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Legally Recognized DAOs Protect DeFi Communities by Holding Leaders Accountable

Legal incorporation may represent the best path forward for many decentralized organizations, in terms of limiting personal liability and protecting users.

Written by

Mark Lurie

Published on

March 30, 2022

It’s easy to pay lip service to decentralization and community building, but when the going gets good — when there are billions of dollars at stake — some people tend to get greedy. This trend is embodied in the high-profile imposition of Wonderland, in which multiple crypto founders ignored the wishes of their community and made unilateral decisions that ultimately destabilized and damaged their projects. Sadly, blockchain technology has not yet evolved to the point where all decentralized autonomous organization (DAO) decisions can be put to a public vote or constrained by other smart contract checks and balances, which represent the dream of complete on-chain governance. 

But there is another way. Specifically, a DAO legal entity: incorporation with bylaws that can accommodate flexible forms of governance and obligate leaders to follow the rules as written. Eyes tend to glaze over the second they see the words “legal incorporation”, yet this yawn-inducing bureaucratic process may be the answer to much of what ails decentralized finance (DeFi) today. Shipyard recently incorporated AdmiralDAO to help reduce its founders’ personal liability, and to ensure that the core contributors have a legal obligation to abide by the community’s collective decisions. The latter is key to giving Shipyard’s community a voice and preventing leadership crises, such as the slow-motion train wreck involving SushiSwap and Wonderland.

Sushi & Wonderland’s Leadership Crisis

In August 2020, the anonymous person(s) ChefNomi launched a decentralized exchange (DEX) called SushiSwap and encouraged the creation of a “community-built open-source ecosystem” which quickly attracted hundreds of millions in user funds. Weeks later, Nomi abruptly left with $13 million in community funds as Sushi’s price cratered. Eventually he returned the funds under community pressure and effectively ceded leadership to Sushi’s lead developer, 0xMaki. 

By its one-year anniversary, Sushi had seemingly righted the ship, with $3 billion in liquidity and a 15-fold price jump in nine months. In September 2021, 0xMaki resigned from his leadership post and transitioned to an advisory role. “Sushi is failing,” a former contributor tweeted in November, in a post that exposed five core Sushi devs who were bypassing the community and making all of Sushi’s key decisions. “Hope bad actors can be called out and removed.” Two weeks later, CTO Joseph DeLong also resigned, describing Sushi as “imperiled within and without” and in need of “radical structural transformation”. 

Sushi’s community rallied together and came up with several proposals in an attempt to address what it viewed as the core problem — the handful of leaders who seemed more focused on self-enrichment rather than steering Sushi towards true decentralization. But in January the remaining core team, backed by major Sushi token holder Arca Capital, chose to bypass the community and hand the reins to Daniele Sestagalli, the head of the DeFi collective Frog Nation, which oversees Wonderland and several other DeFi protocols. 

“Frog Nation is here to clean up and bring efficiency back into Sushi,” Sestagalli said in a blog post. But days later the world learned that the anon Sestagalli had hired as Wonderland’s CFO was a convicted felon. This felon had left the now-defunct crypto exchange QuadrigaCX under mysterious circumstances and changed his name multiple times after being convicted of identity theft and credit card fraud.

The CFO consequently resigned and Sestagalli pulled out of SushiSwap, vowing to run Wonderland himself. But the damage had been done. In just a few months, SushiSwap went from being one of DeFi’s hottest platforms to a cautionary tale, fighting for survival. This incident underscores the tightrope DAOs must constantly walk. If control over a DAO’s multisig is limited to a small cabal of decision makers without genuine accountability to the community, mismanagement is a very real possibility. And as long as DeFi founders are not legally obligated to act on behalf of their community and take real steps towards decentralization, leadership crises like Sushi’s will continue to occur in one form or another. 

If Sushi’s DAO was legally incorporated, the organization’s transfer of power would have been conducted in a more above-board manner in accordance with its community’s wishes — or not at all. Of course, once a DAO has been incorporated leaders’ obligations won’t be enforced ex ante, or in advance. But they can be enforced ex post, or after the fact, by litigation. The idea is that the threat of significant legal punishment will pressure leaders to stick to community decisions. While there are plenty of dysfunctional companies, in general legally mandated corporate governance has enabled traditional companies to run effectively for generations, and DeFi communities can likewise benefit through their own form of legal incorporation.

Practical Solutions to Legal Incorporation

Some aspects of DAOs map neatly to existing corporate forms, such as accounting and taxes. But incorporating a DAO is less straightforward than it might seem, mostly due to administrative hurdles. For instance, most jurisdictions require bylaws to be filed with the government in a particular format, but code isn’t written on paper and blockchain code is often unalterable. Also, many legal entities are required to track their membership using a ledger of names, while DAOs typically track membership using tokens. In other words, the existing laws that define legal entities were not designed to account for blockchain’s unique features. As a result, incorporating a DAO is like fitting a round peg in a square hole. 

Fortunately, progressive-minded jurisdictions are already racing to become leaders in the DAO entity market. Some of these places, such as Wyoming, the Cayman Islands, Panama, and Switzerland, have decades of experience catering to specific corporate entities like hedge funds, biotech and insurance companies. These jurisdictions' current laws can be adapted to the needs of DAOs, but they are not perfect solutions and need a revamp. 

That’s why Shipyard incorporated its DAO in the Republic of the Marshall Islands (RMI), a sovereign state with a fast-moving, adaptable legislative process and special status as a Freely Associated State of the US. The country recently passed an amendment to their Nonprofit Statute that enables DAOs to incorporate as nonprofit LLCs with bylaws and membership that can be recorded on the blockchain. 

Legal incorporation in the RMI may well represent the best path forward for many decentralized organizations, given the country’s DAO-specific bylaws and benefits over other crypto-friendly jurisdictions. In order to service blockchain-based projects across the world that wish to be legally recognized on the global stage, Shipyard partnered with RMI’s local government to create MIDAO, a non-profit founded to simplify the incorporation process for DAOs in the RMI while ensuring full compliance. If DAOs are really meant to be handed over to the community, they should consider making a legal commitment via incorporation — at least until they can implement effective on-chain voting. 

Written by

Mark Lurie

Published on

March 30, 2022

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