As DAO gain momentum, it becomes clear that having a legal structure is vital to their long-term success. However, a poorly implemented structure can do more harm than good, from possible management usurpation to regulatory issues that threaten the very existence of the organization.
Sergey Ostrovsky, co-founder of DAObox and law firm partner AURUM.
Arbitrum DAO
This case is interesting from the point of view of structuring a very large and diverse decentralized organization. Also, this is a great example of how the DAO managed to reject the founders’ offer to dispose of the treasury, forcing them to change the management mechanics.
Arbitrum participants decided to be structured in the Cayman Islands in the form of a controlled DAO ownerless foundation company – a legal entity that has no owners or shareholders and is created to achieve certain goals, for example, the development of a blockchain protocol. One of the features of such a structure is its durability – it is able to survive any changes both in the project and the team, including the departure of founders and key contributors.
An ownerless foundation company can be an excellent option for structuring a DAO, however, the procedures and governance mechanisms that were laid down in statutory documents Arbitrum Foundation raise many questions. We have noticed the following:
- Lack of subordination. Both directors and supervisors of the foundation may be appointed and removed without the consent of the DAO. Such an approach, in our opinion, deprives Arbitrum DAO of adequate control over the management of the foundation. In addition, the board of directors received the right to change the composition of the supervisors at its discretion, namely, the latter must ensure that the directors act in the interests of the organization and in accordance with its goals. Thus, a situation has arisen in which the management of the foundation can remove supervisors if, for example, they “start asking questions.” This should cause serious concern among the community, as it becomes possible for both the abuse of power and the subsequent usurpation of control over both the foundation and its assets. A decentralized autonomous organization in this case will not have real mechanisms to protect its own interests.
- Non-recognition of DAO resolutions by the foundation. In such a situation, the members of the organization cannot make decisions on the management of their own foundation company, determine goals and objectives, and influence the board of directors. The absence of direct recognition means that the foundation company is not obligated to follow the decisions made by the DAO or seek its consent to make certain transactions and transactions. This effectively allows the appointed management to ignore the opinions of the members of the organization, which, in turn, can lead to a strong discrepancy between the goals and vision of the DAO and the actions of the foundation’s management.
- reserved powers. There was no list of “reserved matters” in the foundation’s charter documents that required prior approval from the decentralized autonomous organization. This mechanism obliges the foundation to obtain the consent of the members of the organization to take actions that can have significant consequences for the DAO: significant transactions, transfer of IP, disposal of assets, making and receiving loans, etc. Such a procedure is, in fact, a deterrent mechanism that is needed to ensure that the directors of the foundation cannot take the most significant actions that have an impact on the entire organization, without discussion and approval from the DAO, in whose interests they act.
- Lack of defense mechanisms. The proposed structure of the Arbitrum Foundation does not provide mechanisms by which the DAO could protect itself from the unfair actions of management, including in situations where it refuses to fulfill the tasks formulated by the organization, or directly acts against the interests of the organization. Such procedures should be detailed in the founding documents of the foundation.
- Shortcomings of corporate governance. The mechanisms of these processes, set out in the statutory documents, have not been adapted to the special nature of the relationship between the DAO and the foundation. Corporate governance procedures did not take into account the complex dynamics of such interactions at all.
We discovered the problems described shortly before the planned vote on the creation of the Arbitrum Foundation. DAObox published a post on the Arbitrum DAO forum in which we suggested ways to address these shortcomings.
Our recommendations, unfortunately, did not receive the attention and response that we had hoped for. Subsequently, the Arbitrum DAO participants approved the foundation structure with all the gaps described above.
Hector DAO
As in the case of Arbitrum DAO, a structure was proposed for consideration by Hector DAO, which implies the use of the Cayman foundation company as a legal wrapper for HEC.
After reviewing the draft bylaws, we found many of the same problems we found with the Arbitrum Foundation. The identical problematic demonstrates that completely different DAOs face very similar problems in legal structuring:
- Centralization of power. As in the case of the Arbitrum Foundation, the main problem with Hector DAO is that much power is concentrated uncontrollably in the hands of a closely related group of individuals. As discussed above, this approach goes against the decentralization principle that underpins any DAO and poses significant risks to the organization itself.
- Lack of control. In the structure proposed for Hector DAO, the foundation is actually not under the influence of the DAO, there is no management subordination to the participants. In such a situation, serious problems can arise with the definition of the goals of the foundation, as well as control over the actions of management.
- The right to accept shareholders. We found that the foundation company’s bylaws allow it to accept shareholders. This is a very significant point, since the shareholder will receive full control over the company and its assets, which clearly does not correspond to the goals and objectives of creating a legal shell for the DAO. In the absence of adequate checks and balances, such an important decision can be taken by the board of directors without any approval from the members of the organization.
- No reserved powers. As in the Arbitrum DAO, this creates an environment in which foundation directors have unlimited ability to make material transactions and dispose of the organization’s assets.
- Corporate governance procedures. Similar to the Arbitrum case, the foundation structure also did not provide for any mechanisms that the DAO could use to protect its interests in the event that management abuses power or acts against the interests of the organization. Corporate governance procedures also did not take into account the specifics of the relationship between Hector DAO and foundation, as its legal shell.
Just ahead of the scheduled Hector Community AMA session to discuss the creation of the Hector Foundation, DAObox posted their comments and suggestions on the Community Discord channel. One of the founders of the project later replied that the project plans to discuss our proposals with the lawyers who are involved in the creation of the company.
How to structure DAO and create a legal shell for it: 8 recommendations
The mistakes described above and their possible consequences show how important it is for any DAO to create a reliable and transparent legal and corporate structure.
It can be assumed that many of the gaps described in this article were deliberately allowed, for example, to ensure that the founders and the core team of the project receive full authority over the foundation. But this approach completely eliminates decentralization, since it involves establishing control over the foundation by a narrow group of “insiders”.
In order to create a high-quality and balanced legal structure for the DAO, as well as avoid the mistakes described in this material, you need to follow a few basic recommendations:
1. Clearly define goals and objectives legal shell. They form the basis of the organization, their correct formulation will allow uniting the DAO and the management of the structure being created around a common vision. We also recommend setting a ban on changing the purposes of creating a legal shell.
2. Prioritize control of the DAO above the legal shell. Bylaws should include provisions that require management to recognize and comply with resolutions adopted by members of the organization (through Snapshot or other mechanisms).
3. Avoid centralization of power in the hands of several people or one group. The uniqueness of the DAO lies in its decentralization and direct access of the members of the organization to management, which should be reflected in the statutory documents of the legal structure.
4. Enter a system of checks and balances, which allow some stakeholders to control others and vice versa, creating a balance of power and a fair distribution of powers within the organization. For example, important transactions and most significant actions, such as the appointment and dismissal of directors and supervisors, the disposal of IP and material assets, may require the consent of the DAO. This will prevent abuse of power by management and ensure that such decisions are made in the best interests of the organization. The board of directors, in turn, may be given the right to refuse to comply with the resolutions of the AAO in certain situations, for example, if such decisions, in the opinion of the board of directors, confirmed by legal adviser, violate the law or may lead to other serious consequences.
5. Install protective mechanisms, with which the DAO can protect itself from potential abuse by management or actions that are contrary to the interests of the organization. You can introduce a special procedure for resolving disputes and making emergency decisions. For example, provide for the appointment of representatives of the DAO, who can carry out enforcement.
6. Increase transparency. This may include open bookkeeping, publishing decisions and minutes of meetings, regular reporting to the DAO, etc. Keep in mind that there are always problems and issues that should not be made public.
7. Work on clear definitions. Although not discussed above, you need to avoid mistakes in the terminology that is used in the statutory documentation of the legal shell. Carefully work out the main definitions, such as “DAO”, “token”, “resolution” – they should be clearly articulated, taking into account possible hard forks and technical changes.
8. Model negative scenarios. In order for the DAO to cope with management challenges and organizational problems, at the stage of creating a legal shell, probable crisis situations should be carefully modeled and addressed in the statutory documents.
Conclusion
The legal structuring of a DAO is a complex and multicomponent process that requires careful planning and consideration of various factors. By recognizing common mistakes and understanding their potential consequences, decentralized autonomous organizations can create more reliable, transparent and efficient legal structures.
This approach not only ensures transparency and trust from the community, but also creates a solid foundation for the development and growth of the DAO, especially thanks to a properly designed system of checks and balances.
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As DAO gain momentum, it becomes clear that having a legal structure is vital to their long-term success. However, a poorly implemented structure can do more harm than good, from possible management usurpation to regulatory issues that threaten the very existence of the organization.
Sergey Ostrovsky, co-founder of DAObox and law firm partner AURUM.
Arbitrum DAO
This case is interesting from the point of view of structuring a very large and diverse decentralized organization. Also, this is a great example of how the DAO managed to reject the founders’ offer to dispose of the treasury, forcing them to change the management mechanics.
Arbitrum participants decided to be structured in the Cayman Islands in the form of a controlled DAO ownerless foundation company – a legal entity that has no owners or shareholders and is created to achieve certain goals, for example, the development of a blockchain protocol. One of the features of such a structure is its durability – it is able to survive any changes both in the project and the team, including the departure of founders and key contributors.
An ownerless foundation company can be an excellent option for structuring a DAO, however, the procedures and governance mechanisms that were laid down in statutory documents Arbitrum Foundation raise many questions. We have noticed the following:
- Lack of subordination. Both directors and supervisors of the foundation may be appointed and removed without the consent of the DAO. Such an approach, in our opinion, deprives Arbitrum DAO of adequate control over the management of the foundation. In addition, the board of directors received the right to change the composition of the supervisors at its discretion, namely, the latter must ensure that the directors act in the interests of the organization and in accordance with its goals. Thus, a situation has arisen in which the management of the foundation can remove supervisors if, for example, they “start asking questions.” This should cause serious concern among the community, as it becomes possible for both the abuse of power and the subsequent usurpation of control over both the foundation and its assets. A decentralized autonomous organization in this case will not have real mechanisms to protect its own interests.
- Non-recognition of DAO resolutions by the foundation. In such a situation, the members of the organization cannot make decisions on the management of their own foundation company, determine goals and objectives, and influence the board of directors. The absence of direct recognition means that the foundation company is not obligated to follow the decisions made by the DAO or seek its consent to make certain transactions and transactions. This effectively allows the appointed management to ignore the opinions of the members of the organization, which, in turn, can lead to a strong discrepancy between the goals and vision of the DAO and the actions of the foundation’s management.
- reserved powers. There was no list of “reserved matters” in the foundation’s charter documents that required prior approval from the decentralized autonomous organization. This mechanism obliges the foundation to obtain the consent of the members of the organization to take actions that can have significant consequences for the DAO: significant transactions, transfer of IP, disposal of assets, making and receiving loans, etc. Such a procedure is, in fact, a deterrent mechanism that is needed to ensure that the directors of the foundation cannot take the most significant actions that have an impact on the entire organization, without discussion and approval from the DAO, in whose interests they act.
- Lack of defense mechanisms. The proposed structure of the Arbitrum Foundation does not provide mechanisms by which the DAO could protect itself from the unfair actions of management, including in situations where it refuses to fulfill the tasks formulated by the organization, or directly acts against the interests of the organization. Such procedures should be detailed in the founding documents of the foundation.
- Shortcomings of corporate governance. The mechanisms of these processes, set out in the statutory documents, have not been adapted to the special nature of the relationship between the DAO and the foundation. Corporate governance procedures did not take into account the complex dynamics of such interactions at all.
We discovered the problems described shortly before the planned vote on the creation of the Arbitrum Foundation. DAObox published a post on the Arbitrum DAO forum in which we suggested ways to address these shortcomings.
Our recommendations, unfortunately, did not receive the attention and response that we had hoped for. Subsequently, the Arbitrum DAO participants approved the foundation structure with all the gaps described above.
Hector DAO
As in the case of Arbitrum DAO, a structure was proposed for consideration by Hector DAO, which implies the use of the Cayman foundation company as a legal wrapper for HEC.
After reviewing the draft bylaws, we found many of the same problems we found with the Arbitrum Foundation. The identical problematic demonstrates that completely different DAOs face very similar problems in legal structuring:
- Centralization of power. As in the case of the Arbitrum Foundation, the main problem with Hector DAO is that much power is concentrated uncontrollably in the hands of a closely related group of individuals. As discussed above, this approach goes against the decentralization principle that underpins any DAO and poses significant risks to the organization itself.
- Lack of control. In the structure proposed for Hector DAO, the foundation is actually not under the influence of the DAO, there is no management subordination to the participants. In such a situation, serious problems can arise with the definition of the goals of the foundation, as well as control over the actions of management.
- The right to accept shareholders. We found that the foundation company’s bylaws allow it to accept shareholders. This is a very significant point, since the shareholder will receive full control over the company and its assets, which clearly does not correspond to the goals and objectives of creating a legal shell for the DAO. In the absence of adequate checks and balances, such an important decision can be taken by the board of directors without any approval from the members of the organization.
- No reserved powers. As in the Arbitrum DAO, this creates an environment in which foundation directors have unlimited ability to make material transactions and dispose of the organization’s assets.
- Corporate governance procedures. Similar to the Arbitrum case, the foundation structure also did not provide for any mechanisms that the DAO could use to protect its interests in the event that management abuses power or acts against the interests of the organization. Corporate governance procedures also did not take into account the specifics of the relationship between Hector DAO and foundation, as its legal shell.
Just ahead of the scheduled Hector Community AMA session to discuss the creation of the Hector Foundation, DAObox posted their comments and suggestions on the Community Discord channel. One of the founders of the project later replied that the project plans to discuss our proposals with the lawyers who are involved in the creation of the company.
How to structure DAO and create a legal shell for it: 8 recommendations
The mistakes described above and their possible consequences show how important it is for any DAO to create a reliable and transparent legal and corporate structure.
It can be assumed that many of the gaps described in this article were deliberately allowed, for example, to ensure that the founders and the core team of the project receive full authority over the foundation. But this approach completely eliminates decentralization, since it involves establishing control over the foundation by a narrow group of “insiders”.
In order to create a high-quality and balanced legal structure for the DAO, as well as avoid the mistakes described in this material, you need to follow a few basic recommendations:
1. Clearly define goals and objectives legal shell. They form the basis of the organization, their correct formulation will allow uniting the DAO and the management of the structure being created around a common vision. We also recommend setting a ban on changing the purposes of creating a legal shell.
2. Prioritize control of the DAO above the legal shell. Bylaws should include provisions that require management to recognize and comply with resolutions adopted by members of the organization (through Snapshot or other mechanisms).
3. Avoid centralization of power in the hands of several people or one group. The uniqueness of the DAO lies in its decentralization and direct access of the members of the organization to management, which should be reflected in the statutory documents of the legal structure.
4. Enter a system of checks and balances, which allow some stakeholders to control others and vice versa, creating a balance of power and a fair distribution of powers within the organization. For example, important transactions and most significant actions, such as the appointment and dismissal of directors and supervisors, the disposal of IP and material assets, may require the consent of the DAO. This will prevent abuse of power by management and ensure that such decisions are made in the best interests of the organization. The board of directors, in turn, may be given the right to refuse to comply with the resolutions of the AAO in certain situations, for example, if such decisions, in the opinion of the board of directors, confirmed by legal adviser, violate the law or may lead to other serious consequences.
5. Install protective mechanisms, with which the DAO can protect itself from potential abuse by management or actions that are contrary to the interests of the organization. You can introduce a special procedure for resolving disputes and making emergency decisions. For example, provide for the appointment of representatives of the DAO, who can carry out enforcement.
6. Increase transparency. This may include open bookkeeping, publishing decisions and minutes of meetings, regular reporting to the DAO, etc. Keep in mind that there are always problems and issues that should not be made public.
7. Work on clear definitions. Although not discussed above, you need to avoid mistakes in the terminology that is used in the statutory documentation of the legal shell. Carefully work out the main definitions, such as “DAO”, “token”, “resolution” – they should be clearly articulated, taking into account possible hard forks and technical changes.
8. Model negative scenarios. In order for the DAO to cope with management challenges and organizational problems, at the stage of creating a legal shell, probable crisis situations should be carefully modeled and addressed in the statutory documents.
Conclusion
The legal structuring of a DAO is a complex and multicomponent process that requires careful planning and consideration of various factors. By recognizing common mistakes and understanding their potential consequences, decentralized autonomous organizations can create more reliable, transparent and efficient legal structures.
This approach not only ensures transparency and trust from the community, but also creates a solid foundation for the development and growth of the DAO, especially thanks to a properly designed system of checks and balances.
Found a mistake in the text? Select it and press CTRL+ENTER
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