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How To Operate A DAO With Regulation and Case Studies

FWB, BanklessDAO, GitcoinDAO, Mirror DAO, etc., all of these top-stream DAOs, are currently exploring how to address compliance issues.

Why should a DAO have a legal entity?

In 2022, various DAOs have established legal entities. First, ENS DAO set up a non-profit organization in the Cayman Islands: the ENS Foundation. Then GitcoinDAO launched a proposal to follow ENS's lead and set up a Gitcoin foundation in the Cayman Islands, followed by SushiSwap and ApeCoin.

Wouldn't it be great if DAOs had no legal entity and were not regulated by any country?

GitcoinDAO posted an article that explains the issue more fully.

  • with the Gitcoin Foundation, $GTC holders would only have limited liability for the actions of the DAO; without a legal entity, $GTC holders would have unlimited liability personally.

  • Tax considerations. If there is no legal entity, the individual $GTC holder may have to pay taxes on the income of the DAO, even if that income belongs to the DAO treasury and is not distributed to individuals.

  • Signing a contract. DAO inevitably has to cooperate with other companies, how to sign a contract if there is no legal entity? How to hold intellectual property rights? How to solve the health insurance problem of contributors?

Here is introduction of Gitcoin foundation

Do all DAOs have a legal entity?

Going to the Cayman Islands to set up a foundation is a handful for some top-stream DAOs, but what's the reality?

FWB approached top law firms to move forward with a registered entity after receiving a $10 million investment from a16z in October 2021. But till today, it still hasn't been completed. The latest explanation is that efforts are underway to put together a UNA (Unincorporated Non-Profit Associate) structure for the FWB DAO. The pros and cons of UNAs are described in the last section [Compliance Framework].

BanklessDAO also currently has no legal entity and was first discussed as an LLC, but never moved forward. Instead, one of BanklessDAO's subDAOs has set up a legal entity.

Using SubDAO to provide financial and legal protection for DAOs.

This is a new way of thinking, and BanklessDAO's legal guild is no slouch.

0xJustice.eth, who leads governance efforts at BanklessDAO, wrote an article in May discussing the legal entity of DAOs and subDAOs.

First, he dismisses the industry norm that those legally registered DAOs are still DAOs? Members require real names or KYC, and agreements are based on legal contracts rather than smart contracts.Second, a new idea is proposed to address compliance. How can DAOs legally utilize legal tools? subDAO may provide the answer. The options are as follows.

  • DAO does not require a legal entity.

  • SubDAO creates and runs legal entities for DAOs.

  • external legal contracting by SubDAO.

  • the SubDAO holds the physical assets through legal contracts and the DAO does not hold any physical assets.

  • The identity of SubDAO members can be verified by a "third party identity service provider", but SubDAO members remain anonymous to the DAO.

  • The biggest problem of this solution is: what if the SubDAO runs away with the physical assets? This requires an on-chain DEFI solution to assist. For example, physical assets need to be pledged with equivalent digital assets.

There is an article about [DAOs as Digital Nation-States]

Compliance Framework

How do you ensure "decentralization"?

This may be a bit counterintuitive.

The best structures that support "decentralization": UNA, LCA, LLC.

Because they support 100% on-chain, they do not need to deal with any real-world human behavior during operation.

The structure that supports "decentralization" the least: offshore foundations.

Because of the need for off-chain individual operations, which are actually controlled by the foundation members, not by the DAO members.

DAOs without legal entities may not guarantee "decentralization" instead.

Alas, here I see the dilemma of the Mirror DAO. A technology development company (e.g., Mirror team) launches a DAO without a legal entity (e.g., Mirror DAO), and the participation of the company's members in the DAO's activities can be perceived by regulatory authorities as undermining the "decentralization" of the DAO, thus posing legal risks.

How to "distribute profits"?

People with DAO governance tokens, DYDX, ENS, OP, always imagine that they can participate in the distribution of profits. Let's see if that's possible.

First, if a DAO without a legal entity, holding governance tokens, participates in the distribution of profits, it will challenge the definition of "governance tokens" and "equity" under US securities laws.

Second, if profits are distributed in other ways, the LCA and LLC structures are the most appropriate; UNA has greater limitations; and overseas foundations are vulnerable to tax challenges.

How to ensure "legal existence"?

A DAO can have a very high degree of freedom if there is no legal entity, but it also loses the support of the legal system, the main problems are explained in the first section, GitcoinDAO 3 points.

UNA, LCA, LLC, overseas foundations can solve the "legality" problem.

Why did FWB choose UNA?

From the above points, it seems that UNA has more restrictions than LCA and LLC, so why should FWB choose UNA?

First, UNA is very resistant to regulatory scrutiny and far less risky than LCA or LLC, especially for an organization with a large number of people and high revenue, and US regulation is always the sword of Damocles hanging overhead. For the sake of low risk, FWB seems to prefer to forgo direct profit distribution to members in the future.

Secondly, in the form of UNA, the transfer of DAO membership is easy, while LCA and LLC are restricted. fwb, as a social DAO, must consider the potential risk of membership transfer.

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