Decentralized autonomous organizations: A Canadian legal perspective

This article was originally published by The Lawyer’s Daily (www.thelawyersdaily.ca), part of LexisNexis Canada Inc.

Decentralized autonomous organizations (DAOs) are a relatively new organizational form that is being adopted by the blockchain community in the pursuit of building out “web3” (a reinvented Internet based on decentralized protocols). DAOs are built on programmed algorithms with governance structures designed to resemble corporations but adapted to facilitate “trustless” operations.

The structural integrity of DAOs’ governance and protocols minimize the need for their participants to trust one another. This allows for DAO participants to interact with each other pseudonymously, merely providing one another with blockchain address identifiers.

The popularity of DAOs has skyrocketed recently, with the number of active DAOs jumping sixfold since the start of 2019. Their proponents believe that creating applications and crowdfunding through DAOs is the optimal way to develop web3 inclusively. However, groups pioneering the development of DAOs currently face significant legal uncertainties.

Background on DAOs

DAOs are sets of smart contracts on ethereum-based blockchains that incorporate organizational governance rules into their protocols. The intended result of this is to create self-regulating organizations that require minimal human maintenance and oversight. Reducing human involvement is predicted to lower the likelihood of moral hazard occurring in the organization’s management.

DAOs are typically less hierarchical than traditional corporations but similar in that decisions are voted on by their owners (token holders) and that protections are built-in for minority owners to handle issues associated with ownership concentrations.

For some blockchain community members, the goal is for DAOs to remove the need for corporate bylaws, shareholder agreements and other contracts that govern the relationships between individuals involved with a corporation. DAOs are envisioned to remove the need for costly legal actions and a way to preclude issues from heading to “meatspace court” (blockchain-community slang for the traditional legal system). Unfortunately, there is currently a lack of clarity on how DAOs should be characterized.

Are DAOs distinct legal entities, partnerships or something else?

The novel structure of DAOs and their variability of operations creates the difficulty in classifying them. While DAOs share similar governance principles to corporations and in substance subject their participants to rules typically found in the corporate records of a corporation, DAOs are not typically established as distinct legal entities under conventional methods.

Incorporating a separate entity generally requires the creation of constating documents that are filed with a government body to bring the corporation into existence. DAO promoters have typically shunned this approach, but some DAOs have been created by incorporated entities.

The pseudonymous relations between DAO participants also weaken the argument that DAOs may be classified as distinct legal entities. Canadian corporate laws require certain corporate information to be made public or recorded for accountability and record-keeping purposes. For many DAOs it would be antithetical to their operations to conform to these requirements. In the absence of either, it is unclear whether any government would want to provide its token holders with the same limited liability that owners of a corporation are typically afforded.

For these reasons, DAOs may be better characterized as partnerships between their owners due to their ability to enable participants to pursue organized business arrangements amongst each other.

DAOs as partnerships

On the surface, DAOs resemble partnerships. In Ontario for example, a partnership is a relation between persons carrying on a business in common with a view to profit. DAOs serve a similar purpose. DAOs enable individuals with shared goals to pursue business opportunities in a co-ordinated manner. DAOs co-ordinate these efforts by pooling crowdfunded proceeds raised through selling their tokens and disbursing these funds on business opportunities voted on by the owners. The goal is for the profits from these DAO-managed businesses to be paid out to its owners.

The difficulty in classifying DAOs as partnerships stems from their “trustless” nature. An essential aspect of a partnership is that business activities are carried out “in common.” It is unclear whether participants voting on projects presented to them would be considered carrying on a business in common.

There is also uncertainty about whether the underlying smart contracts of a DAO can be regarded as partnership agreements or documents that indicate an intention to form a partnership. While there is a pooling of resources in pursuing business opportunities through a DAO, the mere fact that there is common property, part ownership of property, or a sharing of gross returns does not, in themselves, determine that a partnership exists. (See AE LePage Ltd. v. Kamex Developments Ltd. [1977] 16 O.R. (2d) 193.) For this reason, it is uncertain whether DAOs are a form of partnership or a tool that assists in managing co-owned property with distinct and separate beneficial interests amongst the owners.

Final thoughts

Irrespective of their legal characterization, DAOs represent an exciting opportunity to organize resources for commercial and not-for-profit activities but will require more legal clarity to develop responsibly going forward. Taking actions now, such as exploring DAOs’ legal implications through dialogue and assessing the novel legal relationships they may create, can provide numerous benefits to both DAO participants and the greater blockchain community.

In taking a measured approach to these innovative blockchain-enabled structures, Canada has the opportunity to foster these inclusive vehicles that may accelerate the introduction and development of applications and infrastructure for web3.

*Photo credit to @MagicPattern / UNSPLASH.COM