dYdX Details: How to Build a Legal Framework for a DAO Trust?

Source: dYdX

Compiled by: Gary Ma, Wu Says Blockchain

Summary

The dYdX Foundation is introducing a framework for creating a Guernsey Purpose Trust. This trust structure offers a potential solution to several issues faced by DAOs:

1. Limiting the liability of DAO and DAO committee participants;

2. Allowing DAOs to engage in off-chain activities;

3. Clarifying whether there are any U.S. tax and reporting obligations.

Additionally, the purpose trust created under Guernsey law provides additional benefits that may not exist in trusts from other jurisdictions: flexible trust requirements and favorable tax rates.

The purpose trust is considered in the context of DAO funding programs but can also be adopted by other subDAOs and potential DAOs. The purpose trust is likely a suitable structure for transferring funds from the DAO community treasury that are earmarked for the growth and development of a given protocol. The aim of making this framework public is to provide DAOs with a starting point to assess the applicability of purpose trusts to their operations, allowing them to focus on building protocols and ecosystems rather than searching for an effective operational structure. While DAOs will still need the assistance of legal advisors, the framework significantly reduces the time and cost associated with hiring legal advisors to evaluate similar structures.

Introduction

With the increasing use of DAOs, efforts to ensure their efficient operation have become an important area of research. Due to the lack of comprehensive guidelines, DAOs must invest significant resources to ensure their operations comply with the rules of multiple jurisdictions. In particular, there are many existing laws in the U.S. that apply to DAOs, but there is a lack of guidance specifically addressing the key issues faced by DAOs. Given that U.S. regulators may exercise authority over matters involving securities and taxes, as well as the potential for private lawsuits to impose liability on DAO token holders based on minimal contact, addressing U.S. legal and tax issues, even when constructing DAO operations within the U.S. to more easily fulfill reporting obligations, is a significant component of most analyses. Therefore, exploring solutions for DAOs outside the U.S. often loses meaning due to the complexities of U.S. compliance issues.

Consider using this framework in the following scenarios:

• DAO token governance protocols where only token holders can modify the governance contract; generally, DeFi protocols are like this, but this may not be the case for other protocols, including L1 blockchain networks.

• The purpose trust as a tool for a DAO or subDAO committee focused on specific tasks, such as granting authority, without encapsulating the DAO.

• DAO token holders wish to have a compliant structure that does not require government approval for the formation of entities and does not require ongoing filings or reporting obligations.

• DAO token holders wish to have a compliant structure that does not subject the purpose trust to unnecessary tax levels.

Although this framework does not consider this, it has the potential to be used as an encapsulation for the entire DAO, with some modifications to the mechanisms in the governance documents.

Trust Structure

The purpose trust envisioned in this framework is formed under Guernsey law. Assets are transferred from a smart contract controlled by the DAO to the purpose trust, with one or more trustees ("Trustees") and an executor ("Executor") entering into a written agreement that establishes the purpose trust.

The purpose trust is managed through a purpose trust deed ("Trust Agreement"), which defines the relationship between the trustees and the executor regarding the assets transferred to the purpose trust. The Trust Agreement stipulates that the trustees have a duty to fulfill one or more purposes for the purpose trust.

The trustees must manage the purpose trust according to the terms of the Trust Agreement and must fulfill general fiduciary duties, including acting with honesty and in the best interests of the purpose trust, acting as a prudent business person, and exercising reasonable skill and care. The trustees may use the funds transferred to the purpose trust for any transactions or arrangements that promote the purposes of the purpose trust, and transactions of the purpose trust can be executed using a multi-signature wallet for transferring DAO tokens. The trustees are entitled to continue receiving compensation for their role as trustees, as long as such compensation is approved by the DAO token holders. The trustees are always subject to removal by other trustees based on voting instructions from the DAO token holders. Specifically, the trustees must (and can only) remove other trustees at the request of the DAO token holders.

The executor oversees the activities of the trustees to ensure that the purposes of the purpose trust are fulfilled, similar to the role of a supervisor. The executor may be granted a broad range of rights. This framework envisions that the executor has the right to disclose information from the trustees, including distributions and expenditures from the purpose trust, as well as any potential conflicts of interest related to the actions of the trustees. The powers of the executor are the powers of the trustees, meaning they must regularly consider whether to exercise these powers and must do so in accordance with the Trust Agreement, rather than arbitrarily, capriciously, or maliciously. The executor is always subject to removal by the trustees, who must (and can only) remove the executor at the request of the DAO token holders.

If DAO token holders wish to transfer assets from the purpose trust to a different purpose trust or elsewhere, they can instruct the trustees to terminate the purpose trust and transfer the assets to that different purpose trust or elsewhere, with the approval of the DAO token holders. The trustees must act according to that instruction. However, regardless of how the DAO token holders instruct, the trustees may not transfer the assets of the purpose trust to the DAO or any DAO token holders. To address the situation where there is no decision on transferring its assets after the dissolution of the purpose trust, the Trust Agreement may consider transferring to qualified charitable organizations.

Here is a sample Trust Agreement considered for a DAO funding program. It includes additional mechanisms to ensure the effective operation of the purpose trust and minimize the trust placed by DAO token holders in the trustees and executor.

• Trustees and executors provide Twitter IDs, email addresses, and Ethereum addresses for multi-signature purposes instead of requiring physical addresses.

• Ideally, the Trust Agreement to be executed would be hosted on IPFS rather than a private server, and the trustees and executors would sign the Trust Agreement by signing Ethereum messages referencing the IPFS hash of the Trust Agreement. However, Guernsey law does not allow the electronic signing of Trust Agreements. Therefore, the trustees and executors must wet-sign the Trust Agreement, and the signed Trust Agreement is uploaded to IPFS as the authentic source of the Trust Agreement.

• Trustees operate under general operations in the absence of the purpose trust, which includes real-time written communications, such as Signal, rather than requiring more standard meetings, and funding grants through multi-signature arrangements, even in the absence of the purpose trust.

• DAO token holders refer to the voting requirements for approving proposals using Snapshot at the time, taking actions allowed by the trust agreement through Snapshot, and only DAO token holders can modify these requirements.

• Governance can be transferred to another chain, with the Trust Agreement considering the rights of DAO token holders to continue voting on another chain.

• When voting for the trustees, the trustees must take the following actions:

• Terminate the purpose trust;

• After the termination of the purpose trust, transfer the assets of the purpose trust to the location indicated by the DAO token holders, but the assets of the purpose trust may not be transferred to the DAO or DAO token holders;

• Compensate the trustees and executors;

• Add and remove a purpose from the purpose trust;

• Change the legal jurisdiction applicable to the purpose trust;

• Appoint and remove trustees and executors;

• Modify the Trust Agreement with the consent of the trustees and executors;

Issues Faced by DAOs

The purpose trust addresses the main issues faced by DAOs in terms of entity structure:

1. Limiting the liability of DAO participants;

2. Providing a legal form to engage in off-chain activities;

3. Clarifying existing tax obligations.

Limited Liability of Trustees and Impact on Token Holders

There is significant uncertainty surrounding the status of DAOs, including the potential liability of DAO token holders. This potential liability may include unlimited liability for DAO token holders for their own actions, unlimited liability for all DAO token holders for the actions of another holder, or unlimited liability for a subset of DAO token holders for the actions of holders belonging to that subset.

When the purpose trust replaces the functions of the DAO committee or subDAO, rather than encapsulating the entire DAO, it alleviates the actions of DAO token holders in fulfilling their duties. Since they are not taking action, any attempts to hold them liable are actions of the trustees, who are not part of the DAO. Thus, the potential liability of DAO token holders is significantly reduced.

In contrast, the purpose trust requires the trustees to take action. As long as they act within the terms of the purpose trust, fulfill their fiduciary duties, and clearly indicate to any third party that they are acting in the capacity of trustees of the purpose trust, the liability of the trustees for their actions as trustees is limited to the value of the assets of the purpose trust under their control. Therefore, the purpose trust enables the trustees to take actions to achieve the purposes of the purpose trust without increasing the liability of the trustees and with limited risk to DAO token holders. Additionally, the trustees can be indemnified for actions taken as trustees.

Off-Chain Activities Conducted by or for the Benefit of Token Holders

One issue plaguing DAOs is their inability to take action in the off-chain world, which requires DAOs to:

1. Have an initial development company sign agreements on their behalf, exposing the development company to significant risk;

2. Have a DAO token holder sign agreements, exposing that DAO token holder and potentially all other holders to significant risk;

3. Have the DAO sign agreements, essentially acknowledging the unlimited liability of DAO token holders;

4. Or have the DAO avoid interaction with the off-chain world.

These options are suboptimal.

The purpose trust resolves the issue of DAOs being unable to act in the off-chain world because the trustees can engage in the same types of activities as other entities, meaning, among other things, they can open bank accounts and sign agreements. While the purpose trust is not a legal entity, the trustees hold its assets and act in their capacity as trustees. When the trustees open a bank account, they do so in the name of the purpose trust and are bound by all fiduciary obligations under the purpose trust, and as long as they act in their capacity as trustees, they enjoy the limited liability of trustees. The same applies when signing agreements. Thus, all off-chain limitations traditionally faced by DAOs no longer exist when operating with the purpose trust fund.

Clarifying Existing Tax Obligations

So far, there has been little guidance directly applicable to the issues faced by DAOs, particularly regarding the distribution of tokens they control. In the U.S., DAO token holders may be viewed as holding interests through an entity, resulting in taxable income for DAO token holders in various situations.

Thus far, the solutions created either perpetuate these risks or result in significant tax leakage when attempting to address these risks. For example, the UNA in the U.S. provides a tool for paying taxes and complying with reporting requirements, but it is not a tax-advantaged structure, with the U.S. federal tax rate on taxable income being 21%.

Choosing a structure that subjects the DAO to a 21% tax rate is not ideal when significant measures are taken to eliminate or greatly reduce the ownership of governance tokens by U.S. citizens and the activities of the DAO in the U.S. Conversely, a structure that benefits from the non-U.S. nature of the DAO and its participants is a more suitable solution.

Since the purpose trust envisioned in this article is established under Guernsey law and clearly meets the requirements to be considered a foreign trust (rather than a U.S. trust) for U.S. tax purposes, the primary issue in determining U.S. tax obligations is whether the foreign purpose trust should be classified as a grantor or non-grantor trust. This question is crucial for the purpose trust and DAO token holders because, generally speaking, the income of a foreign grantor trust is taxed to the grantor of the trust, not to the trust or the beneficiaries of the trust (in this case, the grantor is the DAO token holder). Conversely, foreign non-grantor trusts are taxed when distributions are made to U.S. beneficiaries, and the trust itself is responsible for any U.S. tax obligations when it retains U.S.-sourced or effectively connected income.

Sections 673-679 of the U.S. Internal Revenue Code contain various requirements for identifying the existence of grantor trusts. The core issue is whether the grantor retains sufficient dominion and control over the trust's assets, making it appropriate to treat the grantor as the owner of the trust for U.S. federal income tax purposes. In contrast, there are no tests for non-grantor trusts, as any foreign trust is either a grantor trust or a non-grantor trust.

While DAO token holders do retain minimal rights regarding the assets transferred to the purpose trust under this framework, they do not have the right to revoke the purpose trust and distribute the assets to the DAO or individuals, do not have the right to substitute assets, do not have the right to pledge the assets of the purpose trust as collateral for loans, or make direct payments to beneficiaries. Essentially, DAO token holders retain sufficient control to ensure that the trustees and executors fulfill their fiduciary duties, but since DAO token holders cannot direct the assets or decide how to use them for the intended purposes of the purpose trust, it is the purpose trust itself that has dominion and control over the assets of the purpose trust and should be responsible for any tax obligations.

The reason the purpose trust with these specific facts does not have U.S. tax reporting or income filing obligations is that the trust's funds are not involved with U.S. persons, the purpose trust has no U.S. beneficiaries, and the purpose trust does not generate income sourced from the U.S.

Under Guernsey law, the purpose trust has no beneficiaries who are residents of Guernsey and no income sourced from Guernsey, and thus would not be required to pay any taxes under Guernsey law, although it may still have tax obligations in other jurisdictions. If the purpose trust distributes funds to U.S. beneficiaries or persons who could be considered U.S. beneficiaries, such that it would be taxable in the U.S., the trustees would be obligated to provide beneficiary statements to the beneficiaries to pay taxes on the distributions. If the purpose trust receives U.S.-sourced income or effectively connected income, then the purpose trust would need to obtain a U.S. tax identification number, and the trustees would need to file Form 1040-NR to report and pay taxes related to that activity.

Problems Solved by Guernsey

The purpose trust under Guernsey law creates additional benefits that may not exist in trusts from other jurisdictions: the purpose trust has no taxable income and flexible trust requirements.

Tax Obligations of Token Holders and Trustees

As mentioned above, the purpose trust minimizes the tax risks for DAO token holders and trustees. The creation of the purpose trust under Guernsey law also clarifies the tax obligations of DAO token holders when tokens are transferred or exchanged from the purpose trust. In cases where the DAO grants tokens to committees and other committees or subDAOs regularly transfer tokens, the transfers will be governed by Guernsey law and not subject to U.S. tax treatment. Furthermore, it is expected that the purpose trust fund will have no tax filing or reporting obligations in Guernsey regarding that activity.

Flexible Trust Structure for Token Holders

The purpose trust established under Guernsey law provides significant flexibility to create arrangements that maximize the benefits for DAO token holders and participants in the purpose trust. In addition to the flexibility in drafting documents, Guernsey law is also flexible regarding who can serve as trustees and executors, and it can also reserve powers for third parties over the trustees and executors.

Other jurisdictions with favorable tax regimes, such as the Cayman Islands and the British Virgin Islands, have more rigid requirements. For example, both of these jurisdictions require trustees to include a licensed local trust company, which means that as a practical matter, typical DAO committee members cannot serve exclusively as trustees, and the trust will be subject to government decisions regarding trust licenses. The same requirements do not apply in Guernsey (or Jersey).

DAO Status and Trust Requirements

When evaluating the ideal jurisdiction and entity type for a DAO or subDAO committee, maintaining the interests of the DAO and limiting trust in anything beyond code should be a primary consideration. The purpose trust established under Guernsey law allows the DAO to retain all the characteristics of a DAO while continuing to minimize trust in any group or individual.

Benefits of DAOs

One of the main concerns about introducing a legal structure into DAOs is that compliance with corporate formalities designed for centralized and individual organizational structures may undermine the benefits of decentralization and autonomous operation. The benefits of existing without reliance on government, the absence of any central points of failure, effective collaboration among participants, and active participation from a broader community can easily be lost when complying with obligations that are not aligned with technological advancements.

The purpose trust established under Guernsey law eliminates certain issues historically faced by other proposed entity structures. A key issue is the need for an administrative body, such as a state government, to permit the existence of an entity. The purpose trust established under Guernsey law does not require such approval; rather, the purpose trust exists the moment assets are transferred to it, and the trustees and executors sign the Trust Agreement.

Under Guernsey law, the only involvement of the government with the purpose trust is the Guernsey courts adjudicating matters applicable to it. This involvement is analogous to the potential impact of courts on DAOs. As a legal matter, only the courts can terminate the existence of a DAO, just as they can terminate the existence of a purpose trust.

Minimizing Trust

The purpose trust established under Guernsey law does not change the trust required by multi-signature token holders for all tokens transferred from the DAO to it, but it significantly alters the legal rights to align with the intentions of most DAOs.

Historically, DAOs have transferred funds or flowed to multi-signatures for distribution by key holders. In doing so, once funds are transferred to a multi-signature, the DAO loses control over how the funds are used. It is currently unclear what rights DAO token holders retain to demand the return of funds to the DAO or to force the removal of key holders from the multi-signature or to allow new holders to join. Instead, DAO token holders can only trust that key holders will do the right thing with the funds transferred to the multi-signature controlled by the key holders.

When using the purpose trust established under Guernsey law, DAO token holders retain more rights, strengthening the multi-signature arrangements. At a high level, DAO token holders retain the legal rights to direct the removal of trustees, add trustees, remove executors, add executors, or terminate the purpose trust, and transfer funds to locations determined by the DAO token holders (excluding the DAO or DAO token holders). The purpose trust structure with these rights ensures that the trustees and executors can always be held accountable. However, the trustees retain control over day-to-day decisions regarding the use of funds, including transferring all funds to specific uses consistent with the purposes of the purpose trust, while DAO token holders have no rights to direct these transfers.

Trustees

Risks Currently Faced by Multi-Signature Key Holders

All key holders in a multi-signature face a certain degree of regulatory and private litigation risk. Additionally, the tax consequences related to their activities are unclear, and the ability of multi-signature holders to act effectively is limited.

In terms of regulatory and private litigation risk, multi-signature key holders do not have limited liability protection, meaning each of them may be personally liable for their own actions or potentially for the actions of other multi-signature key holders. This liability can arise in various ways, and multi-signature key holders may become trustees of DAO token holders when tokens are transferred to hold the multi-signature, or they may face lawsuits arising from grants made, depending on how the relationship with the grantee develops, including deciding to stop funding the grantee for any reason.

Regarding tax issues, the liability for distributing tokens from the multi-signature that receives funds from the DAO is uncertain. Multi-signature key holders may be viewed as holding interests in a transferred entity, resulting in taxable income for multi-signature key holders when transferring tokens to recipients or exchanging one token for another. Therefore, these transactions may create tax liabilities for multi-signature key holders. The effectiveness of multi-signature key holders is also limited. They cannot sign contracts or open bank accounts without exposing themselves to additional risks. This limits the ability of multi-signature key holders to develop protocols in the most effective manner.

The above risks and limitations are the same across all DAOs whenever someone participates in multi-signatures in the manner typically occurring in a DAO. However, the purpose trust provides an alternative solution to these risks and limitations.

Benefits for Multi-Signature Key Holders

The purpose trust addresses the risks and limitations faced by multi-signature key holders in the following ways:

1. Limiting the liability of trustees;

2. Ensuring their tax compliance;

3. Making them more effective in off-chain activities.

Limited Liability

As mentioned above, the purpose trust requires trustees to take action to fulfill one or more purposes of the purpose trust, and the trustees have limited liability for their actions as trustees. According to the Trust Agreement provided as an example of this framework, no trustee is liable for any loss to the purpose trust fund, whether due to the failure, depreciation, or loss of any investment made or retained in good faith, or due to any error or omission made in good faith or for any other reason, except for the fraud, willful misconduct, or gross negligence of the trustee being held accountable.

Additionally, the trustees are indemnified in the Trust Agreement. Trustees are entitled to be indemnified from the funds of the purpose trust for all obligations or liabilities reasonably and properly incurred by them as trustees in exercising their functions under the terms of the Trust Agreement.

Compliance with Tax Obligations

The purpose trust minimizes the tax risks for trustees, as they are clearly not beneficiaries of the purpose trust. Furthermore, under Guernsey law, the purpose trust does not incur tax obligations, and there are no taxes on the transfer or exchange of tokens under Guernsey law. In the case of trustees continuously transferring cryptocurrency as trustees, transfers or exchanges of tokens to others can occur and then be transferred again, while the purpose trust has no tax obligations in Guernsey. Under Guernsey law, the purpose trust fund also has no tax filing or reporting obligations, allowing trustees to continue operating in the same manner as before the existence of the purpose trust fund, albeit under the fiduciary duties stipulated in the Trust Agreement.

Off-Chain Activities

If the trustees wish to interact with the off-chain world, such as signing off-chain agreements or opening bank accounts to pay those who do not accept tokens, the trustees will be able to do so in their capacity as trustees. The purpose trust is not a legal entity but acts in the name of the trustees, who act in their capacity as trustees. By acting in their capacity as trustees and informing any third party that they are acting as trustees, the trustees can maintain the limited liability mentioned above while operating more effectively to achieve the purposes of the purpose trust. For example, the trustees can sign agreements with grantees to ensure that the grantees open all copyright-protected works created using grant funds and reach enforceable agreements on other terms granted to the grantees.

Executors

The executor only possesses the powers granted to it in the Trust Agreement. These powers allow the executor to provide significant value to DAO token holders by ensuring that the trustees fulfill the purposes of the purpose trust.

Specifically, in the Trust Agreement provided as an example in this framework, the powers of the executor include obtaining disclosures regarding distributions and expenditures made by the trustees from the assets of the purpose trust, as well as any potential conflicts of interest related to the actions of the trustees.

Unless due to the executor's fraud, willful misconduct, or gross negligence, the executor is not liable for any loss of funds in the purpose trust. Additionally, the executor is indemnified for all reasonable and appropriate expenses and liabilities related to the Trust Agreement.

Thus, there is significant certainty regarding liability limitations and indemnification, allowing the executor to ensure that the trustees fulfill their obligations to achieve the purposes of the purpose trust.

Conclusion

The DAO community should consider exploring the use of purpose trusts under Guernsey law to determine whether it is an appropriate tool for the growth of DAOs and protocols. This framework only touches on a specific use case, but many other use cases exist, such as:

1. Encapsulating the entire DAO, with all DAO token holders as trustees;

2. Holding the DAO's treasury;

3. Holding all intellectual property (including copyrights and trademarks) while transferring the repurchase of copyrighted code;

4. Holding fees received from applicable protocols, directly distributing them to other purpose trusts that perform functions for the DAO; or serving as the financial and operational center of the DAO.