Authors
The ADGM recently released the proposal for a legislative framework for distributed ledger technology foundations (Consultation Paper), which considers distributed ledger technology (DLT) projects that look to use DLT for the issuance and trading of tokens using a variety of different structures such as unincorporated decentralized autonomous organizations (DAOs), foundations and companies limited by guarantee.
The aim of the paper is to prepare a new regime that caters to the specific needs and features of foundations that would be attractive to DLT projects and developers, with the intention of issuing the Distributed Ledger Technology Foundations Regulations 2023 (Proposed Regulations).
What are DLTs and DAOs
DLTs are platforms that use ledgers stored on separate but connected devices in a network format. Examples of DLT include Bitcoin, Ethereum, Polygon, etc.
DAOs are decentralized autonomous organizations, a type of governance structure built using blockchain technologies using a combination of voting and staking methodologies to allow a community of persons to make collective decisions in relation to a predetermined activity.
Different kinds of DAOs:
Common kinds of DAOs include the following:
- Basic DAO. Basic DAOs are the simplest. They are essentially a group of individuals who pool their resources and make decisions together. These decisions are made using a consensus mechanism, where members vote on proposals. Basic DAOs can be used for a variety of purposes, including investment funds, social clubs, and charity organizations. Examples of Basic DAOs would be DASH, Augur and MakerDAO.
- Investor DAOs. Investor DAOs are focused on investing in various assets, such as cryptocurrencies, stocks, or real estate. These DAOs are managed by a group of investors who pool their funds together to invest in various assets. The decision-making process is typically based on a voting system, where each member has an equal say. Examples of Investment DAOs would be BitDAO and DAOVerse.
- Service DAOs. Service DAOs provide a particular service or product. For example, for a software product. These DAOs typically generate revenue from the services provided, and the decision-making process is typically based on members' expertise. Examples of Service DAOs would be MetaFactory, Aladdin DAO and Yam DAO.
- Reputation DAOs. Reputation DAOs are based on a reputation system, where members earn points for contributions. These points are used to determine voting power. For example, a developer DAO could give more voting power to members who have contributed more code.
- Hybrid DAOs. Hybrid DAOs combine different types of DAOs. For example, a DAO could be both an investor and service DAO. These DAOs are becoming more common these days.
- Platform DAOs. Platform DAOs build a platform used by other DAOs. For example, developers could create a DAO to build a decentralised exchange (DEX) platform that other DAOs can use to trade crypto. The decision-making process is typically based on members' expertise and the needs of the DAO on the platform.
- Meta DAOs. Meta DAOs govern other DAOs - they are a DAO of DAOs. They typically have a smaller number of members, but a high level of expertise in governance.
Understandably, given the vast array of services and functions fulfilled by different kinds of DAOs, it has been challenging to find a singular structure that can work for all of them. This hasn’t stopped creative solutions using unincorporated DAO structures becoming more and more common, despite the numerous legal and litigation risks they pose.
As such, the ADGM’s proposal is not only revolutionary, but also necessary as DAOs grow increasingly more common.
Differences between traditional foundations and DLT Foundations
A traditional ADGM foundation is a legal entity with its own legal personality. A traditional foundation can hold assets in its own name on behalf of beneficiaries, and allows the founder to have more control over the foundation.
The Consultation Paper proposes a new legal form that can be used for DAOs, which is similar to a traditional ADGM foundation, but adapted to suit the governance and operational requirements of DAOs. The ADGM has taken these key features of a traditional foundation along with attractive features of a DAO (in terms of what the DAO seeks to achieve) to create the DLT Foundation. In essence, the DLT Foundation is an orphan entity, similar to a traditional foundation.
Traditional ADGM foundations tend to be opaque and private, offering great levels of confidentiality while still adhering to ADGM transparency requirements. Contrastingly, the DLT Foundation would allow greater flexibility to put in place transparent governance structures which are preferred by DAOs. In other words, it takes inspiration from DAOs, in which all tokenholders are entitled to vote and participate in the governance of the organizations. This differs to normal company structures, where it is often the board of directors and ultimately the shareholders who tend to make decisions relating to company governance.
While a typical foundation structure tends to be formed for specific activities, as is the convention in the UAE in which businesses are granted licences that allow them to carry out specific business activities, the DLT Foundations depart from this ideology. Instead, DLT Foundations are afforded more freedom in terms of their activity unless the founders decide to restrict such activities.
Main proposals in the ADGM Consultation for DAOs
Legal Personality
While DAO’s generally do not have a legal personality and are unincorporated, the Consultation Paper proposes giving DAOs legal personality (‘DLT Foundations’) to ensure legal, regulatory and operational security. The Consultation Paper also would apply to all tokens and would allow such ‘DLT Foundations’ to operate any activity provided it is not unlawful or contrary to public policy.
The provision of a legal personality (or a ‘legal wrapper’) is the primary reason why the ADGM’s proposal is timely. It is becoming an increasingly common concern for DAO members to be held collectively and individually liable on behalf of a DAO, whether as partners in a partnership or as an unincorporated association of sorts. It is no secret that courts globally have been struggling to find a proper way to define or outline what a DAO actually is.
Affording legal personality to the DAO gives its members a much-needed layer of protection from unchecked liability.
Capital Requirements
DLT Foundations will be obligated to meet a minimum capital requirement of USD 25,000, similarly to ADGM Foundations and other regulated entities. This introduction of a capital requirement is to demonstrate a commitment to the project. This is also, presumably, to ward away less serious or smaller DAOs that do not have the liquidity or consensus among its members to go through with a formal setup.
Governance and control
Typically in a foundations structure, beneficiaries do not have any governance or ownership rights. However, in a DLT Foundation, the concept of a beneficiary is more flexible, allowing distribution of assets to certain persons even where tokens are not issued or distributed.
Through the use of a charter to be created by the DLT Foundation, there is flexibility offered to the founders of the DLT Foundation to define and determine how income and assets are distributed. The charter would be considered a constitutional document for the DLT Foundation, akin to a company’s articles of association. It further demonstrates the flexibility afforded to DLT Foundations in operating their business. The founders of the DLT Foundations, through the charter, would be able to set out governance mechanisms for the structure at their discretion rather than complying with usual strict governance regimes.
The Consultation Paper also reimagines the definition of ‘control’ in respect of founders, tokenholders and beneficial owners with a view of being in line with current beneficial ownership and control requirements such as the disclosure of persons of significant control (those holding more than 25% of voting rights).
The ADGM also details its proposals for governance and control of DLT Foundations, including the introduction of a Foundation Council to govern the protocol, consisting of founders and tokenholders. Building on the concept of tokenholder voting, the ADGM sets out a detailed regime that clarifies tokenholders’ legal status, powers and protections to ensure more transparency within the governance of the DLT Foundations.
Due to ongoing demands of transparency, particularly in the Web3 sector, the Consultation Paper provides that the charter along with the DLT Foundation’s annual accounts and information on the founders, council members and guardian (if applicable) are published. This is further to additional disclosure requirements relating to tokenomics, smart contracts, security audits and whether the DLT Foundation will be singlechain or multichain.
Conclusion
The Consultation Paper and Proposed Regulations illustrate the innovative and sustainable approach taken by the ADGM in respect of encouraging and facilitating crypto transactions. It seems to strike a balance between maintaining the fundamental concepts of DAOs to attract DLT developers and projects whilst providing a more transparent framework that can be regulated. Moreover, the Consultation Paper and Proposed Regulations provide greater flexibility to DLT Foundations, ranging from governance mechanisms to activities it carries out, seemingly to attract more DLT projects and developers. Based on the above, the Proposed Regulations appear to be attractive for most DAOs by complementing the fundamental features of DAOs with more secure legal concepts. The ADGM and UAE continue to be at the forefront of advancements in the crypto space and it will be interesting to see how these Proposed Regulations will operate in practice.
Client Alert 2023-094