DAO Structuring and Legal Wrappers: Lessons from Arbitrum and Hector DAO, and 8 Essential Recommendations on DAO Structuring

In this article, we will discuss the cases of Hector (HEC) DAO and Arbitrum (ARB) DAO as two recent examples illustrating the complexities of DAO structuring and issues that the DAOs and their communities may encounter. By studying these examples, we can glean valuable insights and lessons on DAO legal structuring.

This material was prepared in collaboration with DAObox, our affiliate project providing infrastructure solutions for DAOs and Web3 communities and specialising in DAO structuring.

As Decentralized Autonomous Organizations (DAOs) continue to gain traction in the digital world, it has become increasingly clear that the choice of a legal structure is vital to their long-term success. More and more DAOs are looking toward legal structuring, whether due to legal and regulatory reasons, or because they need a corporate structure to use in their operations.

A poorly chosen or implemented legal structure can lead to a range of issues, from power imbalances to conflicts of interest, all of which can have far-reaching implications for the overall sustainability of the DAO. In essence, the legal structure can determine the efficiency of a DAO’s decision-making processes, its ability to meet the needs of its members, and its capability to resolve internal disputes effectively.

In this article, we will discuss the cases of Hector (HEC) DAO and Arbitrum (ARB) DAO as two recent examples illustrating the complexities of DAO structuring and issues that the DAOs and their communities may encounter. By studying these examples, we can glean valuable insights and lessons on DAO legal structuring.

Arbitrum DAO: Unraveling the Layers

The Arbitrum DAO case provides an interesting perspective on the structuring of a very large and diversified decentralized organization. This is also an excellent case demonstrating how a sufficiently decentralized DAO can reject structuring and treasury management proposals made by the core team standing behind the protocol, forcing them to change the approach and amend the proposal. But now not about it.

Eventually, the Arbitrum DAO decided to establish a Cayman Islands ownerless foundation that was meant to be controlled by and subordinate to the Arbitrum DAO. A self-owned foundation is a type of entity that has no owners or shareholders, and is established for the fulfillment of a specific purpose, for example, to facilitate the development of a blockchain protocol.

Issues Discovered

While a Cayman Islands foundation can be a favorable option for a DAO legal wrapper, the specific procedures and controls outlined in the foundation of the new Arbitrum DAO structure raise concerns, and our review of the Arbitrum Foundation’s constituent documents revealed several significant issues.

Inadequate Subordination. One of the main issues discovered was inadequate subordination — the directors and supervisors of the foundation could be appointed and removed without the consent of the DAO. This may undermine the principles of DAO supremacy and decentralization, leaving the foundation’s managers operating outside the purview of DAO oversight and accountability.

This lack of control over the managers of the foundation raises critical concerns regarding the potential abuse of power and the subsequent usurpation of control over the legal entity and its assets. Suggested governance mechanics allowed directors to replace supervisors (who are meant to oversee the board, creating a ‘directors > supervisor’ situation) and change the board composition at their discretion, even if it contradicts the DAO’s intentions.

The primary risk associated with this lack of subordination is the vulnerability of the DAO and its members. When a DAO has limited influence over the appointment and removal of directors, it creates an environment where the managers of the foundation can potentially act in their own self-interest, disregarding the DAO’s objectives and preferences. This situation leaves the DAO and its members exposed to potential misuse of funds, unauthorized decision-making, and a lack of accountability.

Lack of DAO Recognition. Another major issue was the lack of direct recognition of DAO resolutions by the foundation which restricts the authority of the DAO and hinders its ability to exercise control over its own foundation’s decision-making processes, goals, and assignments.

The absence of direct recognition means that the foundation is not obligated to follow the resolutions adopted by the DAO or seek its consent for significant decisions and transactions, allowing the management to essentially ignore the DAO. The inability of the DAO to guide and steer the foundation’s long-term and short-term goals diminishes the decentralized nature of the DAO and may lead to misalignment between the DAO’s vision and the actions of the foundation, potentially resulting in governance issues and a deviation from the DAO’s intended objectives.

Absence of Reserved Authority. The foundation’s constitution lacked a defined list of “reserved matters” necessitating prior approval from the DAO, such as the disposal of critical assets or intellectual property, substantial transactions, dissolution of the entity, related-party transactions, loans, and more.

Moreover, no stipulation has been made to subject the foundation’s special resolutions (pertaining to material issues) to the DAO’s approval. These provisions ought to be instituted to ensure that directors refrain from initiating significant transactions or activities affecting the foundation and DAO without seeking prior consultation and approval from the DAO.

Absence of Defensive Strategies. The proposed structure of the Arbitrum Foundation did not establish the mechanisms through which the DAO could shield itself from potential mismanagement or actions that run counter to the DAO’s best interests.

For instance, in scenarios where the directors undertake actions contrary to the DAO’s vision and objectives, the DAO would likely lack an established set of protective measures or contingency plans to assert its interests effectively.

Shortcomings in Corporate Procedures. Broadly speaking, the governance procedures outlined in the constitution appeared insufficiently tailored to the distinctive ‘DAO-foundation’ context. They barely addressed the intricate dynamics and unique interactions between the DAO and the foundation.

Solutions Offered

Shortly before the anticipated vote for the formation of the Arbitrum Foundation, we stumbled upon the aforementioned issues and decided to address them in a post on the Arbitrum forum here. DAObox has further suggested paths forward and how to deal with these issues in the most efficient manner. Sadly, our suggestions didn’t receive the attention or response we had hoped for.

Consequently, the structure of the Arbitrum Foundation ultimately chosen and employed by the Arbitrum DAO contains the unresolved issues we highlighted.

Hector DAO: A Closer Look

Similarly to the Arbitrum DAO, the Hector DAO was presented with a structuring proposal that recommended the adoption of a Cayman Islands foundation as its legal wrapper.

Interestingly, when we dug deeper into the proposed governance structure of the Hector Foundation, we uncovered something quite intriguing: it turned out that the issues we identified in the governance of the Arbitrum Foundation were also present in the proposed structure for the Hector Foundation.

It’s remarkable how similar these issues are between the two cases which highlight the common challenges that DAOs face when it comes to establishing solid legal structures.

Issued Discovered

Centralization of Power. Mirroring the situation in the Arbitrum Foundation case, the primary concern in this instance is the excessive centralization of power. Almost all authority could be concentrated in the hands of a closely connected group. As discussed previously, this approach contradicts the principle of decentralization that underpins DAOs and may pose substantial risks for the DAO itself.

Limited DAO Control. In the proposed structure, the foundation wasn’t essentially under the authority of the DAO. The legal wrapper did not recognize the DAO resolutions and the managers were not adequately answerable to the organization. This situation suggests that the DAO may struggle to effectively shape key decisions and actions of the legal entity, or even influence the management of the foundation in their decisions.

Shareholder Appointment Rights. Our review revealed that the constitution permits the appointment of shareholders, or owners, within the foundation. This provision implies that the directors could, at their discretion, confer ownership of the foundation onto a particular person. In such a case, the appointed party would gain complete control over the foundation and its affairs. Without the necessary checks and balances discussed earlier, such a pivotal decision could be made even without requiring DAO approval.

Lack of Defined Reserved Authority. The constitution proposed for the Hector Foundation also fell short in defining a list of “reserved matters” and significant resolutions requiring the DAO’s prior approval. This oversight provides directors with essentially unfettered authority concerning substantial matters and the disposition of the foundation’s property.

Additional Concerns. Echoing the issues found in the Arbitrum case, the suggested structure of the Hector Foundation failed to set up protective mechanisms that the DAO could activate should directors or supervisors act against the DAO’s interests or breach the foundation’s constitution. The governance procedures did not adequately address the relationship between the Hector DAO and the prospective foundation.

Solutions Offered

DAObox promptly conveyed its findings to the project team via their Discord channel, ahead of a scheduled community call intended to delve into the structuring issues of Hector DAO. One of the project’s founders responded later that our suggestions would be discussed further with their legal advisors.

8 Essential DAO Structuring Recommendations

Given the potential pitfalls discussed in this article, it is crucial for DAOs to build a robust and transparent legal structure. It might be contended that the lapses and blunders outlined in this article were enacted purposefully. For instance, the founders and core team members of a project might aim to retain unequivocal control over the legal structure, intending to sidestep potential mistakes that the DAO might make.

However, such an approach starkly undermines the tenets of decentralization. It inherently implies the consolidation of control within the foundation by a select coterie of “insiders.” And, importantly, achieving this level of influence and oversight doesn’t necessitate such tactics, for example, by following these eight essential recommendations:

Clear Purpose and Objectives. Clearly define the purpose, goals, and objectives of the anticipated legal structure. This will guide the decision-making process and help align the community and legal wrapper management around a common vision.

Prioritize DAO Control. DAO control over the legal wrapper should be at the core of the structure. At the very least, add language to the constitution that gives the DAO the authority and requires the foundation to recognize and follow the DAO resolutions.

Balance of Power. Avoid centralizing too much power in the hands of a few individuals or a single group. A DAO’s unique value proposition lies in its decentralized nature. This decentralization should be reflected in its governance structure, with fair representation and a balanced distribution of decision-making authority.

Checks and Balances. Institute checks and balances, such as approval requirements for significant decisions and actions. This can prevent the misuse of power and ensure decisions are made in the best interests of the DAO. For example, define the list of “restricted matters” and material resolutions that require a DAO approval, including appointment and removal of directors and supervisors, disposition of material property and IP, issuing loans, acting as guarantor, and so forth. Directors, on the other hand, should be in a position to refuse a DAO resolution in certain circumstances, for example, if, upon the reasonable determination of the wrapper’s legal counsel, such resolution violates the law or applicable regulations.

Protective Mechanisms. Develop mechanisms through which the DAO can protect itself from potential mismanagement or actions that are contrary to its best interests. This could include dispute resolution processes and protocols for emergency decision-making, including the appointment of DAO representatives.

Foster Transparency. Foster transparency in the DAO’s operations. This could involve open bookkeeping, publishing meeting minutes, regular reporting to DAO, and making proposals and voting processes accessible to all members.

Work on the Definitions. Although this was not discussed above, you need to avoid making mistakes in your definitions. Work carefully on the major definitions, such as the “DAO”, the “token”, “DAO resolution”, and governance procedures — these should be clearly defined, taking into account possible hard forks and changes. All critical terms must be clearly defined to avoid potential confusion or misuse.

Model Negative Scenarios. To be in a position to address the major governance and organizational problems that the foundation and DAO may face, you need to carefully model possible situations, especially those relating to potential abuse of power or misuse of funds, and address those in your governance procedures and constituent documentation.

In Conclusion

In conclusion, the legal structuring of a DAO is a complex process that requires meticulous planning and careful consideration of various factors. By being aware of common mistakes and understanding their potential consequences, DAOs can proactively build legal structures that are robust, transparent, and effective.

This not only ensures a strong foundation for their growth but also fosters trust within their communities, especially with checks and balances implemented in the structure.