Terrestrial Docking Stations for DAOs: The Swiss Association and the U.S. UNA
The "regimelessness" of DAOs currently prevents them from accessing real-world services. In this post, we look at two entities which we believe may soon be part of every DAO stack.
Radical decentralization and its consequences
Many of our clients have several “core units” that contribute to various aspects of their decentralized protocol.
MakerDAO for instance has more than a dozen such units, e.g. one to research new types of collateral, another one for legal matters, yet another for marketing, etc.
Each unit is typically a DAO without anchor in any terrestrial jurisdiction and is siloed off from the governance and operations of the other DAOs in the project. Their communality lies in the shared purpose of growing and maintaining the protocol.
Whilst ideologically pure, practically such setup quickly bumps into the limits of what an individual DAO or a string of independent DAOs can do.
For instance, whilst most individual contributors to the DAO may be happy to receive payment in crypto, some may prefer to receive payment in fiat, sometimes even as salaried employees.
Furthermore, a DAO cannot sign agreements, can’t have bank or exchange accounts, and has no way to pay taxes if taxes apply.
What is required is a “docking station” for DAOs: a terrestrial landing zone for DAOs to plug into so they can access shared real-world services without introducing an element of centralization.
Permissionless limited liability entities
This post is the result of preliminary research into two entities, both Associations, which we believe may meet this demand: The Swiss Association and the U.S. Unincorporated Non-Profit Association (“UNA”).
Let’s start with the older of the two: the Swiss Association.
As with many legal structures in Switzerland, the Swiss Association (Verein in German, as in fer-INE) is not new.
Associations have long permitted a variety of entities to affiliate as members while maintaining their status as individual legal organizations.
Real-world Associations range from local sports clubs to FIFA to international legal services firms and global corporations.
Importantly, there is no need for any filing or registration to form a Swiss Association, in contrast with Associations in other jurisdictions such as Germany.
As soon as a minimum of two initial members adopt its statutes, the Association is formed and acquires separate legal personality under Swiss law, with its liability protections enshrined in the Swiss Civil Code.
This is why we refer to the Swiss Association as a permissionless legal entity: one of a rare breed of legal structures that can be formed contractually and benefit from limited liability without the need for approval from public authorities.
Transposable to blockchain
As a result, Associations can be setup instantly and onchain, in the same way OtoCo currently spins up Series LLCs in Wyoming and Delaware.
As a permissionless legal entity, it can be called into life by two parties signing its statutes as a transaction on blockchain. If a real-world Association can be formed by a minimum of two individuals and/or body corporates, by extension so should two or more DAOs.
Its analog statutes can be abstracted into a smart contract or series of smart contracts.
Any bylaws or other procedural documents that typically complement the status of a real-world Association would take the form of onchain proposals voted on by its DAO members.
Art. 60 of the Swiss Civil Code imposes additional requirements, It summarily states that “The articles of association must be done in writing and indicate the objects of the association, its resources and its organization.”
We believe each of these requirements can also be smart-contractified:
In writing: Whilst untested, it can be deducted from recent Swiss blockchain laws related to digital asserts that any smart contract signed on blockchain has equivalence with written contracts.
Object: Swiss Associations have the widest degree of latitude to define their object, which can be a political, religious, scientific, cultural, charitable, social or other non-commercial purpose. Consequently, the Swiss Association is a definite candidate to bind together independent developer units who work towards a common goal, such as the maintenance and growth of a decentralized protocol.
Resources: This is generally understood to refer to financial resources, traditionally by way of a compulsory and voluntary membership fees. For an onchain Association, this could be by way of Membership token which is issued to new Members in return for a fee and burned when Members voluntarily or involuntarily leave. The Association’s Treasury could then simply be a multi-sig wallet.
Organization: A Swiss Association is required to have an Assembly (or General Meeting) and a “Committee”, essentially a Board of Directors.
The Association’s “Assembly” would simply be the collective of member DAOs. For the purpose of exercising their rights, the Association could issue a governance token. Alternatively, a project’s native token could be used.
Real-world Associations typically only hold a General Meeting once a year. In an onchain Association, each vote by the member DAOs would effectively constitute an assembly.
The Committee would be elected from the Association’s Members or be sourced from outside the membership base. To avoid centralization by the backdoor, the statutes can reduce the powers of the Committee into pure rubber-stamping of onchain votes by the Assembly, and introduce governance protocols for the election and tenure of Committee Members.
Note that the above requirements under Art. 60 of the Swiss Civil Code do not include the choice of a specific registered address upon creation of the Association: A mere indication of the Canton where the Association will be based is sufficient.
Core use case: a docking station for DAOs
We then highlighted that whilst encouraging, the proposed model statutes represent a somewhat awkward hybrid between the workings of an analog Association and a potentially fully smartcontractified one.
Expect OtoCo to launch its suite of open-source smart contracts for an onchain Association in 1Q2022.
Perhaps in contrast with the DAA as conceptualized by MME and others as a possible legal wrapper around a DAO, we are designing the Association as a shared docking station for a number of DAOs who each contribute to a common project and wish to share real-world resources.
As mentioned above, this demand comes from a number of legacy projects in the blockchain space that are actively dismantling their Foundation - or keep it purely as holder of intellectual property such as logos and trade names - and leave the maintenance and further development to a number of entirely independent “pods” or “core units”.
In this context, the use of an Association as a way to share resources has a number of clear benefits:
No partnership, no agency, no liability, no control
An Association allows for multiple core units to operate as independent and fully autonomous entities: their membership of an Association does not make the DAOs “partners” in a unified partnership and as members, the DAOs are not legal partners with each other. In addition, core units cannot act as agent of the Association or any other member DAO, cannot obligate the Association or any other DAO, and each DAO is liable only for its own acts or omissions (to the extent such liability could be attributed to it) - and not those of the Association or any other member. Conversely, the Association cannot act as an agent of any of its member DAOs, does not in any way manage or control any member DAO, cannot obligate any member DAO and is liable only for its own acts or omissions.
Whilst the Association has to comply with Swiss law, none of its member DAOs are subject to Swiss law (unless they could independently be found to operate from Switzerland or otherwise be subject to Swiss law as a result of their own operations). Conversely, the Association is not subject to any of the laws its member DAOs could be found to operate under.
Indifferent about the legal nature of its members and their location
In addition, an Association is indifferent about what legal structure its members adapt. It can accommodate to individuals, corporates or partnerships, each with or without limited liability in whichever territory they operate. This also means that not all of its members have to be DAOs: a mix of DAOs and more traditional dev studios incorporated as Limited Companies or C-Corps is possible.
Unified representation without local compliance
Despite the different nature and geography of its constituent members, an Association can represent itself internationally as a single organization, without complying with the regulations and tax codes of each country in which it operates.
Tax and securities laws
As a result of the above, the Association also does not have to file multiple tax returns. It only pays tax in Switzerland and Associations with charitable or other public non-profit objectives may apply for an exemption from Swiss income and capital taxes under certain conditions. An Association would also not be subject to the SEC in the U.S. or similar bodies in other countries even if some of its members could be seen to operate there.
No sharing of revenues or pooling of profits
Finally, the Association does not share in the revenues of its members and there is no pooling of profits at the Association level.
The above characteristics allow for an Association to be the face of a decentralized project without being dragged into each of the jurisdictions its members may be found to operate in.
This can be useful for marketing and community relationship purposes, but also helps the member DAOs overcome three major painpoints:
As things stand, DAOs can’t get fiat banking however their Association could provide banking and payment services to its DAO Members. Banks will open an account for an Association on the basis of who its Directors are, but without the requirements to KYC each of its members, the same way your sports club has banking relationships without asking you as member to pass DD with its bank. The same analysis applies to accounts with centralized exchanges which are denied to DAOs as result of their lack of legal persona.
Associations have separate legal persona hence they can enter and sign contracts in their name. This could include arrangements with e.g. innovative employment platforms such as remote.com that would allow its member DAOs to indirectly employ contributors under a traditional employment contract, removing another key obstacle for DAOs to operate in the “real world”.
In tradfin, Assocations have become a preferred vehicle for mergers, primarily because many issues that plague corporate mergers, such as due diligence issues, differences in profitability and compensation schemes etc are not present in a Swiss Verein.
It is difficult to imagine how two blockchains or decentralized projects, from the way they are currently governed, could be merged. However, given the myriad of projects, mergers at some point are probably inevitable. An Association structure should help such fusion between two communities and cultures whilst maintaining a decentralized governance structure.
Limitations of the Swiss Association
No profit distribution
What an Association can’t do is distribute income to its members, which sets it apart from a Partnership or a company paying dividends.
However for our “docking station” use case, there is no need to distribute income at the Association level, and Associations can still make grants to Members (or anybody else who helps further its objective) out of its own resources.
The latter could provide a mechanism for DAOs to pledge some of their respective treasury to the Association and together vote on grants for initiatives that further the ecosystem as a whole, including grants that can be converted into fiat at the Association level to pay for more traditional efforts e.g lobbying campaigns.1
Associations can be for profit however such associations need to register with the commercial registry in Switzerland.
There is ample caselaw delineating not-for-profit and for-profit activities however it is unclear how this would be applied to the Treasury activities of an Association with DAO Members. For instance, could a significant windfall from the appreciation in price of a project’s token be seen as a for-profit activity? Most likely not, since Associations are allowed to make money, but not as their purpose. But how about yield farming with its Treasury? Only time will tell.
Finally, Swiss law is heavily statute-driven and is seen by many common law practitioners as overly prescriptive and rigid. Language too may be an obstacle though an Association’s statutes can allow for English to the exclusion of any official Swiss language.
All in all, we do not see the above limitations standing in the way of Swiss Associations being repurposed to bind together independent development DAOs who work towards a common goal, such as the maintenance and growth of a decentralized protocol.
A U.S. sibling: The Unincorporated Nonprofit Association (UNA)
Further research into a possible legal framework for DAOs recently came out of Andreessen Horowitz by its General Counsel Miles Jennings who in October co-authored a proposed Legal Framework for Decentralized Autonomous Organizations together with David Kerr, Principal at legal services firm Cowrie LLC, with the help of i.a. Aaron Wright of Cardozo Law and TheLAO.
The proposal analyzes in detail the taxation, entity formation and operational issues related to DAOs from a U.S. perspective and proposes the use of an Unincorporated Nonprofit Association as a legal wrapper around DAOs so they can file and pay U.S. taxes, open a bank account, sign legal agreements and limit the liability for DAO members.
As expected, the analysis is rigorous and the proposed solution could work both on an individual DAO level as well as a collective of DAOs that need the type of “docking station” described above.
In many ways, the UNA is the U.S. sibling of the Swiss Association which - as siblings go - very much resembles it but is also different in some key ways:
As with the Swiss Association, the UNA meets the requirements of a not-for-profit entity for state law purposes.
Note that not-for-profit would not imply that a UNA is tax-exempt (see below). At the same time, there is a lot that a non-profit can do to before it would be seen as for-profit (also further below).
Tax is the big elephant in the room DAOs often prefer not to talk about. As we have seen, the Swiss Association does not have to deal with tax at the member DAO level, so individual member DAOs that have a nexus with the U.S. may still consider wrapping themselves in a UNA to deal with their individual tax responsibilities.
In grossly simplified terms, DAOs that hold crypto token are deemed to hold taxable “virtual currency” as defined by the IRS. Selling or exchanging crypto as a capital asset results in a capital gain or loss, and receiving crypto as payment for goods or services classifies as income.
What this means is that the DAO’s governance tokens retained in its Treasury and its Treasury activities generally are taxable if they have been generated by a U.S.-based development studio2.
As a taxable entity, The UNA would then be capable of filing and paying taxes, which would remediate the DAOs inability to pay taxes.
UNAs break free from some of the restrictions of some more common U.S. entity structures such as the C-Corp or the LLC, which are designed for centralized management.
The general legal consensus is that not wrapping a DAO in limited liability is just dumb: DAOs would likely be seen as general partnerships with unlimited liability for its partners.
Practically however, smart contracts pre-empt a lot of the litigiousness that results from sloppy agreement execution in a centralized setup. As a consequence of how traditional companies (or “tradcos”) are managed and the endemic agency problems resulting from relying on humans, limited liability is much higher on the desirability list for owners and managers of tradcos compared to DAOs.
A DAOs potential liability could be further reduced by somehow binding its Treasury to use DAO assets to satisfy any judgments that may be entered against it, the same way tradcos retain a percentage of their earnings towards a litigation fund.
However, in the absence of such automatic arrangement, or in the case the community of token holders is unwilling to commit DAO Treasury assets to satisfy a judgment, there are real risks that liability may fall on individual DAO members. Such risks are particularly acute in tax matters. As result, an UNA that just pays what is due may be preferable over assertive tax structuring which could potentially leave U.S.-based individual contributors to a DAO exposed.
An “unincorporated” entity
In the U.S., “unincorporated” refers to how entities are created:
incorporated entities create a separate legal entity to pursue a business objective. They are formed by filing for incorporation with a State Registry (or in the case of Series LLCs such as OtoCo’s onchain LLCs, derive their incorporated status from an agreement with a Master entity that in turn is registered).
Unincorporated structures are created by contract and controlled by State law in the pursuit of a shared objective. Similar to the Swiss Association, this does not void the unincorporated entity from limited liability.
Most DAOs do not have a shared business or for-profit purpose: they are smart contracts that allow governance token holders to table and vote on proposals that control the underlying protocol or decentralized application and that direct the DAO treasury to foster the growth of the project.
In this setup, the appreciation of the value of the governance tokens DAOs hold is incidental and may even be uncorrelated to their efforts. The existence of taxable revenue or member profit does not automatically indicate a for-profit intent, however particular care should be exercised to safeguard the UNA’s not-for-profit status at all costs.
The biggest risk from using the UNA setup is that, as nonprofit entities, they are organized under state law, with each state defining nonprofit differently.
As a result, legal privileges and liability protections vary widely between jurisdictions.
However, in the absence of regulatory clarification on many aspects of DAOs, the UNA entity structure presents itself as a much needed limited liability wrapper around DAOs.
Locating potential liabilities in DAOs is delicate and untested.
As a result, perhaps too many in the decentralized community play Catch Me If You Can, assuming that because nobody is responsible, nobody can be made responsible.
However, legal liability is like energy: the overall amount remains the same, it just moves around.
It is unimaginable that if DAOs one day become the dominant coordination mechanism for human activity (they will), they will be allowed to operate with complete impunity (they won’t).
If we want to preserve DAOs as radical agents, they’ll occasionally need to develop weak bounds.
Our proposal is to pair them with existing, recognized organizations such as the Swiss or U.S. non-profit Association each time DAOs need to borrow limited liability to share services or discharge duties.
DISCLAIMER: This contribution should not be seen as legal or tax advice and may not reflect all current updates to applicable laws or interpretive guidance.
Note that a Swiss Association will be subject to an audit if two of the following figures are exceeded in two successive business years:
total assets of CHF 10 million;
turnover of CHF 20 million;
average annual total of 50 full-time staff.
There is a lot more nuance to this analysis however this post is not the place to examine the detailed tax position but rather takes taxes as a given and looks at ways for a DAO to pay them.