[This post has been authored by Prakarsh and Shruti Mishra, students at National Law Institute University, Bhopal.]
Technological advancements are being increasingly sought after and mainly pertain to maximizing automation to cut costs. These demands have led digital experts to develop a potential regime of fully automated and decentralized corporations known as ‘Decentralized Autonomous Organizations’ (DAOs). To understand the concept of DAOs, we need to understand the basics of the technology that formed their foundation i.e. blockchain. Simply put, blockchain is exactly what it sounds like – a series of blocks and each of these blocks contains some information that is assigned a particular code. Any new information is contained in a new block which is then added to the series and linked to the previous block.
The security offered by blockchain is what makes it so attractive to users. A copy of each blockchain series is saved in multiple ‘nodes’, i.e., various computer resources in the network. If any individual wishes to tamper with data in any of the blocks, then he shall have to (i) Hack into the blockchain which is extremely difficult (ii) Change the information of that block for each of the series (iii) Change the codes in every other block in the series (for all the copies). This, prima facie, poses to be almost an impossible task.
DAOs, thus, make use of this technology and provide a system of decentralized governance. This is a new concept in the realm of technology and corporate governance and hence needs to be studied comprehensively.
What are Decentralised Autonomous Organisations?
DAOs are structured digital entities that are formed for decentralized governance of goods, information, management, etc. The main objective of such structures is a non-central controlled decision-making entity. They are similar to any other organizations which have their own rules of management, except here, the rules are in the form of a code. The bitcoin network, for instance, is a loosely structured public DAO that engages in the management and regulation of bitcoins. However, DAOs may be put to more specific uses.
Similar to how the working of a blockchain is described, the DAO rules are divided among various members of the network. Every member is given certain incentives (usually a token that may be exchanged for cryptocurrency), for following the rules that have been encoded. As each member is personally incentivized, there is no scope for personal gain or bias. Additionally, a DAO works on the basis of blockchain technology which makes sure that a single or a few corrupt individuals in the network may not endanger the entire process.
For their smooth functioning, DAOs employ multiple smart contracts. In fact, even proposals relating to DAOs are in the form of smart contracts. A smart contract is basically a code which executes a specific task upon completion of an event. Every proposal which gets a majority of votes from the acting members is automatically executed.
‘The DAO’ could be called one of the first attempts at executing a Decentralized Automated Organization properly. It used the Ethereum network and was created as a private equity financing for autonomous vehicles. The concept involved rewarding participants with DAO tokens that could be exchanged for cryptocurrency. The venture was able to collect over a hundred and fifty million dollars and yet failed in its implementation due to a bug in its smart contract codes.
Despite its failure, the DAO revealed to a world an entirely new phase of corporate activity that has surfaced along with the pathbreaking technology, that is blockchain. This may be considered as the point where the line between corporate governance and technology began to disappear.
Legal Position on DAOs
A universal definition covering the scope and nature of DAOs in its fullest sense is still a highly debated topic. This is mainly because the technology behind it is still at a rudimentary phase and its true potential may not be known. However, this does not mean that policies and initiatives relating to DAOs are not being deliberated upon.
In the common law system, a DAO may be considered as either a general partnership or a joint venture (like ‘The DAO’). In the case of a general partnership, the liability is joint and several and the same is the case with joint ventures. In a civil law jurisdiction, on the other hand, a partnership is understood as the coming together of two or more people for a common contractual objective or goal. A DAO may fall under the scope of this definition, be declared as a partnership and made subject to similar liabilities. Austria, being a civil law country, has defined the liability of partners in a partnership to be whole and individual. If a DAO were to be set up in Austria, the members may be subject to similar liability.
Even when incorporated, the concept of a separate legal entity may not be as strictly applicable to DAOs, in comparison to their corporate counterparts. Since, in the case of DAOs, all members are actively involved in making every decision concerning the organization because of its decentralized nature, there is a strong likelihood that the veil is lifted off a DAO’s separate legal identity when challenged in a court. As a consequence, any or all members could be held liable as decision-makers because every member is equally involved in the decision-making process. In the United States of America (US), there have, however, been instances of penalizing ventures like ‘The DAO’ for offering unregistered securities for funding.
‘The DAO’ had established a subsidiary company in Switzerland, a civil law jurisdiction, and was registered as a Limited Liability Company. This was meant to connect the digital corporate system with the real world. However, after the early collapse of ‘The DAO’, this subsidiary remained largely dysfunctional. These instances show that the merger of DAOs and the real corporate world has already begun, and it thus, calls for extensive deliberations that would pave the way for a smoother integration.
The EU, too, has discussed the legal position of DAOs extensively by way of establishing expert committees for submitting reports on blockchain and AI. The EU still, however, has not rolled out a specific policy in which DAOs may fit. The Secretariat had established the Blockchain Observatory Forum and has communicated how their report states that DAOs may enter into contracts and act like any other corporate entity will give rise to a legal personality. They may be classified as partnership agreements, joint ventures, or even as civil law partnerships. However, DAOs have a high level of diversity and discretion in implementing their own rules of conduct. This, in addition to a missing board of directors or officials, makes its legal status ambiguous.
Another important aspect to discuss is the position of the ‘tokens’ that are granted by DAOs as incentive or payment. These may be considered as an investment, an asset, property, or even money depending on the perspective of the financial regulators. This has been extensively discussed in the United States of America (US). The US has a multilayered (State & Federal levels) regulatory framework for governing financial institutions. When ‘The DAO’ was launched in the US, it caught the eye of the Securities and Exchange Commission (SEC).
In the case of SEC v. W. J. Howey Co., the US judiciary has established the ‘Howey Test’. This test is used to determine whether an entity is providing its users with securities and if yes, then it would need to adopt the regulations given by the SEC. The SEC found that all the requirements under the test were being fulfilled by ‘The DAO’ and the tokens could be considered as a security/digital assets, hence it needed to be registered with the SEC. Therefore, it can be reasonably presumed that this position would be relevant for any other DAOs that may come up in the future.
In India, if Initial Coin Offerings are made in a DAO structure, then the SEBI may have the power to regulate it. However, for this to happen the tokens (which are usually in the form of Cryptocurrency) will need to fall under the ambit of ‘securities’ under the Securities Contracts (Regulation) Act, 1956. The tokens offered by DAOs to its members may have a chance of being recognized as securities as the government has the power to declare any instrument as a security under the said Act. Additionally, in this context, the Indian Judiciary has held that ‘securities’, under the meaning of the Act, must be freely tradeable – this condition is certainly fulfilled by DAO tokens. That said, such a situation seems improbable in the near future as the government has, on more than one occasion, refused to give any legal backing to cryptocurrencies and is deliberating a bill to ban all cryptocurrencies in India.
Effect of DAOs on Corporate Governance
The DAO’s decentralized structure will help in getting rid of the principle-agent issue in any governance structure. This issue may be explained by way of an example – say, there is a politician who has been democratically elected. He makes decisions based on his political agenda and pre-election promises, which is, in turn, what the citizens elected him/her for. Usually, it is given that in an ideal democratic structure, such a politician will take decisions for the masses, i.e., in their interest. However, there may be instances where such a politician (or an ‘agent’ of the people) is corrupted. As a result, his decisions are coloured by personal bias, greed, mistake, etc. Now, consider a system where such an agent doesn’t exist at all. Every person gets their say and the majority decides on every managerial aspect/issue by itself. This is called decentralized management.
The principle-agent issue is prevalent in not just in a democracy, but in corporate governance as well, and the DAO structure might help revolutionize this. The board of directors, CEO, other management and corporate officers may be replaced by a central code. Further, the concerns relating to voting rights in a corporation, the weightage of votes, type of votes etc., may also be addressed by how DAOs function. The voting rights may be exercised by all token holders, or only by those who hold tokens above a required level. These provisions will not only help in creating a highly democratic but also more transparent atmosphere. Considering how corporations are increasingly being considered as social institutions, a democratic and transparent nature seems indispensable.
The aforementioned instance may, however, be a very advanced application of DAOs. Even if for the time being, blockchain and DAOs are used simply for record maintenance, a strong level of transparency can be achieved, which may be unattainable using traditional human resources.
Decentralized Automated Organizations are being put to an increasing number of uses. Presently, a DAO, in its developmental phase, may soon provide a virtual automated court for arbitration proceedings and dispute resolution. The jurors, here, need to collect a specific number of tokens on the basis of which they may be inducted to decide a dispute. Upon a majority decision, the contract that introduced the dispute will be disposed of.
DAOs may also tackle various wrongdoings that occur within corporations. If such issues of personal bias and selfish aspirations are dealt with at the very onset of the decision-making process, then it would save an immense amount of time and resources.
DAO and blockchain technology may revolutionize almost every economic sector and even the personal lives of people. However, there are still numerous issues that stand as obstacles in the widespread application of such technology. These issues pertain, mainly, to costs and complexity of the technology. Blockchain is comparatively a very new creation. It takes years before any technology is incorporated on a large scale in the corporate realm. Economic viability is one of the most important aspects of consideration in the corporate world. That, coupled with scepticism about new and rudimentary technology, will cause a delay in its implementation, even after it has been sufficiently developed. However, with the number of startups in today’s world, the incorporation of newer technology, as an additional selling point, may expedite the integration of blockchain into the corporate world.