Starting a DAO in the USA? Steer Clear of DAO Legislation

When decentralized autonomous organizations (DAOs) blew up last year, the web3 community quickly realized that forming legal entities around their operations could save them a lot of trouble. Legal entities could limit the liabilities of their participants, increase certainty about tax jurisdiction, and make it easier to transact with the real world.

Before lawmakers wrapped their heads around DAOs, a number of projects used existing U.S. legal structures, such as unincorporated nonprofit associations, cooperatives, and LLCs. However, none of these options were created with blockchain in mind.

Things changed when some U.S. states passed legislation to create new types of legal entities custom-made for DAOs and crypto-native companies, including Vermont’s BBLLC, Wyoming’s DAO LLC, and Tennessee’s DO LLC.1

What is a DAO? Mapping Out the Ecosystem

What is a DAO? Mapping Out the Ecosystem

This article offers a 10,000ft view on the ‘Decentralized {Autonomous} Organization’, or DAO tooling and project landscape. It’s intended to be complementary to introductory posts like Linda Xie’s ‘A beginner’s guide to DAOs’. The goal is to help contributors and participants better acclimate themselves with the distinct project categories and relevant infrastructure leading the growing…

The Defiant

From a high level, it’s encouraging to see states engaging with web3 through their legislation. However, as I’ll show, these DAO-specific statutes aren’t necessarily the best option for DAOs seeking a legal identity.

It is far from apparent that DAOs would benefit from utilizing the BBLLC, DAO LLC, or DO LLC. That said, many states are considering similar legislation and examination of those existing structures can help inform the areas necessary to make these laws viable.

DAO legislation in the U.S.

Vermont Blockchain-Based LLC.

In July of 2018, Vermont became the first U.S. state to enact LLC legislation tailored to blockchain-based companies. While the law doesn’t explicitly mention “DAOs,” it generally applies to companies that “utilize[] blockchain technology for a material portion of its business activities.” BBLLCs are also subject to the provisions of Vermont’s standard LLC law.

A company that registers as a blockchain-based limited liability company (BBLLC) must include in its operating agreement a summary of the company’s mission or purpose, information about the blockchain technology to be used, protocols for responding to security breaches, voting procedures to address certain types of matters, the procedure for becoming a member, and the rights and obligations of each group of participants.

Additionally, the statute provides that a participant may wear multiple hats, such as being a manager and a developer, so long as that person complies with any applicable fiduciary duties. Fiduciary duties typically include a duty to refrain from competing with the organization. However, as with a standard LLC in Vermont, that duty may be reasonably restricted in a DAO’s operating agreement.

Wyoming DAO LLC.

In July 2021, Wyoming enacted the nation’s first law to mention DAOs: the “Wyoming Decentralized Autonomous Organization Supplement,” which was subsequently amended in March of this year. DAO LLCs are also governed by Wyoming’s standard LLC law.

In Wyoming, an organization electing to be a DAO LLC must specify in its articles of organization “how the decentralized autonomous organization shall be managed by the members, including to what extent the management will be conducted algorithmically.” The DAO must also include the following disclaimer in its articles or operating agreement:

NOTICE OF RESTRICTIONS ON DUTIES AND TRANSFERS

The rights of members in a decentralized autonomous organization may differ materially from the rights of members in other limited liability companies. The Wyoming Decentralized Autonomous Organization Supplement, underlying smart contracts, articles of organization and operating agreement, if applicable, of a decentralized autonomous organization may define, reduce or eliminate fiduciary duties and may restrict transfer of ownership interests, withdrawal or resignation from the decentralized autonomous organization, return of capital contributions and dissolution of the decentralized autonomous organization.

The articles of organization must also contain the public key of “any smart contract directly used to manage, facilitate or operate the decentralized autonomous organization.” Failure to include this information in the articles is grounds for dissolution of a DAO LLC. A DAO LLC must also amend its articles each time its smart contracts are updated or changed.

The act provides that DAO management “shall be vested in its members or the members and any applicable smart contracts.” The law further requires that any smart contracts used must be “capable of being updated, modified or otherwise upgraded.”

As a default rule, Wyoming’s statute provides that members do not owe any fiduciary duties—such as the duty not to compete—to each other or to the organization unless the organizational documents say otherwise. (For standard Wyoming LLCs, the default rule is the opposite.)

Wyoming’s law provides that, unless otherwise provided for in the articles of organization, smart contract or operating agreement:

• A person becomes a member by acquiring “property that confers . . . a voting or economic right” (such as a governance token);
• Membership interests are computed as either a member’s share of digital asset contributions, or one member/one interest (if there have been no digital asset contributions by members); and
• A member withdraws by disposing of the property (i.e., governance token) granting a voting or economic right.

A Wyoming DAO LLC dissolves if the DAO “failed to approve any proposals or take any actions” in a one-year period.

Tennessee DO LLC.

In April of this year, Tennessee followed in Wyoming’s footsteps, passing its own DAO legislation. Tennessee’s statute, however, refers to the entity type as a “decentralized organization,” or “DO.” (The omission of “autonomous” is likely a nod to the reality of how most DAOs actually function.) DO LLCs are also subject to Tennessee’s standard LLC law.

Tennessee’s law is very similar to Wyoming’s in many respects, including:

• Similar disclosures must be made in the articles of organization;
• The articles must include the public keys of any smart contracts used to operate the organization;
• Any smart contracts used in the management of the organization must be capable of modification or amendment;
• The articles must be amended if any smart contracts have been amended or changed;
• Default rule (which can be altered) is that members owe no fiduciary duties to each other or the organization;
• Default rules apply for computing membership interests unless the articles or smart contracts provide otherwise; and
• A DO LLC dissolves upon failure to take actions or approve proposals in a one-year period.

The Tennessee law borrows language from the text of the old Wyoming law, such as:

• A decentralized organization may be “member-managed” or “smart contract-managed”;
• Default rule (which can be altered) is that at least a majority of membership interests must vote on a matter in order for the vote to be valid; and
• A member may only withdraw “in accordance with the terms set forth in the articles of organization, the smart contracts, or, if applicable, the operating agreement.”

Comparison

VTWYTNRequired disclosuresMission or purpose of DAOStatutory noticeStatutory noticeMust identify public key of smart contract(s)?NYYMust smart contracts be capable of amendment?NYYDefault quorum requirement?NNYDissolve on failure to take actions or pass proposals in 1 year period?NYYFiduciary duties by default?YNN

Are These New Legal Entities Any Good?

It’s encouraging to see states recognize the economic and cultural value of DAOs through legislation. Certainly, these statutes have raised awareness of how DAOs would benefit from the protection of a legal entity. As evidence of this, a search of Wyoming’s records for “DAO LLC” entities returns nearly 400 results as of May 2022.

Most DAOs would benefit from the protection of a legal entity—but do these DAO-specific entity types offer the best option? In short, no. These laws impose additional burdens on DAOs without conferring any real benefits in exchange. Additionally, all three statutes suffer design flaws that presumably stem from a fundamental misunderstanding of blockchain technology and how DAOs really function.

More disclosure requirements than standard LLCs (VT, WY, TN)

These statutes require a DAO to make specific disclosures in its operating agreement and/or articles of incorporation that no standard LLC would be required to make. Indeed, no standard Vermont LLC would be required to provide a “summary description of [its] mission or purpose” in its governance documents, nor would any standard Wyoming or Tennessee LLC be required to disclose information about the technological solutions that it would be using in its operations.

Premature operational decisions required (VT, WY, TN)

These statutes require DAOs to make strategic decisions about how they will operate before they have barely begun. Wyoming’s and Tennessee’s statutes require a DAO to identify the public keys of smart contracts that will be used in management and operations. Vermont’s statute also requires specific disclosures about the nature of the blockchain technology to be used.

In reality, many DAOs begin as loose groups of individuals coordinated by social media platforms. These groups may later choose to adopt smart contract solutions for voting, treasury management, and so on, based on the needs that evolve. No standard LLC business would be required, at incorporation, to make lasting decisions about its software, bank accounts, or communications platforms; it is not clear why DAO entities should be treated any differently.

Failure to resolve conflicts between operating agreement and smart contract (WY, TN)

Both Wyoming and Tennessee contain several default rules that apply unless the DAO specifies otherwise in its articles, operating agreement, or smart contract. However, both statutes fail to resolve conflicts between the operating agreement and a smart contract. Suppose a DAO LLC’s operating agreement provides that members must vote on the admission of a member, but that same DAO’s governance smart contract allows tokens to be freely transferred, without the requirement of a vote. Can someone become a member simply by virtue of purchasing a token (as implied through the smart contract’s functionality), or does that member have to be voted in (as provided in operating agreement)?

Unrealistic default quorum requirement (TN)

Tennessee, by default, requires a majority of interests to vote for a vote to be valid. Anyone who has participated in a DAO would immediately understand why that default rule is unworkable: DAO votes typically have very low participation, particularly on matters of minimal consequence.

In fact, it would in many cases be irrational for a majority of members to participate in on-chain voting (which costs gas) since DAOs often reach soft consensus off-chain prior to engaging in an official vote. Requiring majority participation by default in all circumstances ignores the reality of how DAOs function. While a DAO may override that default rule in its governance documents or smart contract, a better design would be a default rule that works with, and not against, most DAO use cases.

False dichotomy between “member-managed” and “smart contract-managed” (TN). Tennessee’s statute requires a DAO to elect between being “member-managed” and “smart contract-managed.” This supposes a false dichotomy – and is likely why Wyoming abandoned the language – given that even the most autonomous of DAOs require member interaction to decide and execute transactions. This may give less savvy participants (and their unsavvy lawyers) a false understanding of where accountability would lie when a smart contract executes the will of the members.

Misunderstanding of the technology (WY, TN)

The Wyoming and Tennessee statutes both require that any smart contracts utilized by the DAO be capable of upgrade or amendment. By their very nature, smart contracts are immutable, so to “amend” a smart contract must mean to abandon it in favor of a new smart contract, or to have storage variables capable of modification. But these statutes give no interpretive guidance on that point, and, thus, seem to fundamentally misunderstand the nature of the technology.

Unworkable default rule on dissolution (WY, TN)

Both the Wyoming and Tennessee statutes provide that a DAO LLC – unlike a standard LLC – will dissolve if it fails to “approve any proposals or take any actions” within a 1-year period. While perhaps well-intentioned, this rule makes an unfounded assumption that all DAOs should take actions at least once a year. What about a DAO-governed protocol that does not require any DAO action unless and until an emergency arises?

In short, the statutes discussed above—while passed with good intentions—simply offer DAOs the option of a less-optimal LLC format. It is unclear why a DAO would choose one of these entities over a standard LLC (or another choice of entity). Since there is no one-size-fits-all solution, DAOs choosing a legal entity should seek guidance from a crypto-savvy attorney.

Some Ideas for Legislative Efforts

As discussed, the BBLLC, DAO LLC, and DO LLC fall short of providing DAOs a sensible option for legal protection. However, states interested in creating a home for DAOs have opportunities to learn from the shortcomings of these statutes and to address real pain points that DAOs face in interacting with the traditional legal system.

Enable crypto-native entity formation.

Currently, the only way to create a legal entity—even a BBLLC, DAO LLC, or DO LLC—is to apply through a state’s Secretary of State (either through their website, or through the mail) and pay filing fees in fiat currency. If states want to encourage DAOs to form under their legislation, they should offer a crypto-native formation option, including filing fees paid in crypto assets. Just as states make traditional company registries available online, a state could easily maintain a blockchain-based registry of DAO companies.

Provide clearer principles of deference to smart contracts

As discussed above, the Wyoming and Tennessee statutes fail to resolve conflicts between an operating agreement and a smart contract. A better design choice would be a default rule providing that a smart contract’s functionality trumps any provisions in a written operating agreement. For the typical DAO participant, how governance actually works is much more salient than what a legal document says about how it should work.

Consider offering a default class of non-capital membership interests.

Under the Vermont, Wyoming, and Tennessee laws, a member’s interest in the DAO would consist of both a governance interest and a capital interest, just like in a standard LLC. Many DAO participants do not understand the third order consequences of this, including federal tax disclosure requirements (which, in turn, may require a DAO to know the identities of all of its members in order to issue valid K-1s) and the potential applicability of U.S. securities laws. As such, for many DAOs, splitting economic and voting rights into separate membership interest classes may be preferable. States crafting DAO legislation could consider codifying such an approach into an out-of-the-box solution for DAOs.

Engage with industry experts.

Existing DAO legislation reflects a fundamental misunderstanding of blockchain technology and DAO culture. Fortunately, there are crypto-fluent legal practitioners and academics who are eager to engage with states considering DAO legislation. Bringing these voices into the discussion will lead to much better legislative outcomes.

Jordan Teague is an attorney and smart contract developer based in the U.S. In her crypto native law practice (www.antifirm.com), she focuses on governance, regulatory, and other legal issues facing web3 organizations. For advice and support with this research, Jordan thanks the DAO Research Collective.

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