Decentralized Autonomous Organizations (DAOs) under English Law
The Law Commission of England and Wales has embarked on a comprehensive agenda with a view to facilitating the use of digital assets. One of its latest projects concerns so-called Decentralized Autonomous Organisations, or DAOs, which dominate the ever-expanding Decentralised Finance (DeFi) universe.
Blockchain technology allows for the creation of software-based organizations that can interact with third parties by executing ‘smart contract’ code. These DAOs may issue tokens that confer on the holder certain control and/or cash flow rights not dissimilar to traditional equity and debt instruments. The founders behind a DAO may opt for a traditional business entity type, for example a (Swiss) foundation or a company. Frequently, however, a DAO may start operations without any formal formation document in place. Here, the question arises whether the DAO – or, more precisely: its human participants – qualify as a particular type of traditional business organization. In most jurisdictions, the main option would be a general partnership.
This question is highly relevant for both regulatory and commercial law purposes. As for the former, given the strive towards decentralized governance mechanisms in DeFi, it may be difficult to identify any particular ‘entity’ that can function as the regulatory access point. In an extreme scenario, a DeFi application may be controlled entirely by interacting smart contracts and the pseudonymous user base voting their (tradable) governance tokens. Centralising human interventions will still be necessary and the classification of the relevant participants as partnership – formed under a particular legal system – would enhance legal certainty in this respect.
From a commercial law perspective, whether English partnership law applies to a DAO may become pertinent in a setting such as the following: after moving to a decentralized governance structure, the governance token holders vote for a buggy upgrade of the DAO’s smart contract code that subsequently causes loss to the user-claimant. The defendant is a core founder-developer who holds a significant amount of governance tokens but neither voted for nor was involved in the implementation of the faulty upgrade. Having deep pockets and being domiciled in England, they are being sued before the English courts based on their personal liability as a DAO partner.
For the classification of a DAO, as a partnership or otherwise, it is necessary to distinguish between its key human constituencies, thereby also delineating its boundaries (for details see here). A DAO is likely to originate from a group of developers with an idea for a decentralized application (DApp). This group will develop the smart contract code and launch it on the relevant blockchain platform. Next, by depositing crypto assets with a smart contract, users may obtain tokens that represent a loan or a share in a liquidity pool or money market. As a bootstrapping technique, users may be rewarded with governance tokens that allow them to vote on certain parameters of the underlying smart contract code. There will likely be a significant overlap between these three constituencies at first: developers are likely to be the first users and governance token holders; however, if successful, the user base and governance token holder base may expand over time and separate to some extent. As a fourth constituency we may include the validators that maintain the network.
In line with the private international law of corporations and the principle of lex incorporationis, whether an organization is a partnership is determined by the law under which it is organized. In many cases there won’t be a written partnership agreement at all. Here, given that a partnership is based on contract, the common law principles for determining the lex contractus will be decisive. In the absence of a contractual stipulation, this is the law to which the contract has the ‘closest and most real connection’. For a network of smart contracts that run on a decentralized network with a dispersed community of developers, users, governance token holders and validators, determining the ‘closest and most real connection’ will be a difficult and fact-sensitive affair, taking into account all the relevant circumstances (notably the domicile of the main developers/userbase/governance token holder base and/or any jurisdictional links of the referenced financial assets).
Under English law, an organization will be a partnership only of it meets the conditions set out in the definition of sec.1(1) of the Partnership Act 1890: (i) a contractual relationship between two or more persons; concerning a (ii) business carried on in common (iii) with a view of profit. The numerous ‘normal incidents’ of partnership that have been identified in the case law are not prerequisites for the existence of a partnership, which is to be determined exclusively by reference to the conditions set out in sec.1(1).
As a bare minimum there must be an agreement between the parties, a meeting of the minds, with the intention to form a partnership, supported by consideration. To qualify as a partnership, the contractual relationship must concern a ‘business’ which, pursuant to sec. 45 of the Partnership Act 1890, includes ‘every trade, occupation, or profession.’ Importantly, the business must be carried out in common, that is, two or more persons must conduct a single business together for their common benefit. This requires that the participants have, as regards the business, expressly or impliedly accepted some level of mutual rights and obligations as between themselves. Finally, the business must be carried out with a view of profit. A partnership will only exist if the profits are intended to be realised for the common benefit of the participants. It does not qualify if individuals come together with a view to promoting the individual profitability of their own businesses.
Based on these considerations, it seems reasonably clear that users and validators (as such and without more) will not be partners in a DAO partnership. By contrast, for a ‘typical’ DAO that seeks to provide one or more financial products as part of the DeFi universe, developers and possibly also governance token holders may qualify as DAO partners under English law, provided a sufficient link to England can be established. Still the risk of personal and unlimited liability for DAO debts of developers seems low, and even more remote for governance token holders. The evidentiary hurdles for a claimant appear to be quite significant, not least for proving that the defendant was a partner at the time the DAO debt was incurred.
Where DAO constituencies amount to a partnership under these parameters, the default provisions of the Partnership Act 1890 will rarely be a good fit. In the absence of an express agreement, it may be possible to imply ‘in fact’ terms that are more suitable by derogating from the Partnership Act 1890. Terms implied in fact are terms which were not expressly set out by the parties, but which they must have intended to include. For the typical DAO, alternative arrangements that replace unsuitable default provisions will be necessary for a DAO’s governance arrangements to make commercial sense. Although rarely a partnership agreement itself, a White Paper may be relied upon for ascertaining the participants’ intention in this respect.
Michael Anderson Schillig is a Professor of Law at King’s College London.
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