I previously wrote about the legality of Decentralized Autonomous Organizations (“DAOs”) and stated then the subject was way too complex to discuss in a single article. After a recent twitter spaces discussion I had (which is hosted every Tuesday at 4:00 EST by one of my favorite artists and decentralization maxi CΞdΞrKing) I figured it was time for a follow-up article on the subject.
In my prior article, I warned about when a DAO likely would be considered a security under existing US laws, and the risks that posed for investors. In this article, I will be less of a gloom and doom attorney out to ruin your fun, and explain circumstances on when a DAO would not be a security, and could be the future of corporate governance in America.
DAOn’t Be a Free Rider
When the Securities Act of 1933 was written, there was no such thing as a DAO. Nor were the almost 100 years of subsequent court cases and administrative rulings further defining “security” written in a Web3 context. However, those 100 years of principles are going to apply once DAOs enter the mainstream. Just as open source software opened the floodgates of technological developments, so too do DAOs represent an opportunity for a completely new form of corporate governance and economic participation.
While I discussed the four major prongs of the Howey Test in my prior article, this article is going to focus on the 4th prong: whether the profit obtained by investors is primarily from the efforts of others. This is where the legal battle will be fought in most DAOs. The catch-22 being that the more truly decentralized a DAO is, the more likely it is to pass this test, but the less ability it will have to fight off an SEC ruling to the contrary.
There are plenty of examples of groups of people getting together to fund business ventures which are not security assets. An example is found in partnerships. Some courts have adopted per se rules that partnership interests are not securities. See, e.g., Goodwin v. Elkins & Co., 730 F.2d 99, 107 (3d Cir. 1983). Other courts have adopted a presumption that partnership interests are not securities, but permit a finding that partnership interests are securities when a partner has so little control over the management as to be a passive investor. See Williamson v. Tucker, 645 F.2d 404, 424 (5th Cir. 1981).
In securities law, substance is often more important than form. While there is no obligation for a partner in a general partnership to actually participate in the management of the venture, the less involved a group of partners are in the activities of the company, the more likely their ownership interests will be considered securities. The same applies to other corporate structures such as LLCs or LLPs where the investors’ duties are nominal or insignificant, their roles were perfunctory or ministerial, or they lacked any real control over the enterprise.
As stated in Williamson, “A scheme which sells investments to inexperienced and unknowledgeable members of the general public cannot escape the reach of the securities laws merely by labelling itself a general partnership or joint venture.” Id. at 423.
**Note, while there is certainly more regulatory red-tape securities must jump through, there are also more protections in place for investors. Being a member of an LLC or general partnership has more risks for somebody looking for a passive investment than investing in a security. I may cover that in a later article.
Mechanisms for DAOs To Avoid Securities Regulations
There are mechanisms which DAOs can put in place, which help it avoid securities regulations. If you are looking to form a DAO or wish to join one, here are few things to consider either implementing or looking for:
- Application Process- Having an application process where members must describe the value they can add to the management of the venture’s activities. What can this person add other than just money? Having a way to weed out the “inexperienced and unknowledgeable members” of the public is a good starting point.
- True Voting Rights– Most DAO’s have proportional voting rights. This is fine so long as there is not a single majority member which can effectively rob other members from having meaningful control over the venture. Additionally, there should be a system in place which makes it possible for any member to propose a vote to the larger group. Members do not need to exercise this control, but it needs to be available to them.
- Review and Buy-Out Mechanism– Similar to the application process, there should be a process in place to weed-out free riders and encourage active participation in the venture. I advise all my clients that, while nobody likes to think about it, setting up a venture to end effectively is as important as setting it up to begin effectively. Having regular check-ins on member non-economic contributions is an important factor in maintaining status as a non-security asset. Also have something in place that, if the members decide to dissolve the venture, there is an effective and known pay-out mechanism.
- Regular Updates from Management Team– A DAO could theoretically be set up in a truly autonomous way in which there is no top level or day-to-day management and where everything is automated provided there is a successful vote on an action. However, with the current state of technology and the occasional need for quick decision making, this is likely impractical for a group of any real size. This means there will need to be a management structure in place, and a hierarchy of roles. This isn’t an issue, so long as these managing members are subject to regular checks and balances, and can be replaced in an non-cumbersome manner if necessary.
None of these, alone, is strictly necessary to maintain status as a non-security asset, but they would all certainly help fight off any such ruling by a court or the SEC. You need to treat DAOs more as a business you are part owner of and less as a stock certificate or hedge fund.
The Future of DAOs
With Covid and the associated quarantine periods, people got used to a more autonomous and remote work setting. People also came to realize that jobs which were traditionally only done in a central office setting could be done just as efficiently without the unnecessary overhead.
Right now, DAOs are primarily being used as investment vehicles for groups to invest in otherwise unobtainable art. However, in the future I can very much see the traditional partnership or LLC being transformed into a DAO with all of its associated technological efficiencies and automated processes. It can be used in a way which both streamlines production and gives more ownership to individual contributors.
Who knows what the future holds? Maybe I will be the founding partner of the first law firm DAO. Hell, if your DAO is looking for a member to join and serve as counsel, let me know! Or maybe you have an idea for a business which you just need a little bit of funding and sweat equity to make a success. With a little marketing and a solid solidity developer you can make that dream business a reality.
We are just at the tip of the iceberg on the opportunities that DAOs and transparent/autonomous corporate governance represent. If you are reading this now, congratulations. Just as people during the dot com bubble had the opportunity to get in at the ground floor of Web1 giants like Google and Amazon, you have the opportunity to get in to their Web3 counterparts that are coming.
NFTs represent a growing demand for individuals to have ownership over their online identifies and digital assets. DAOs represent a way for individuals to take ownership over the businesses of the future in a truly meaningful way. As I stated in my prior article, investing in a DAO is not without risks from a regulatory perspective, but I genuinely believe that they will be the next true innovation to come out of blockchain technology.
As always, I am an attorney, I am not your attorney. For legal advice, you should always consult (and pay for) an attorney.