Decentralized Autonomous Organizations: New Technology Meets Traditional Risk Management

Decentralized Autonomous Organizations: New Technology Meets Traditional Risk Management
October 2, 2024 5 mins

Decentralized Autonomous Organizations: New Technology Meets Traditional Risk Management

Decentralized Autonomous Organizations: New Technology Meets Traditional Risk Management

Decentralized Autonomous Organizations (DAOs) must embrace strong governance and secure optimal insurance coverage to effectively mitigate risk and guard against negative financial impact.

Key Takeaways
  1. DAOs have a unique set of legal and financial risks due to their relatively new existence. Therefore, directors and officers (D&O) insurance becomes a significant risk management tool for these organizations.
  2. Traditional D&O insurance products do not meet the needs of a DAO or its members. Careful coverage tailoring, new and emerging products, and an experienced broker are required to optimize D&O renewal results.
  3. How a DAO defines its process and procedures for financial oversight and decision-making can influence its risk profile.

D&O coverage for DAOs implicates unique legal considerations due to DAOs’ decentralized nature and relatively new existence.

Some courts have indicated that members of a DAO could be held personally liable for the DAO’s actions. In Sarcuni v. bZx DAO, for example, plaintiffs accused certain bZx DAO members of negligence following a phishing incident and plaintiffs’ subsequent financial losses. The complaint alleged the defendants, as DAO members, to be general partners of the bZx DAO. The court allowed the case to proceed, implying that DAO members involved in the DAO’s governance could be held personally liable. 

Simply put, a DAO is a club with a shared goal, but instead of a board of directors, everyone in the club can vote on important decisions. A relatively new concept, the term DAO was first used in the 1990s and became widely known in the blockchain and Web3 communities by the mid-2010s.

DAOs possess three key characteristics: 

  1. they are decentralized, allowing every member to vote rather than concentrating power among a select few.
  2. they are autonomous, relying on smart contracts rather than human intervention to operate.
  3. they use blockchain technology to record all activities, making the DAO’s actions transparent and verifiable.

It is prudent for DAOs to obtain D&O coverage for a few reasons. 

First, even though DAOs do not have traditional boards of directors, certain members of a DAO may carry out crucial tasks for the DAO or hold more decision-making power than others. D&O insurance safeguards these individuals from personal financial losses should they get sued for actions taken on the DAO’s behalf. 

Second, it can be difficult to pinpoint who is responsible for any given action because decision-making in a DAO is spread out. This ambiguity increases the risk of lawsuits against the members of the DAO — the more decision makers involved, the more potential for lawsuits to arise naming them. 

Lastly, with DAOs being a relatively new concept, D&O insurance can offer protection against any unforeseen legal challenges that might arise.

One might wonder how a DAO engages in such activities as purchasing D&O insurance if it is not a legally recognized entity. The answer is that a DAO typically will create an entity to serve as its “legal wrapper,” allowing the DAO to execute certain essential legal and operational functions. 

The entity most DAOs choose as their “legal wrapper” is that of the non-profit foundation. These foundations are incorporated in jurisdictions conducive to blockchain projects, such as the Cayman Islands. Foundations suit DAOs well because, unlike other governance structures, they do not include any owners or shareholders. The foundation’s board of directors only has a duty to act pursuant to the foundation’s governing documents and does not have a fiduciary duty to any shareholders.

Due to this lack of ownership, foundations also provide a flexible governance structure that allows individuals other than board members to exercise control. DAO token holders can direct the board through votes to a greater extent than they could under regimes wherein shareholders hold voting power. The foundation performs essential tasks for the DAO, including ensuring securities law compliance, holding intellectual property, and providing a vehicle for early-stage funding. 

While D&O policies undoubtedly offer benefits to DAOs, complex challenges arise due to the evolving legal landscape. Traditional D&O policies are not tailored to DAOs. While DAO-specific insurance products are emerging, they are still in their infancy. Due to DAOs’ decentralized structure, it can be difficult to define who exactly is covered by a D&O policy. Likewise, it can be difficult to identify bad actors within a DAO and to prevent them from influencing decisions. Without the proper internal procedures in place, D&O insurance might not cover situations where intentional wrongdoing has occurred within a DAO.

DAOs can safeguard against D&O lawsuits, thereby making themselves a more attractive risk to insurers, in a few ways. DAOs should clearly define decision-making roles and responsibilities, just as traditional corporations define the roles and responsibilities of D&Os in their corporate bylaws. This helps avoid ambiguity regarding D&O coverage. A DAO should also define its procedures for financial oversight and dispute resolution. Another useful tool is a risk register listing all potential risks and the corresponding mitigation strategies. Developing a comprehensive risk management strategy is crucial to protect against D&O claims.

The legal landscape surrounding DAOs is evolving, and D&O policies for these organizations are likewise evolving to meet unique needs. When seeking D&O coverage, DAOs would be wise to consult a broker experienced in DAOs. If you have questions or are interested about coverage, please contact your Aon broker. 

 
Aon's Thought Leaders
  • Alexandra Collins
    Senior Broker
  • Glenn Morgan
    Senior Vice President, Digital Asset Practice Leader

General Disclaimer

This document is not intended to address any specific situation or to provide legal, regulatory, financial, or other advice. While care has been taken in the production of this document, Aon does not warrant, represent or guarantee the accuracy, adequacy, completeness or fitness for any purpose of the document or any part of it and can accept no liability for any loss incurred in any way by any person who may rely on it. Any recipient shall be responsible for the use to which it puts this document. This document has been compiled using information available to us up to its date of publication and is subject to any qualifications made in the document.

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