Setting up a legally sound decentralised autonomous organisation (DAO) in Estonia – doable or mission impossible?
This guest post about DAOs in Estonia is contributed by Priit Lätt, Partner at PricewaterhouseCoopers Legal in Estonia. PwC Legal is part of PwC’s international network, providing legal services, and connecting clients with tax, financial and accounting experts from all over the world.
A decentralised autonomous organisation (DAO) is a new kind of governance model for web3 businesses. It is typically understood as a community of individuals that leverage distributed ledger technology (DLT) solutions. Their aim is generally to decentralise the governance of an application or an asset (a software protocol) to eliminate human involvement (error, inaction or fraud). A DAO is a totally new kind of organisation – a self-governing body operating on democratic principles that is not influenced by outside forces.
This article considers the possibility of setting up DAOs in Estonia using existing legal vehicles.
1. Rise of DAOs
Before jumping into practicalities, let’s briefly consider some real world examples of decentralised projects using a DAO governance model.
According to DeepDAO, a DAO stats platform, DAO treasuries experienced more than 40x value growth in 2021. At the time of publishing this article (1 November 2022), the DAO treasury was $11.2 billion.
One of the great examples of DAO use cases is MakerDAO, which aims to provide a decentralised stablecoin called DAI pegged to the US dollar in a 1:1 relation. Think of this DAO as the largest central bank for the decentralised finance world bringing real world assets on-chain.
In Estonia, several startups have publicly announced plans to use a DAO structure. For example, the Summer of 2022 saw a spin-off transaction, unique in Estonia and on a global scale. The blockchain-based enterprise Solid World DAO grew out of eAgronom, an Estonian startup, which is developing a carbon trading program. Solid World DAO aims to simplify the trading of carbon credits and make the market safer and more attractive by operating through a decentralised autonomous organisation. Solid World DAO is building the world’s first public good infrastructure for pre-purchased but not yet certified carbon credits. This will increase investment in carbon credit projects and in turn helps to stop climate change. As a first step towards its launch of a software protocol and full decentralisation, Solid World DAO chose to establish itself in the legal form of an Estonian non-profit association.
In mid-August, the Estonian commercial register also incorporated INO MTÜ. It aims to be the first internet native organisation utilising the non-profit association legal form in order to reduce legal risks and test the suitability of Estonia’s legal framework to create and manage DAOs efficiently. Of course, both projects are using Estonia’s advanced digital infrastructure.
2. What are the legal challenges for DAOs in Estonia?
There is currently no general legal framework for DAOs at the global, EU or Estonian levels. The only exception is in the US State of Wyoming. There, the Limited Liability Company Act “Wyoming Decentralized Autonomous Organization Supplement“ has been in force since 1 July 2021. It applies the Wyoming Limited Liability Company Act to DAOs so they can have legal status as limited liability companies.
On a positive note, there has been some policy movement closer to home. At the EU level, one of the last draft versions from April 2022 of the Markets in Crypto Assets Regulation (MiCA) included a definition of a DAO. It stated that “a ‘decentralised autonomous organisation’ means a rule-based organisational system that is not controlled by any central authority and whose rules are entirely routed in its algorithm”. However, the final text of MiCA does not include this definition or any reference to DAOs.
The lack of general legal framework for DAOs creates uncertainty regarding the liability of the parties involved in the decentralised project. Yes, DAOs rely on lex cryptographica, the only governing law is the protocol or smart contract. Code is law. However, these statements do not mean that DAOs as well as its „members“ are immune to traditional legal norms. Despite the virtual nature of DAOs, the initiators, builders, developers and participants are human, thus triggering a need to safeguard their rights and interests.
The biggest legal challenges or issues DAOs face are:
(a) Lack of global recognition (or determination of applicable law)
Because DAOs do not operate in any given jurisdiction, regulators, courts or users may face challenges applying their national laws. As opposed to traditional software applications, located at a particular server under the control of an operator located in a specific jurisdiction, DAOs run on every node of a blockchain (ie, both everywhere and nowhere). The traditional theories to determine the jurisdiction for companies in most jurisdictions are linked either to the place of incorporation or the headquarters. In the case of a DAO, this is not really helpful, because in most cases both of these places cannot be determined.
(b) Lack of personality (or corporate status)
There is no legal entity which makes it difficult to create accountability in the traditional legal sense. Even if a regulator, court or user had jurisdiction over a DAO, there is a question whether the regulator, court, or user has the authority to impose rules on such a DAO.
(c) No incorporation = unlimited liability
Any member – literally anyone who has ever voted on a governance proposal – can be held fully liable.
These issues can expose members of a DAO to joint and several legal and tax liabilities under a number of jurisdictions.
3. How to set up DAOs in Estonia from a legal point of view?
Basically, there are two different options for setting up a legal structure of a DAO:
- DAOs without a registered legal entity (entity-less): otherwise known as pure on-chain DAOs. This is a DAO with no „legal wrapper“ and thus all of its members are likely to have joint and several liability.
- DAOs that utilise a „legal wrapper“: a DAO is managed by a legal entity, and the members are legally part of this legal entity. This approach aims to create liability both for the DAO’s managing entity and its members. Please note that there are also DAOs that utilise a limited „legal wrapper“ whereby the DAO is managed by a legal entity, but the members are legally not part of this legal entity. In this case, the DAO has a legal personality in order to contract with „real-world“ entities and manage „real-world“ assets, but the members would still lack limited liability. This structure is under legal assessment in a class action against MakerDAO for loss of funds due to protocol failure on 12.03.2020.
DAOs without a registered legal entity
This option is used a lot throughout the decentralised ecosystem in order to create a fully or true decentralised structure. This kind of DAO is neither a natural person nor a legal person (since this organisation is not recognised as a legal person by a legislator). In many jurisdictions (including Estonia), this structure could be classified as a partnership (in Estonia seltsing; in Austria Gesellschaften bürgerlichen Rechts; in Germany Gesellschaft; in France societe civile) under civil law.
According to Estonia’s Law of Obligations Act, „In a contract of partnership, two or more persons (partners) undertake to act to achieve a mutual objective and to help to achieve the objective in the manner established by the contract, above all by making contributions.“ In Estonia, a partnership does not have a legal capacity, it cannot effectively enter into contracts and it cannot sue and be sued. In addition, all the members would have direct and unlimited liability for the partnership’s obligations, irrespective of the member’s personal contribution in the DAO. This is the most significant issue and risk. Thus, a DAO without a legal entity (i.e., a partnership) triggers several major legal issues.
DAOs with a registered legal entity
The option of using a full liability wrapper seems to be the best option for DAOs looking for the most legal certainty and safety. Of course, the quid pro quo is that they must comply with all the necessary regulations and give up some kind of decentralisation.
The most suitable legal vehicles to manage DAOs in Estonia are the private limited company (in Estonian, Osaühing or OÜ) or the non-profit association (in Estonian, mittetulundusühing or MTÜ). The 2020 amendments to the Estonian law extended digital possibilities of adoption of resolutions of shareholders and members of all legal entities. It is possible to carry out fully virtual general meetings and members of the management board are not required to attend the meetings. In addition, shareholders and members of all legal entities are entitled to adopt of resolutions without calling general meetings. Thus, conducting voting in discussion channels such as Discord is actually possible.
For foreign entrepreneurs looking for a jurisdiction to manage their DAO with a registered legal entity, e-Residency makes it possible (and easy). E-residents can incorporate and run their legal entities in Estonia all online, without ever needing to travel here.
Now, let’s assume that the builders or founders are willing to give up some decentralisation (at least at the initial stage), designate trusted representative(s), and intend to achieve some non-profit purpose(s). These DAOs could use a non-profit association as their legal wrapper. Currently in Estonia, the formal requirements for setting up and managing non-profit organisations are (most) favorable for many DAOs. The primary functionality of these DAOs’ protocols is not to make a profit, but to create and vote on governance proposals. The non-profit entity would control the smart contracts underlying the DAO’s protocol and direct the actions of the DAO treasury to foster the development and growth of a decentralised ecosystem. This indicates to the non-profit nature of the organisation.
Final words on DAOs in Estonia
So stated Valdis Dombrovskis, the European Commission’s Executive Vice-President, at the Tallinn Digital Summit in 2021.
This digital future is already here, and it is decentralised and operated by autonomous communities. For proper functioning and in order to realise full potential of these decentralised communities and projects, legal clarity is needed for DAOs.
In the meantime, existing legal vehicles under Estonian law – private limited companies and non-profit associations – combined with e-Residency digital solutions, makes it possible to minimise legal exposure of decentralised projects.
If you are interested in learning more about setting up a DAO in Estonia, contact the author via the link below: