Decentralized Autonomous Organizations (DAO) – Challenges and Perspectives

Kropotkin, a revolutionary and anarchist, points to Zenon’s forecast of a time when people, regardless of borders, will unite and create the “Universe,” without the need for laws, courts, temples, and money for exchanging mutual services. It seems that with the development of technology, above all blockchain, we are one step closer to realizing these ideas. An obvious example is decentralized autonomous organizations (DAO).

DAO refers to an organization based on rules (smart contracts) recorded on the blockchain and controlled directly by its members, without delegating management powers to a central entity (e.g. a board of directors or CEO). The conditions for an organization to be considered a DAO are not fully defined, and the ones most often mentioned are:

• reliance on blockchain;

• smart contracts;

• digital assets that members contribute to the autonomy and functioning of the DAO;

• the ability to scale globally.

DAO in many ways resembles existing companies. First, participation in DAO governance is based on token ownership, similar to shareholders owning the corresponding class of shares. Second, DAO has rules under which it operates, such as the charter of a joint-stock company or the founding act of a limited liability company. Third, DAO assets can be invested in various projects or used to develop its own products, and can grow on the basis of revenues generated from successful investments or fees from its products.

However, using blockchain and smart contracts for a DAO means transparency because the rules are known in advance and remain permanently recorded on the network. In addition, it also means security for DAO members because the rules cannot be changed unilaterally. The decision-making process is open to all members, decision-making is efficient (no meetings, vote counting, etc.), and decisions are permanently recorded on the network.

In traditional companies, decisions are often made behind closed doors, without minority shareholders or members being able to follow the decision-making process or influence decisions. Non-transparent management of a company can lead to large losses for investors, but also for the state because it is left without tax revenues. The most famous case is Enron.

Are there any drawbacks to the DAO concept?

Although the possibilities that DAO offers are great, and the advantages over traditional companies are undeniable, we must not lose sight of the fact that DAO also has its dark side. In this sense, the problem with direct decision-making comes down to encouraging DAO members to vote on a particular proposal, that is, to actively participate in the decision-making process.

In addition, in order to make a decision, the DAO member must be sufficiently informed about the proposal being voted on. An informed decision may be an elusive goal because within a DAO it is harder to involve as many members as possible, often tens of thousands, which by its nature means an exceptional diversity in terms of education, expertise, etc. An additional problem is created by the tokens themselves, which give members certain rights, above all voting rights.

Namely, the legal nature of tokens is not entirely clear, which causes difficulties. Specifically, if a token fails the test for determining whether it is considered a security or not (e.g. Howey test in the U.S., or the standards under MiFID II in the European Union), capital market rules and anti-money laundering (AML) rules will apply to it, which represents not only a major administrative burden for the DAO as the token issuer but also for the members themselves.

In addition to the governance issue of DAO, the biggest challenge this concept currently faces is that legal systems do not recognize DAO as a legal form. The absence of regulation means that DAO members are exposed to claims by DAO creditors. In other words, members can be held personally liable for DAO obligations because DAO is not a formal business entity whose liability for business obligations is tied only to DAO assets, i.e. it does not have limited liability.

DAO is still a new term in the business world, but as time goes by, it could very easily gain wider use globally.

The lack of legal personality makes business interaction with conventional business entities, as well as with individual contractors (e.g. freelancers), more difficult. So far, only the U.S. state of Wyoming and the Marshall Islands have recognized the status of a legal entity with limited liability.

The absence of regulation also carries serious tax and AML risks. They stem from the unclear nature of the tokens and the projects DAO engages in. Specifically, if tokens are considered securities, there will be an obligation to identify the members, i.e. the token holders. Failure to comply with AML rules can mean high penalties for members. As for the tax aspect, difficulties may arise in determining the taxpayer for the profit earned by DAO.

Specifically, if the profit is attributed to the DAO, the question arises as to the jurisdiction in which that profit is reported, i.e. where tax is paid. On the other hand, if the profit is attributed to DAO members, they will be required to independently report the income to the tax authorities. In that case, there will be an additional problem – whether income from DAO is considered capital income or will fall under the so-called other income, which is generally taxed less favorably.

Back to the Future

After presenting the basic philosophical values, potential, and challenges of DAO, it is worth looking at the opportunities in Serbia that can affect the creation and operation of DAO, especially since there are already a couple of domestic DeFi projects that operate as DAOs (Thales) or are on their way to becoming one (Tempus Finance).

As mentioned, DAO is not regulated in Serbia, that is, it has no legal personality under domestic law. This means that all the problems discussed above exist. Still, the domestic legal system recognizes two institutes into which DAO could fit. These are the cooperative and the (civil) partnership.

A cooperative is a legal entity that represents a special form of organization of natural persons (cooperators) who, through business based on cooperative principles, achieve their economic, social, cultural, and other interests and who manage and control the business of the cooperative. Cooperative principles are almost identical to those on which DAO is based, and some of them are:

• voluntary and open membership;

• control by cooperators is exercised through the cooperative as a democratic organization controlled by its members, who actively participate in decision-making and in formulating its business and development policy;

• the economic participation of cooperators is realized by members contributing capital to their cooperatives and democratically controlling it;

• concern for the community.

  
  

If we wanted to treat DAO as a cooperative, the main objection would be that our Cooperative Act prescribes the obligation to have management bodies. In other words, that would lead to centralization of the DAO. However, even if that problem were overcome, the question remains whether by fixing DAO as a legal form, DAO remains an organization, or becomes merely a tool for managing a legal entity.

On the other hand, the (legal) nature of a partnership seems more suited to the DAO’s need to remain decentralized. A curiosity is that partnership is regulated by the Civil Code for the Kingdom of Serbia from 1844 (GZ), which is still partially applied. The Civil Code provides that a partnership agreement exists when two or more persons agree to contribute their labor or property, and then share the profit, if any, among themselves. In DAO, developers contribute their knowledge, and members their digital assets.

“No partner may appoint another person in his place without the consent of the others, nor may he admit anyone else into the partnership, nor conduct any business that would be detrimental to the partnership.” DAO members also approve the admission of new members or a new way of managing DAO projects. The Civil Code further provides that “the partners shall consult on the business, and whatever is decided by the number of votes shall remain,” and that “every partner may inspect the partnership accounts at any time, and may not be denied this,” which are principles on which DAO is based – joint management and transparency. An additional advantage of a partnership over a cooperative is that a partnership is not subject to registration, i.e. a partnership is not a legal entity, just like DAO.

We can conclude that DAO, like digital assets, has a lot of potential for application, but that regulation is necessary, that is, regulation of the legal form of this organization, primarily because of the legal certainty of its members.