The Legit Ledger Podcast Ep. 8
Introduction to DAO Legal Issues with Alex Lazar and Gabe Khoury
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Listen to the original podcast released August 30, 2022 here: https://www.sheppard.com/multimedia-417
In this episode of The Legit Ledger, Sheppard Mullin attorneys Alex Lazar and Gabe Khoury discuss the legal issues surrounding Decentralized Autonomous Organizations or DAOs, including the manner in which DAOs function, the types of legal structures popular with DAOs, and important considerations for individuals thinking about creating or joining a DAO.
Guests:
About Alex Lazar
Alex Lazar is a partner in the Corporate Practice Group in the firm's New York office, where he leads the firm's Emerging Company & Venture Capital Team and the Blockchain & Fintech Team. Alex advises clients on a range of matters from startup through IPO, including company formation and founder matters; seed, angel, venture capital, growth equity, and other capital raising transactions; mergers and acquisitions; technology and brand licensing; and other complex commercial transactions, including joint ventures, development, collaboration, and consulting arrangements. He also represents clients in structuring token rights and various matters involving token issuances and token and cryptocurrency trading and exchange.
About Gabe Khoury
Gabe Khoury is an associate with the Corporate Group in Sheppard Mullin's Washington, D.C. office. As Lead Associate of the Blockchain and Digital Assets team, he handles regulatory compliance issues relating to the use of blockchain technology, social media, Web3, video games, online gambling, virtual goods and currency, social tokens, decentralized autonomous organizations, decentralized exchanges, cybersecurity, privacy, E-sports, the metaverse, money transmission, financial technologies, NFTs, and artificial intelligence. Gabe holds certifications in NFT technology, Metaverse Technologies, and Blockchain Law from the Blockchain Council.
Transcript:
Gabriel Khoury:
Welcome to another episode of the Legit Ledger. My name is Gabriel Khoury, the Lead Associate of the Blockchain Team at Sheppard Mullin. And today I'm your host as we continue our journey through the exciting world of blockchain-related legal issues.
Gabriel Khoury:
But before we begin, a quick programming note. if you've listened to and found any of our podcasts insightful, please do share and subscribe. We are available on all major podcasters and as always, please reach out with any questions, comments, or concerns. Our contact information is in the show notes below. We look forward to hearing from you.
Gabriel Khoury:
Today's episode will cover an intro to Decentralized Autonomous Organizations or DAOs, as they will be referred to today. Today's goal is to provide a basic primer of what a DAO is and some of the legal issues that arise in relation to DAOs. In future episodes, we'll cover some of these points mentioned more in depth.
Gabriel Khoury:
Our guest for today's episode is Alex Lazar. Alex is the Co-Leader of the firm's Blockchain Team and the Co-Leader of the firm's Emerging Company and Venture Capital Team. His practice often encompasses many crypto-related matters, and I think it’s best for him to give you a little brief background as to how he got into his position of the world today. Alex, thanks for joining us.
Alex Lazar:
Thanks, Gabe. It's great to be with you today.
Gabriel Khoury:
Great. Thanks. Can you please introduce yourself and tell the listeners a little bit about your practice and how you got to your position at Sheppard Mullin?
Alex Lazar:
Sure. My practice focuses on working with founders and companies, generally speaking venture-backed technology companies, across a variety of industries. And we work with companies from the earliest stages of new company formation through various rounds of capital raising growth strategy and representing companies in various exit transactions, including IPOs, acquisitions usually by other large technology companies or sometimes private equity funds, and just working with the founders and the management team on all the legal issues that come up along the way.
Alex Lazar:
I started working with blockchain and crypto companies probably in 2014 and, over the years, it's become more and more of a focal point of my practice. And certainly, in the past few years, we've all seen a very intense and exciting time in the blockchain and crypto industry. So we work with these companies on many of the legal issues that arise, especially in connection with issues around DAOs, crypto issuances and the like.
Gabriel Khoury:
Awesome. Thanks Alex, for that brief background. So let's get right into it. First question is, what exactly is a DAO?
Alex Lazar:
Sure. I think it's worth noting, first of all, that while there is somewhat of a technical definition of a DAO, which we'll get to in just a minute, these days people refer to DAOs very casually and they use the term with a number of different meanings.
Alex Lazar:
The technical definition of a DAO is an organization constructed by rules encoded as a computer program, generally speaking a smart contract, that's controlled by the organization's members and not influenced by centralized governance. That's essentially what a DAO is. It's a smart contract encoded set of rules that the members control rather than a centralized governing body.
Alex Lazar:
People will often use the term DAO to refer to what I just described. Sometimes they'll use the term DAO to refer to the legal entity that owns the assets that constitute the DAO, and we'll talk about DAO entities or DAO wrapper entities in a few minutes, I think. And sometimes people just reference a DAO as a reference to the network itself, to the token holders. So it's important when we hear people use the term DAO to be thoughtful about how is this person actually using it? We want to make sure we're talking about the same thing and we're talking apples to apples and not apples to oranges.
Gabriel Khoury:
And what about whenever a member of a community of a DAO proposes a rule? In that regard, how do individuals vote on those proposals? What actually happens?
Alex Lazar:
Sure. In order for the members of the DAO to submit proposals or to vote, first the DAO, the network, has to launch. So as we discussed previously, the first thing that needs to happen is that the creators of the DAO need to determine that they want to create a DAO. They need to have a purpose for it and then they will create the smart contract, and they'll determine what rules will initially govern the DAO. Then, they'll write the code that embodies those rules and agreements and governance procedures.
Alex Lazar:
Then, in order to launch the DAO, they'll deploy the smart contract on the blockchain. These are inherently blockchain-based organizations. In order for the DAO to function, to have members, those members are going to need to hold the tokens that are the operative token for this blockchain. So they will then need to get tokens into the hands of the people who will be the members.
Alex Lazar:
Typically, or I would say in recent history, DAOs have operated for the most part on their own native tokens that the DAO will mint and issue to the initial members, and there's different ways that those issuances can happen. We can talk about that a little bit later or probably in much greater detail in a future podcast, but the DAO will generally mint the tokens and issue them through some mechanism. It could be a token sale, it could be an issuance to existing people who were associated with the creation and formation of the DAO or the strategizing around it. It could be an airdrop for people who've passed connection to use the product.
Alex Lazar:
But through some mechanism, they'll conduct an initial issuance of tokens. Once there are token holders, you then have a network and you have members of the DAO community. At that point, the rules that were previously created and encoded in the smart contract will come into effect and be able to operate because there's now a community that they can operate with respect to.
Alex Lazar:
So at this point, members, the token holders, can submit proposals. And in some DAOs, there might be rules that say that you have to hold a certain number of tokens or a certain percentage of the total outstanding token supply in order to be able to submit a proposal. The idea being that those who have a significant stake in the, no pun intended, but a significant stake in the community should be the ones who are proposing rules. Sometimes there will be limitations on how many tokens someone can have.
Alex Lazar:
But whatever the rules are, the applicable members can submit proposals for the DAO to act or for modifications to the rules of the DAO, whatever the case may be. Again, each DAO will have a different community, but it's often something like a proposal submitted via a Discord post. And then, there will be some discussion of the members around that proposal. And eventually, there will be a vote and the token holders will vote on the proposal. And if the proposal is approved, it will thereafter be adopted and carried out. And if it is not approved, it's not approved. But that's the general procedure for how members of DAOs and token holders would submit proposals.
Gabriel Khoury:
Awesome. Thanks, Alex. And if I am a token holder or a member of a DAO, what types of proposals can I make? Can you provide the listeners some sort of examples that you have found in the past?
Alex Lazar:
Sure. It really can be anything as long as it's not something that's contrary to the charter or bylaws or rules associated with the DAO. Very often, there can be proposals around creating workflows or projects for the DAO to carry out to allocate resources to that project. So to adopt the project and allocate a budget to a project and to have certain members of the community or other parties carry out that work stream, there can be proposals for amendments to the rules of the DAO.
Alex Lazar:
We mentioned before there might be a token ownership threshold for members to submit proposals. Maybe that's not the right threshold, and it needs to be changed, so that could be a proposal. There can be proposals to enter into transactions with third parties. There's been a recent trend towards certain DAOs have been interested in engaging in token swaps with other DAOs so that they can cross-pollinate and be involved in a more linked, again no pun intended, more networked community. So something like a token swap with another DAO might be something that's appropriate for a proposal in a community vote.
Gabriel Khoury:
Okay. Thank you, Alex. My next question is about the legal structure that DAOs have. In your experience, what are some of these legal structures that are popular with the DAOs? And what are some of the advantages or disadvantages of these legal structures?
Alex Lazar:
Sure. When DAOs were first created and based on the technical definition that I offered earlier, there is not inherently a legal entity associated with a DAO. Now, speaking as a lawyer, there are a number of concerns that arise if a DAO does not have a legal structure. And when we talk about a legal structure, we're talking about some sort of legal entity that owns the assets and operates the assets that constitute the DAO.
Alex Lazar:
If there's no formal legal entity owning this, you can run into questions like, could it be construed as a general partnership under applicable state laws? Now, in most states or many states, a general partnership is a form of recognized legal entity, but it doesn't actually require any filing with the Secretary of State. It doesn't require an operating agreement. It can be something as simple as multiple parties operating a common enterprise together with no formal agreement or state filing.
Alex Lazar:
One of the problems with that form of entity, in the context of a DAO, is that all of the individual partners in the partnership can have full joint and several liability for all of the obligations of the enterprise. That could potentially mean that each individual token holder could have full liability for all of the obligations of the entire DAO, including if the DAO gets into legal trouble, and there's legal liabilities.
Alex Lazar:
So again, speaking as a lawyer that advises organizations that are considering or working with these types of structures, we really do tend to recommend from a liability management standpoint, and from some other issues that we'll talk about in a minute, that it's beneficial to have some form of formalized legal entity structure that is a good fit for what you're trying to execute to hold the DAO assets. Sometimes people refer to these as DAO wrapper entities because, again, the entity itself is not a DAO, but the DAO is housed within some entity.
Alex Lazar:
So you can have a DAO with no legal entity. Again, a question arises as to whether it might be construed as a general partnership under applicable state laws. People who have moved to formalize legal entity structures to house DAOs have looked to a number of different structures. One of the early ones was a DAO LLC and the limited liability company structure, and we've seen these in different states. We've seen Wyoming LLCs. We've seen Delaware LLCs.
Alex Lazar:
Delaware, because of its history, is a very popular jurisdiction for forming business entities for a number of reasons that we don't need to go into right now. The Delaware LLC has continued to be a popular choice for DAOs that choose to structure as LLCs. They're highly flexible in terms of how you can write the corporate governance. It's possible with Delaware LLCs, for example, to waive fiduciary duties of managers and members, which is something that is appealing in structuring DAOs. That's one structure that works.
Alex Lazar:
A couple examples of DAOs that have chosen to structure as LLCs, ConstitutionDAO, which garnered some publicity a number of months ago. It was an entity or a DAO that was formed to raise money to attempt to buy an original copy of the United States Constitution that ended up not being able to do that. But that DAO structured as an LLC. Flamingo DAO, which is focused on NFTs, is another DAO that's an LLC. So that's one popular structure. And the flexibility of LLCs, especially in Delaware, has made them popular for that reason.
Alex Lazar:
Another entity type that we've seen a little bit is trusts, in particular, recently dYdX Foundation introduced a framework of a purpose trust. When we look at what trusts are and how they work, especially in the United States and the dYdX Foundation was proposed a Guernsey Trust, not one in the United States. But when we look at them, there are some disadvantages potentially to trust.
Alex Lazar:
In particular, the trustees are going to be generally considered to be fiduciaries, which can have some issues in the structure of a DAO. It also tends to centralize control over the assets a little bit in the trustees, which may be contrary to the mission of the DAO. Trust can actually work well to house assets for individual DAO work streams. Trusts generally don't require filings with Secretaries of State, and there are certain types of trusts that might.
Alex Lazar:
But in general, trusts won't require that. They can be created usually with a simple agreement. The assets for the work stream can be controlled by the trustees. You don't have necessarily the same centralization issues with respect to an individual work stream. In terms of it's not such a concern to have more centralization within an individual work stream where the DAO has already voted to allocate assets and carry out the work stream.
Alex Lazar:
So trusts might work well for that and then the trustee, who's leading the work stream, can hold the trust assets in trust and use them for the benefit of the work stream. There still can be some reporting and accountability issues associated with that, but trusts are another entity that people have considered and some people have used. So you don't usually hear a lot about corporations as owning DAOs. I think there's a good reason for that.
Alex Lazar:
Corporations are, by their nature, tend to be highly centralized with the board of directors, especially in the United States, that has control. Fiduciary duties are usually non-waivable by the directors. If it's a for-profit corporation, you'll have shareholders which can create conflicts of interest between the token holders, who are the members of the DAO and the equity holders who own equity in the company or in the corporation. So they tend not to work, but we don't really hear a lot of talk about that or see DAOs being operated as corporations.
Alex Lazar:
There has been a lot of discussion about offshore DAO entities, and there's a number of jurisdictions that have been popular. I think some of the jurisdictions that have been most popular are Cayman and BVI. I'm not an attorney licensed to practice in Cayman or BVI, so I can't give any legal advice on that, but we have worked with companies that have moved to set up organizations in these jurisdictions because they feel that they are a good fit for DAOs.
Alex Lazar:
One that has been quite popular is that the Cayman Foundation Company. One of the advantages of the Cayman Foundation as a DAO entity is that a Cayman Foundation, it has the flexibility of a Delaware LLC. You can really write the terms of it to be whatever you want them to be, but it can be ownerless. So you avoid any issues of conflicts between shareholders and token holders. You don't have the same fiduciary issues. Because of that, you have the flexibility. So if you're looking to create a DAO that is especially focused on community governance, the ability to have an ownerless foundation that is highly flexible, it can be a really nice fit and a really nice overlay for the governance structure of the DAO.
Alex Lazar:
Now, currently Cayman organizations are not able to issue tokens, so what you typically see when a company wants to or when a DAO wants to structure as a Cayman Foundation Company, is there will be a top level company or a holding company in Cayman that has the governance structure housed in it, but the tokens are actually issued by a BVI subsidiary. That's a wholly-owned subsidiary of the Cayman Company. BVI companies are currently able to issue tokens, and there's a well-established procedure for that in BVI.
Alex Lazar:
The DAO entities and other jurisdictions as well, we've seen Switzerland, we've seen Singapore, but I think for the most part, we're still seeing a lot of Cayman, BVI, Delaware LLCs are probably some of the most prevalent ones.
Gabriel Khoury:
Wow. Thanks, Alex. That was a fantastic brief introduction to the legal structures for some DAOs. But what about co-ops? I've seen some news recently that some owners are considering setting up their DAOs at co-op. Could you provide a little background as to that?
Alex Lazar:
Sure. People have compared DAOs to the co-op structure, and the co-op structure, of course, is a historical structure. It's a known entity structure that exists and is used for certain limited purposes. Because of the somewhat looser, more decentralized governance of a co-op, people have sometimes felt that it's a good fit for DAOs. I think on some level, it's more of a good philosophical fit. We haven't really seen a lot of activity in that area. And I have not really seen DAOs forming as co-ops.
Alex Lazar:
There's been some talk also within the past year about unincorporated associations as a possible structure. It's partway between the idea of a co-op and a general partnership or just no entity structure. It's a really interesting way of thinking about it.
Alex Lazar:
Again, we haven't seen anybody try to implement that at this point, and I think there's still some amount of thinking, planning, flushing out to do before anybody would actually move to do that, but it's something we're certainly keeping an eye on and will be interesting to see if any DAOs choose to move in that direction.
Gabriel Khoury:
So with all the different legal structures that are possible with a DAO, how can community members decide which one is best for them?
Alex Lazar:
It's a good question. And it's really going to depend on the individual DAO, the mission and purpose of the DAO, the nature of the governance structure of the DAO, and a number of other factors that include tax issues and all sorts of issues. There's no one best fit, and there's no one-size-fits-all. It's really something that each individual project should consider with its members and consider with its legal and tax and other advisors to consider all of the different issues that impact that choice and will lead to the best possible choice for that particular DAO.
Gabriel Khoury:
Okay. Thanks, Alex. It sounds like DAOs are a very complex beast. There’s quite a bit of legal issues that were not discussed in today's episode, and just a few of them are tax and some regulatory reporting requirements, securities laws issues, jurisdiction issues, intellectual property issues, and some liability issues. Each of these will be discussed in future episodes of this podcast. But just as one last final question for this episode, Alex, is can you provide any practical guidance to an individual who's considering joining a DAO and/or someone who is creating a DAO?
Alex Lazar:
Yes. There are so many issues that impact DAOs, and many of them are the same types of issues that impact any type of organization, but many of them are somewhat different because of the governance structure of many DAOs. As a practical matter, for people that are considering leading the creation of a DAO, you really have to have a clear view of what your mission's going to be and how you initially plan for the DAO to operate.
Alex Lazar:
You also have to understand that once the DAO is launched, the creators of the DAO will no longer be able to control it. Once it's decentralized and tokens are issued, and governance is distributed, it will really be the community that is leading it. So in many ways, the focus should be on creating a structure that allows for robust, decentralized, and autonomous governance of the DAO from the beginning.
Alex Lazar:
And there are different entity structures that might facilitate that for different types of purpose. And there are some DAOs that are not intended to be quite as decentralized, and maybe they would have different priorities that would lead to different choices, but it's certainly important to consult with legal counsel early on to understand the various issues. You mentioned tax, securities laws.
Alex Lazar:
It's important to understand whether the token that the DAO is considering issuing is likely to be deemed a security for US and other international securities laws purposes that will impact decision-making. Many tokens, of course, are securities and some are not. It's important to consider jurisdictional issues. There are some types of DAOs and entity types that might require certain people to be physically based in certain countries. That's obviously a consideration, so all of these considerations are really important. Some of them will close off certain paths. Some of them will open other paths.
Alex Lazar:
And if they're thoughtfully considered with tax and legal advisors as the leaders of the project, work on developing what they see as the best pathway from a business and commercial standpoint, usually you find a path that seems to become clearly the best one and makes the decision easier for you.
Gabriel Khoury:
Absolutely. Thank you, Alex. And that's it for this week's episode. Thank you to Alex for this brief primer on DAOs. And to our listeners, please stay tuned for future episodes where Alex and some future guests will discuss and take a deeper dive into some of the points mentioned today.
Gabriel Khoury:
If you have any questions about the topics discussed today, please reach out to either one of us. Our contact information will be in the show notes below. Also in the show notes will be various blogs written by our Blockchain Team about the topics that we discussed on this episode. Please make sure to check those out as well. And until next time, stay legit.
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