Legal status of Kusama / Polkadot DAOs

Much has been written about the W3F’s approach to engaging with the SEC and the strategy to morph DOT from “security to software”.

Three years ago, in November 2019, Web3 Foundation made a decision that changed its trajectory and led to a transformation in business processes, people management and communications to the general public. We chose to take the U.S. Securities and Exchange Commission (the “SEC”) up on its offer to “come in and talk to us.” Today, we will tell you why. Web3 Foundation is pleased to announce a landmark achievement towards the realization of Web 3.0: the Polkadot blockchain’s native digital asset (DOT) has morphed and is no longer a security. It is software.

To date Parity and W3F employees have not engaged in governance directly (afaik) and there has been direct guidance that no employees should receive treasury funds.

This begs an important question for those currently involved directly in governance by voting their tokens or receiving treasury funds from proposals; what exactly is the legal status of the Kusama or Polkadot DAOs (not just the DOT token), and in turn what are the potential liabilities for those participating?

Regulation by enforcement

Some of the latest crypto enforcements in the US have focused on DAOs with the most high profile case being that of OokiDAO.

On Dec. 20, 2022, Judge William Orrick of the U.S. District Court for the Northern District of California concluded2 that Ooki DAO could be sued because Ooki DAO was an unincorporated association, and – to the disappointment to many advocates in the crypto community – that the CFTC’s service made through the DAO’s online community forum was sufficient.

Several organizations, including venture capital firm Anderseen Horowitz (a16z), filed amicus briefs4 in support of the defendant Ooki DAO. The issue before the court, as expressed in the amici’s argument, was that Ooki DAO can neither be served nor be a defendant because:

  • It is a technology, not an entity;
  • It is not subject to enforcement under the CEA; and
  • It is not an unincorporated association.

Each argument was unsuccessful. First, according to Judge Orrick, the Protocol is controlled by the Token with administrative keys, and it was the actions of these Token Holders that the CFTC sought to regulate, not the Protocol itself. Therefore, the court held that the DAO was not merely a technology. Second, the court ruled that Ooki DAO was subject to the CEA because the CEA makes it unlawful for any “person” to engage in activities that do not conform to the requirements of the CEA,5 and the CEA’s definition of a “person” includes “individuals, associations, partnerships, corporations, and trusts.”6 Therefore, an unincorporated association falls within the definition of a “person” under the CEA and may subject to the CEA. - National Law Review

In the UK, the Law Commission - an independent body was asked by HM Treasury to offer guidance to the government on the legal status of DAOs and any changes which were required to English law.

As in the US, the Law Commission’s proposed starting point is that a DAO which is not designed with a particular structure in mind might be characterised under English law (as in the US) as an unincorporated association or general partnership.

This post 'That’ll be the DAO: an overview of the structure and status of decentralised autonomous organisations under English law’ is a great summary of the current situation gives gives broad context.

Governance engagement and community liability

Governance engagement is low in crypto - its not just a Polkadot issue. There are many issues, but a large one is that investors have taken the same line as Parity/W3F and are not active for legal reasons, namely…

Liability under a contract entered into on behalf of an unincorporated association would attach to the members of the association at the time the contract was entered into who authorised the contract, who would be jointly and severally liable.

Taking an extreme example - were treasury funds received by an organisation who conducted illegal activities, those community members voting to approve a spend would be jointly and collectively liable for those actions.

Where does this leave the treasuries as an organisational entity?

This is an open question - it would be great to hear from the W3F about their views not on the DOT token, but on the DAO’s likely position as an unincorporated association.

It seems oddly misaligned for there not to be a comment or even a warning to token holders about the potential liabilities of contributing to the DAO. Those participating in the ecosystem via companies will retain some legal protections, but many I’m sure are not operating in this way - and so this question is likely most pertinent to them.

Beyond legal issues, there then come tax issues - without incorporation of some kind, there can be no defined place of belonging which then informs rules such as whether VAT should be charged on services. (VAT on Services in/to the ecosystem) With no place of belonging, VAT is charged, unless the organisation is issuing grants and is structured as a public body..

Would love to hear from the legal brains in and around the ecosystem on this question and thoughts around incorporating an entity that offers a safety net for community members operating without protections, as a duty of care if nothing else.

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I think it could go further than this. By participating in a community (i.e. holding tokens, and accepting that the token has a governance process) every token holder could be caught in this net.

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yup. but i don’t think anyone really cares. yolo!

Update to this:

In initial discussions with lawyers related to the incoming guidance in the UK (and following US enforcement), it would be useful to begin to establish a governance taxonomy… namely breaking up the role of the KSM/DOT tokens (or any Substrate network) within the architecture of the protocol.

Voting with DOT to approve a runtime upgrade fits within the ‘software not security’ story, whereas the operations of the treasury likely constitutes ‘an unincorporated association’ and should be structured, documented and treated differently from a legal perspective.

Given the research and guidance we’ve had so far - establishing national 'subDAO’s with some associated legal structure would be wise. Note this doesn’t mean holders need to KYC, but can remain anonymous, but the spending decisions would have some recognition within the articles of an incorporated entity.

Interesting to read about the exclusion of team members from any treasury spendings, smart.

In our case we have set up two bodies in the EEA ( non profit foundation and corporation ) in a highly regulated environment for the DAO to separate economic, protocol and governance concerns. The idea is to maximize protection for all community members contributing and to be able to acquire licenses and or passport licenses across other legislations whenever needed.

While I think this kind of structure will support to establish a “better” legal DAO, intuitively I see a cooperative as a much better fit for legal DAOs in general, as there are many questions wrt securities, liabilities, democratization sufficiently defined. Sadly there are not many legal teams (at least I could not find any) who would have experience in that and research topics like this typically consume more funds than the average legal set up.

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Thanks for comment - could you clarify “our case”? do you operate a parachain?

Yes, we are running zero network (sub/zero on kusama), GameDAO and Game3 Foundation.

Would you mind describing your legal structure, its cost and a link to the lawyers who helped you get up and running? There are a few aspiring parachain developers in the community who have no idea how to handle these legal hurdles (ourselves included). Thank you.

sure, happy to meet and chat in person on Decoded or some of the other events!

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We won’t be at decoded but at least one of the DAO members should be there. I’ll have them reach out. Thank you.

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The Commodity Futures Trading Commission (CFTC) filed and settled charges last week against a blockchain protocol and its founders that could have an enormous ripple effect on the crypto industry.

Speaking to CoinDesk from the Messari Mainnet conference in New York City, Dilendorf said he was “blown away” by the number of people speaking on DAO-related panels at the conference that were either unaware or did not acknowledge existing guidelines from the SEC on DAO governance.

What did surprise many crypto lawyers, however, is that the CFTC’s complaint indicates the regulator sees all voting governance token holders as potentially culpable members of a DAO.

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happy to help outside decoded as well.