either makes everyone part of the General Partnership or no one. If it makes everyone part of the partnership then any Plaintiff seeking damages from the General Partnership would simultaneously be jointly and severally liable. He would therefore owe himself any damages won. Generally speaking, proof of work blockchains have no governance structure at all and consensus is never final; therefore, they are not likely to be General Partnerships.
If an immutable smart contract is deployed to a proof of work chain and said contract has no governance features then it would be exceedingly difficult to classify it as a General Partnership or Unincorporated Nonprofit Association. However, if the contract has even a modest amount of governance then the Partners/Members would likely be those who can exercise that governance power.
On blockchains with the power to reach consensus on forks, there is no such thing as an immutable contract. Even if a user deployed a smart contract and then removed all keys allowing them to modify the contract would still fall under the management of the broader blockchain governance. In effect, token-weighted blockchains are either a General Partnership or UNA and any “immutable” smart contracts contained within would fall under the management and control of the broader blockchain.
This creates an interesting challenge on whether a smart contract platform can legally separate itself from the contents of the smart contracts it is hosting. If the host platform maintains that all state is a non-binding opinion of the observers then it would follow that nothing on-chain can turn it into a for-profit business.
Transaction Fees & Profit
Most blockchains utilize some kind of “fee” to prevent spam. This fee is paid with the tokens tracked as part of the blockchain state. Whether or not these fees constitute profit depends upon whether the tokens are property or opinion.
Imagine a company, such as Apple, were to accept shares of its own stock in exchange for services. The shares, being a form of property, would be income to Apple. In this case, the shares represent fractional ownership of all the property owned by Apple.
Now imagine if Apple owned no property. Imagine it had no intellectual property rights, no trademarks, and no other contractual rights of any kind. Under this situation, Apple would be unable to sell you any goods or services! Being unable to sell any goods or services its shares would have no intrinsic value nor contractual value.
Now consider a hypothetical unincorporated association called SmartChain in which everyone involved has explicitly agreed that no one may do business in the name of SmartChain and that SmartChain may own no property. The fee represents a non-binding change in the shared opinion of the associates and signing a statement that affects the fee does not guarantee anyone the right to have the transaction incorporated. No tangible things nor contractual rights have changed hands.
Can you sue a DAO?
Yes. Since all DAOs are likely to be classified as either a General Partnership (GP) or Unincorporated Nonprofit Association (UNA), it is my opinion that most DAOs can be sued. If a DAO achieves the status of a UNA then its members have a degree of protection against personal liability; however, if the DAO has no property then there is little point in suing the DAO because even if you win there is nothing to collect. On the other hand, if a DAO is a General Partnership then in many (most?) cases the partners are jointly and severally liable and your lawsuit may be able to collect against their personal assets.
Can a DAO file a lawsuit?
Yes, if a DAO has a governance process by which it can authorize a registered agent and someone who is willing to accept that role then the DAO can file a lawsuit against others. In doing so, the DAO would have to claim damages which would imply that the DAO held common property and positive contractual rights. This status would make proving the status as a UNA more difficult and greatly increase the risk of a DAO being deemed a General Partnership. This is especially risky for smart contract platforms which do not want their tokens to be deemed shares in the General Partnership.
So while it is technically possible for a DAO to file a lawsuit, it would likely result in mutually assured destruction; therefore, unless a DAO has already been deemed a GP or is willing to accept General Partnership status then it is unlikely to ever want to (or need to) file a lawsuit against anyone.
Blockchains and smart contracts empower individuals to draw their own conclusions about the world at a scale that was impossible without the power of modern computers, cryptography, and networks. This enables a new kind of collaboration based entirely on “smart reputation” or “smart opinions”.
In the past, we had to rely upon contractual rights interpreted by courts to determine who owned what. This gives the courts tremendous power over all person-to-person business interactions. If a group of people continues to act and talk as if a blockchain state is the evidence of a binding agreement over fractional ownership of commonly held property then they are likely in the realm of a General Partnership. On the other hand, if a group of people explicitly swears off creating any positive contractual rights or obligations then it is far more likely to be considered an Unincorporated Nonprofit Association.
In both cases a lawsuit can be filed on behalf of or against the association and in both cases there is no need to file any paperwork with the government nor have any explicit agreement in order to form the legal entity. Without an explicit agreement then the government will likely impute the standard previsions defined by the uniform acts. I suspect that most people involved with DAOs do not want these standard provisions; therefore, it is imperative that all parties explicitly adopt mutually agreed upon terms to limit the degrees of flexibility a court or plaintiff has in ascribing liability to those participating in the DAO.
Everything in this post is just my opinion and has not factored in the full history of common law nor the multitude of jurisdictions. Do not rely on this as legal advice, instead please consult your own attorney. Even if my understanding of the “law” is logical, we live under the rule of man and courts can be unpredictable. I am not a lawyer and everything I have said may be wrong or incomplete. Hopefully, one day, we can move to a world powered only by smart contracts and completely eliminate the unnecessary risks associated with interpreting laws and guessing how they might be selectively enforced.