Blockchain and DAOs – A Guide to Functionality and Associated Legal Issues
As Blockchain has progressed in recent years there have been broad speculation in its application and potential. This article attempts to highlight to the average lawyer how a blockchain functions and some of the associated legal issues in the field.
Blockchain Basics
For those who are unaware, a blockchain is a system in which a record of transactions made in a cryptocurrency are maintained across several computers that are linked in a peer-to-peer, publicly accessed, network.[1] The data on a blockchain is structured into blocks and each block contains a transaction or bundle of transactions. Each new block connects to all the blocks before it in a cryptographic chain in such a way that it’s nearly impossible to tamper with. All transactions within the blocks are validated and agreed upon by a consensus mechanism, ensuring that each transaction is true and correct.[2] Some blockchains such as Etherium or Solana are more sophisticated and have the infrastructure to support complex data as opposed to just a ledger of financial transactions.[3] The data in these blocks can include computer programs that run when certain conditions are met, these are called smart contracts.[4] Using a series of smart contracts a group of individuals can get together on the blockchain, pool their resources and form a Decentralized Autonomous Organization.[5]
DAOs can be compared to corporations on the blockchain, many foreign jurisdictions treat them as such as well.[6] Individuals become DAO members by purchasing a token the DAO mints on the blockchain. This token grants the member of a DAO voting rights in governance decisions for the DAO, similar to how shares of capital stock offer a shareholder voting rights in a corporation.[7]
IP Rights Associated with Ownership
Ownership of digital assets on a blockchain, such as Non-Fungible Tokens (“NFTs”), is no different than off-chain digital asset ownership. An individual still has the same legal rights associated.[8] Crucially, an NFT transaction does not affect intellectual property (“IP”) rights, though the associated copyright can be bundled with the sale of an NFT if the owner wishes.[9] An NFT is simply certificate of ownership of a particular digital representation, often it an image, but anything can be minted as an NFT.[10] While this seems very obvious, groups have wasted vast amounts of money over the past few years because of the mistaken belief that ownership grants copyright.[11] Earlier last year a DAO focused on NFT collection wasted 2.66 million Euros over an NFT of the Dune movie script, believing it granted them copyright to it.[12]
Many of the computer programs in smart contracts are open-source, free for anyone to use.[13] This is often considered part of the crypto culture which is often distrustful of legal systems and centralized ownership.[14] However, computer code that is not open-source is of course protected by IP law and is considered a valuable intangible asset for individuals and organizations involved in blockchain. Recently two DAOs focused on decentralized finance (“DeFi”) became involved in heated IP litigation over copyright infringement of their software code.[15] Compound DAO, one of the DAOs involved in the dispute is valued at over $5.5 billion, is accused of infringing on Curve Finance’s, valued at over $6.6 billion, software code.[16]
However, what is important to consider is can a DAO even sue? DAOs are not legal entities in most jurisdictions.[17] For that reason most DAOs favor Wyoming and Malta as DAO havens, where they are recognized legal entities.[18]
What can I do with a DAO?
DAOs are quickly gaining ground and are considered legal entities in Wyoming, granting them ownership rights in the real world.[19] Wyoming has adopted legislation that recognizes DAOs as a form of LLCs and grants them the same powers associated.[20] This is generally an easy and practical solution to the rise of DAOs, as they usually like to use LLCs when ownership of off-chain assets is involved.[21] It is general practice for a DAO to own and use an LLC to transact in U.S. jurisdictions.[22] The LLC is often subordinate to the DAO, whose founders and governing members register the LLC in Delaware, and transact in the real world through the LLC. ConstitutionDAO is an example of a DAO that employed an LLC for the purpose of attempting to purchase a copy of the United States Constitution at auction, had the DAO won the LLC would have been the entity that owned the Constitution and the DAO.[23]
There still exist questions in: what can a DAO do legally? Many DAOs have gotten in hot water with the SEC as they can qualify as investment contracts under the Howey Test, meaning they promise a return on their token holder’s investments from labor that the token holder does not contribute in.[24] Therefore it is prudent for attorneys to understand how a DAO functions, how its services are monetized, and if it could possibly satisfy the Howey Test as a security. Additionally while many DAOs function through LLCs and are registered in safe haven jurisdictions, what occurs when a DAO is involved in a dispute outside of Wyoming for an asset the LLC does not own?[25] Indeed, something such as on-chain computer software raises legal questions, for if copyright was not transferred to a DAO’s LLC first, what legal rights would a DAO have to copyright if it is not recognized as a legal entity?[26] These questions should be resolved by legislature in more states recognizing DAOs as a legal entities, especially due to the growing presence of DAOs in everyday life.
Real World Uses for DAOs
DAOs have gained more attention over the past few months with their use in the Ukraine war effort, either contributing to Ukraine’s war chest or humanitarian aid.[27] DAOs such as UkraineDAO raised several millions of dollars in aid for Ukrainians.[28] Sports fans may have also read how BuytheBroncosDAO is attempting to purchase the Denver Broncos by raising $4 billion for their acquisition.[29] While DAOs can give individuals the power of doing remarkable things with real world impact, at their heart they are online interactions in Web 3.0, the next iteration of the internet focused on decentralization rather than the centralized control that is common in Web 2.0.[30]
In the era of Web 2.0, an individual might join Tinder if they were interested in online dating or a Facebook group if they were interested in discussing a hobby – platforms controlled by centralized entities. In Web 3.0 an individual can instead join a DAO focused on what they are interested in, where they have voting power in governance decisions to determine what the DAO does.[31] With the rise of Web 3.0 and the growing innovations in blockchain, it is likely that blockchain DAOs will only become more popular. Therefore, it is prudent for attorneys to educate themselves on how they operate and possible legal issues likely to arise.
Footnotes
