Published: 23:42, May 27, 2024 | Updated: 10:00, May 28, 2024
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Law reform needed to boost the development of DAOs
By Johnny Ng Kit-chong

Imagine a business where everyone has a say — no CEO dictating from the ivory tower, but a community of stakeholders jointly steering the ship. This is the promise of decentralized autonomous organizations (DAOs) — blockchain-powered entities that are revolutionizing business governance.

At the foundation of DAOs lie two revolutionary technologies: blockchain and smart contracts. Blockchain is a decentralized digital ledger, recording transactions across a network of computers. It is the backbone enabling cryptocurrencies and other distributed applications. Smart contracts, on the other hand, are self-executing digital agreements, in which the terms are directly coded into the software.

Collaboratively governed and code-driven, DAOs leverage blockchain technology to create a democratic, transparent and self-executing business model. Compared to the top-down hierarchies of traditional corporate structures, DAOs empower their stakeholders to collectively steer the organization’s direction, allocate resources, and oversee its activities. Voting rights are typically tied to ownership of the DAO’s native cryptocurrency or tokens, granting the community a direct say in the decision-making process and fostering a more collaborative approach to business management.

DAOs also promote accountability, as all transactions and decisions are transparently recorded on the blockchain, allowing the stakeholder community to verify and validate the organization’s operations. As this innovative technology continues to evolve, DAOs may offer businesses new pathways to manage their affairs and engage with their stakeholders in a more collaborative and transparent manner.

DAOs as catalysts for Web3 innovation in HK

As the internet has evolved from the static “read-only” experience of Web 1.0 to the “read-write” capabilities of Web 2.0, the advent of Web3 promises to profoundly reimagine the digital landscape. Unlike the current centralized model, Web3 envisions a future in which ownership and control are returned to the users.

DAOs can play a significant role in driving technological advancements in the Web3 ecosystem. They offer a range of opportunities, from funding and investment to research and development support, as well as incubation and acceleration programs.

For example, the Ethereum Foundation operates as a DAO and plays a significant part in funding research and development efforts within the ethereum ecosystem. The foundation supports academic institutions, collaborates with technical experts, and allocates resources to advance the state of the art in critical areas like scalability, privacy and security.

Similarly, ConsenSys Mesh, a profit-based DAO, runs multiple incubation and acceleration programs for Web3 projects. They provide mentorship, resources and networking opportunities to early-stage startups and developers, fostering an environment conducive to innovation and technological development. These initiatives demonstrate the diverse ways in which DAOs are empowering the Web3 ecosystem.

Indeed, the Hong Kong Special Administrative Region government has recognized the transformative potential of these emerging technologies. Financial Secretary Paul Chan Mo-po recently delivered encouraging remarks about Web3 at the Digital Entertainment Leadership Forum 2023, speaking of the revolutionary power of Web3 to inspire new business and digital models.

Given these promising developments, it is now time for Hong Kong to tend to this burgeoning ecosystem, embracing the opportunities presented by DAOs and positioning itself as a hub of Web3 advancement. Just as nearby regions such as Singapore have leveraged the opportunities provided by Web3, so too must Hong Kong remain attuned to the latest developments, nurturing the technological seeds that will shape the digital tomorrow.

Legal characterization of a DAO in HK

The current legal landscape in Hong Kong presents a veritable labyrinth of challenges for these blockchain-based collectives. The options before them are akin to a choose-your-own-adventure tale — from the uncharted territory of unincorporated associations and general partnerships, to the more familiar paths of proprietary limited companies and companies limited by guarantee.

Yet, each route is fraught with its own obstacles. For DAOs categorized as general partnerships or unincorporated associations, the challenge is that the DAO will not be treated as a separate legal entity. Consequently, the DAO cannot hold assets or contract with third parties in its own name. Their members also face the perilous prospect of unlimited liability, a sword of Damocles hanging over the entire collective.

While the task of crafting a comprehensive regulatory regime for DAOs may seem daunting, the potential rewards of forging a path toward their emancipation are immense. By tailoring the law to the unique needs and principles of these decentralized entities, we can unleash their transformative potential, allowing them to flourish as engines of financial empowerment, community-driven governance, and technological progress

Registering as a proprietary limited company does grant the DAO a separate legal personality and the shield of limited liability. However, this risks compromising the very essence of decentralization that defines these blockchain-based organizations. Their governance decisions would be shackled to the traditional corporate procedures, a fate akin to a caged bird yearning for the boundless sky.

Registering a DAO as a company limited by guarantee may be a more idealistic approach. This structure establishes the DAO as a separate legal entity responsible for its own debts, while not having share capital. However, the model may be more suited for charitable or nonprofit purposes. It may limit the DAO’s ability to differentiate members’ rights based on shareholding, which is a common feature of many blockchain-based DAOs.

Moreover, the classification of tokens as securities is a significant risk for DAOs. If a token is deemed a security, the DAO responsible for its issuance may be held accountable for any noncompliance with securities laws and regulations. The decentralized and pseudonymous nature of DAOs can make it challenging to determine legal responsibility, and regulatory bodies may attempt to hold the DAO itself or its core contributors liable for any infractions.

A clarion call for legal reform

It is clear that Hong Kong’s current legal framework is not yet fully woven to accommodate the unique attributes of DAOs. If the city aspires to be a beacon for blockchain business, it must embark on a transformative journey, rewriting the legal narrative to create a hospitable environment for these decentralized entities to flourish.

To navigate this uncharted territory, Hong Kong would do well to gaze across the seas, drawing inspiration from other jurisdictions that have embarked on a transformative odyssey.

For example, Hong Kong could look to the Cayman Islands, a fellow common law jurisdiction, for inspiration. The Cayman Islands has enacted the Foundation Companies Act of 2017, which allows for the establishment of “ownerless” foundations. A Cayman Foundation is defined as a legal person, without any shareholders. Instead, the requirement is to be overseen by a supervisor or supervisory authority with no ownership or economic entitlement in the foundation itself. Also, since the Cayman Foundation is still a company, it has liability protection — for example, for the developers of a DAO from any personal liability — since the directors manage the objectives and business of the DAO for the Cayman Foundation, which is acting as the DAO’s legal wrapper.

This model aligns well with the decentralized and collective governance principles that are central to the DAO model. Rather than being beholden to traditional corporate shareholders, these ownerless foundations can be managed in a way that empowers the broader DAO community to make decisions democratically.

If Hong Kong wants to become a hub for DAOs, it could also look at what Abu Dhabi has done. In 2023, Abu Dhabi, the capital of the United Arab Emirates, released the Distributed Ledger Technology (DLT) Foundations Regulations — the world’s first legal framework designed specifically for blockchain foundations and DAOs.

This new legislation in Abu Dhabi addresses some of the key challenges that DAOs face. For example, it helps clarify the legal status of DAO tokens, ensuring they do not get classified as securities. It also provides a way for DAOs to have legal personhood, without requiring a high amount of initial capital (just $25,000).

Importantly, the Abu Dhabi regulations expressly allow for decentralized governance models in these DLT Foundations. This means DAOs can have their decision-making processes structured around token-holder voting, rather than being beholden to traditional corporate shareholders.

Additionally, the regulations do not prohibit these DLT Foundations from providing financial services, as long as they obtain the proper authorization from Abu Dhabi’s financial regulator. This could be very useful for DAOs that want to offer financial products or services as part of their operations.

The legal considerations for DAOs extend far beyond the confines of corporate law, encompassing complex domains such as securities regulations, taxation and anti-money-laundering constraints. To truly emancipate these digital collectives, a comprehensive and thoughtful legal approach is undoubtedly needed — one that requires us to venture beyond our well-trodden legal comfort zones and embrace the bold new horizons that this era of innovation offers.

While the task of crafting a comprehensive regulatory regime for DAOs may seem daunting, the potential rewards of forging a path toward their emancipation are immense. By tailoring the law to the unique needs and principles of these decentralized entities, we can unleash their transformative potential, allowing them to flourish as engines of financial empowerment, community-driven governance, and technological progress.

The author is a member of the Legislative Council.

The views do not necessarily reflect those of China Daily.