【Blockchain Blog】Renewal/DAO (1) - Latest Developments in Japan (Sendai City's Regulatory Reform Proposal Using the National Strategic Special Zone System)
- Under current laws of Japan, founders of DAOs need to be mindful of the “Inadvertent Partnership Formation Problem.”
- Japan’s government has moved to study the DAO as a form of organization and its legal framework for future legislation.
- Sendai City has proposed legislation that would create a DAO-specific law to the Cabinet Office, as the first local government in Japan to take such an action. Sendai City hopes to encourage the formation of DAOs in the city and foster activity related to digital assets and Web3.
Basics of Decentralized Autonomous Organization (DAO) in Japan
DAO stands for “Decentralized Autonomous Organization.”
In a blockchain project, the operation of such a project is shifted from being managed solely by the protocol developer to being entrusted with on-chain governance by the holders of governance tokens in order to promote the decentralization of operations within the community.
In this case, the organization formed and managed by the holders of the governance tokens is a DAO. Although its legal nature has not been sufficiently studied in Japan, some issues have been raised regarding the legal stability of DAOs, such as “When conducting business through a DAO, there is a high possibility that the DAO will be deemed as a partnership (kumiai) and the constituents will bear unlimited responsibility regardless of their intention, unless a specific statutory business organization, such as a joint stock company or limited liability company, is explicitly selected” (known as the “Inadvertent Partnership Formation Problem”). (*1)
Trends in Japan to Date
In response to such issues, on March 30, 2022, a project team of the Liberal Democratic Party (the leading political party in Japan) released its “NFT White Paper - Japan's NFT Strategy for the Web 3.0 Era.” (*2) The NFT White Paper focused on the following areas: expectations for DAO utilization, the need to formalize the legal status of DAOs and to consider the creation of a system that would allow DAOs to be incorporated.
Some key excerpts from the NFT White Paper:
- “DAOs, a new governance system in which diverse stakeholders who agree on the same mission can participate, has the potential to be used as a tool to solve various problems and issues that occur in the real world, and expected to be used as a tool for, among others, revitalizing local regions, solving social issues, and managing sports organizations.”
- “In Japan, taking the above global trends into account, the legal status of DAOs under Japanese law, the content of legal rights and obligations of members and participants, taxation, etc., should be promptly clarified. Further, a system should be established to allow DAOs to be incorporated in Japan using National Strategic Special Zones (for example, by designating “DAO special zones” and “blockchain special zones”).”
In addition, in June 2022 the Cabinet Office (the chief executive body of the government of Japan) released two plans related to the further study and development of policies related to Web3, including NFTs and DAOs. These plans – titled “Basic Policy on Economic and Fiscal Management and Reform 2022” (*3) and the “Grand Design and Action Plan for a New Form of Capitalism. ~Investing in People, Technology, and Startups~,” (*4) – demonstrate the Cabinet intention to study regulatory improvements to promote Web3, including advancing the utilization of NFT and DAOs.
Also in June 2022, the Cabinet approved the “Priority Policy Program for Realizing a Digital Society,” (*5) which proposes that the Digital Agency, a Japanese government agency established in accordance with the administrative reform agenda by the former Prime Minister, Yoshihide Suga, (*6) should formalize the legal status of smart contracts and DAOs and the legal issues involved in their utilization, as described below.
Some key excerpts from the Priority Policy Program:
- “A DAO is an organization in which participants operate autonomously without an operating company, representatives, or a board of directors, etc. The operating rules of a DAO are coded by smart contracts, which put decision making into effect without the intervention of human discretion.”
- “The Digital Agency, in cooperation with related ministries and agencies, will organize issues for ensuring the security of signatures made by automated processes that do not involve the will of natural persons, including smart contracts that constitute DAOs, and their positioning under the Civil Code and the Act on Electronic Signatures and Certification Business.”
- “Domestic and foreign DAOs should be studied in relation to specific use cases such as social contribution activities and local communities, as well as their relationship with legal entities, and their positioning under the current laws and the issues to be addressed when they are utilized.”
Following this, the Web 3.0 Study Group was established at the Digital Agency. Various discussions are being held on various topics regarding DAOs, including the ideal form and legal characteristics of DAOs, consideration of use cases in Japan, and even the transformation of the study group itself into a DAO. (*7)
(*1) Akimasa Yanagi, “Legal Status of DAOs and Legal Responsibility of Members,” Journal of Law and Politics, No. 132 (March 2022), p. 23.
(*2) NFT White Paper - Japan’s NFT Strategy for the Web 3.0 Era (March 2022) (https://www.taira-m.jp/Japan%27s%20NFT%20Whitepaper_E_050122.pdf)
(*3) Basic Policy on Economic and Fiscal Management and Reform 2022 (June 7, 2022)(https://www5.cao.go.jp/keizai-shimon/kaigi/cabinet/2022/2022_basicpolicies_ja.pdf)
(*4) Grand Design and Action Plan for a New Form of Capitalism. ~Investing in People, Technology, and Startups~ (June 7, 2022)(https://www.cas.go.jp/jp/seisaku/atarashii_sihonsyugi/pdf/ap2022en.pdf)
(*5) “Priority Policy Program for Realizing a Digital Society” (June 7, 2022)
(https://www.digital.go.jp/assets/contents/node/basic_page/field_ref_resources/5ecac8cc-50f1-4168-b989-2bcaabffe870/d130556b/20220607_policies_priority_outline_05.pdf) (Digest version in English: https://www.digital.go.jp/assets/contents/node/basic_page/field_ref_resources/0f321c23-517f-439e-9076-5804f0a24b59/fdefa215/20220722_en_priority_summary_01.pdf)
(*6) The Digital Agency was established on September 1, 2021, with the aim of accelerating the digitalization of Japan. It is responsible for the improvement of user-friendliness of online public services and regulatory reform to allow use of new technologies. (https://www.digital.go.jp/en/)
(*7) Digital Agency Web 3.0 Study Group (1st meeting) (https://www.digital.go.jp/councils/31304f21-d56a-4d15-b63e-3b9ef1b96e38/)
Sendai City’s Regulatory Reform Proposal Using the National Strategic Special Zone System
In the midst of these developments, Sendai City proposed a regulatory reform package to the Cabinet Office in order to accelerate Web3 business, thereby becoming the first local government to directly refer to the legalization of DAOs and utilizing the National Strategic Special Zone System. (*8) The details of this proposal were published on the city’s website on October 19, 2022. (*9)
Sendai City’s regulatory reform proposal consists of the following three components:
(1) Clarification of tax and accounting standards for digital tokens;
(2) Legalization of decentralized autonomous organizations (DAOs) and lifting of existing restrictions on DAOs under the Financial Instruments and Exchange Act and Payment Services Act; and
(3) Making it possible to acquire tokens via the most widely used investment vehicle in Japan (i.e., Investment Limited Partnerships).
Before proposing the regulatory reform package set forth above, Sendai City conducted interviews with entrepreneurs and researchers involved in Web3 business, held discussions with relevant ministries and agencies, and attended various conferences hosted by Web3 businesses to study measures necessary to activate Web3 business in the city.
In the course of discussions between Sendai City and the author of this report, (*10) we classified the DAOs currently being established in Japan into two main categories: (i) those that aim to build local communities; and (ii) those that aim to conduct economic activities through investment in other businesses with a view to earning a certain return on their investment. While category (i) DAOs that primarily focus on local community building are analyzed as having achieved their objectives to some extent even under the current legal system, category (ii) DAOs that have economic activities in their sights have some obstacles including the following: (a) token holders of a DAO are subject to heavy taxes if they hold governance tokens issued by the DAO; (b) it is difficult to recruit sufficient participants (token holders) unless their limited liability is ensured in relation to the DAO’s economic activities; (c) if an entity under the Companies Act that guarantees their constituents’ limited liability (e.g., a joint stock corporation (kabushiki kaisha) or limited liability company (godo kaisha)) is used as a DAO, autonomous management of the organization by token holders may be hindered because of the required legal management procedures under the Companies Act; (d) if a governance token falls under “securities,” its issuer, a DAO, should be subject to disclosure requirements and other regulations under the Financial Instruments and Exchange Act, and, as a result, flexible financing via tokens may be impaired; and (e) an “Investment Limited Partnership,” which is the predominant form of investment vehicle in Japan, is prohibited from investing in tokens under the current Investment Limited Partnership Act. In particular, it has been discussed that it would be difficult due to the current legal system to utilize governance tokens and smart contracts to automatically distribute profits according to each member’s contribution (not limited to capital contribution) to the DAO while maintaining the anonymity of such members.
In Sendai City, there are many entrepreneurs and supporters who have a strong interest in Web3 business, and there is already a DAO called “Michinoku DAO,” which was established under the leadership of an independent venture capitalist in the city. (*11) In addition, there are many startups in the deep tech industry that originated from Tohoku University in the city, and there is a strong need for this special zone proposal. On the other hand, there are also cases of Web3 entrepreneurs in Japan relocating their headquarters overseas, such as to Dubai and Singapore, given their legal and tax advantages, and there has been discussion on the urgent need for action toward the arrival of the Web3 era among Sendai City project members.
Through this proposal for a National Strategic Special Zone, Sendai City intends to further invigorate the startup scene to thereby quickly establish an environment in which entrepreneurs engaged in Web3 business can be active in Sendai, the Tohoku region, and throughout Japan. As an extension of this, they also aim to contribute to the global development of the Web3 business by creating an environment in which entrepreneurs involved in the Web3 business (especially those related to the crypto field), who are currently leaking overseas, can stay in Japan and take on the challenges posed by their business.
Starting with this Special Zone proposal, Sendai City is considering holding various conferences in the future, bearing in mind the way in which to realize regional development through the acceleration of Web3 business.
Before Sendai did so, Fukuoka City submitted a proposal for a National Strategic Special Zone seeking to revise the current Investment Limited Partnership Act to allow certified Investment Limited Partnerships to acquire tokens issued by startups, and it is possible that similar proposals will be made by other cities designated as National Strategic Special Zones in the future.
(*8) The National Strategic Special Zones, which aim to enhance economic growth by implementing regulatory reforms, were established in 2013 in Japan, and 10 areas have been selected as such zones (including Sendai City). The overall objective of this system is “to make Japan the best climate for doing business.” In the above 10 areas designated by the national government, bold regulatory reforms and other measures, such as tax incentives, are comprehensively and intensively promoted for projects carried out jointly by the central government, local governments, and the private sector. As of April 2020, over 100 reforms have been realized, and over 350 projects are ongoing as a result of these regulatory reforms. (https://www.chisou.go.jp/tiiki/kokusentoc/english/index.html)
(*9) Conference for the Acceleration of Web 3.0 businesses and Proposal for Regulatory Reform in Sendai City National Strategic Special Zone (October 19, 2022)(http://www.city.sendai.jp/project/koho/kisha/r4/1019tokku.html)
(*10) Kota Fujii supports Sendai's regulatory reform proposal by participating in negotiations with the relevant ministries and agencies.
(*11) Post-disaster 10 years, “Reconstruction” and formation of Tohoku Web 3 economic zone by Michinoku DAO (https://note.com/fukudome_hideki/n/n9b257cf0f2d4b)
Announcement: Renewal of Blockchain Blog
This winter, our new publication, (*12) “Legal Q&A for Web3 Entrepreneurs” (the “Web3 Q&A”), has been published by Kinzai Institute for Financial Affairs.
The Web3 Q&A covers specific legal issues that arise around the blockchain, NFT/NFT Market, Play to Earn, DeFi, and Metaverse areas, including 9 questions on the blockchain, 15 questions on NFT, 4 questions on Play to Earn, 7 questions on DeFi, and 12 questions on Metaverse, as well as 18 questions on taxation. However, there are many legal issues that could not be covered in this book due to space and time constraints.
Given such situation, we relaunched our Blockchain Blog to explain the related legal issues that we could not dive into in the Web3 Q&A.
In this first installment, we introduced one of the latest developments in Japan regarding DAO, a regulatory reform proposal by Sendai City utilizing the National Strategic Special Zone system.
We will continue to post the latest legal topics on blockchain industry on an ongoing basis.
(*12) Kaori Noguchi edited and authored the Web3 Q&A with 11 other attorneys from the firm.