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Decentralized Autonomous Organizations: The New LLCs?

Aug. 2, 2022, 8:00 AM

Behind the recent volatility of crypto asset prices lies the disruptive technology of blockchain and the distributed, decentralized ethos that spawned it. And a new kind of corporate structure designed to fit the culture behind this technology has emerged: decentralized autonomous organizations.

Just as LLCs were widely adopted in the 1990s, DAOs may soon become a more popular corporate form. Unlike traditional corporate structures where the goal is to centralize decision-making, DAOs decentralize control, vesting power and purpose among tokenholders themselves. Unsurprisingly, these organizations raise legal questions.

What Is a DAO?

Conventional corporations centralize power in a governing officer or board that steers the organization based on what it determines is in the best interest of its shareholders. One variation on this model is the public benefit corporation, which may consider the public good alongside the mandate to increase shareholder value.

Some companies behind crypto projects have organized as PBCs (prior to DAOs being viable options) so that their operational decisions—such as what to do with their IP—and be guided by the best interest of their communities in addition to fiduciary duties to “owners.” But PBCs still centralize decision-making power in the hands of a few.

DAOs decentralize control by forgoing the traditional board or executive officers and distributing decision-making power across tokenholders. Governance is conducted through a series of proposals that members vote on using blockchain. Because tokens are exchangeable and regularly change hands, the voting cohort is dynamic.

While the specific governance rules vary from DAO to DAO, in general, whoever holds a token gets a vote. For many DAOs, tokenholders remain anonymous and are identified only by their wallet addresses. The backbone (and much of the perceived stability or instability) of the DAO is its treasury; some DAOs (such as Uniswap and BitDAO as two of the largest) have millions or even hundreds of millions of dollars’ worth of value locked in smart contracts controlled by tokenholders.

DAOs allow for the coordination of capital and human effort from potentially thousands of individuals with a vested stake in the DAO. However, when the first DAOs were formed without any legal form or formal government recognition, token holders began raising concerns that they would be subject to unlimited personal liability for the actions of the DAO.

Without a recognized corporate form, the law assumes that individuals working together in a common enterprise have formed a general partnership and, unlike stockholders, the token holders would not be immune from personal liability resulting from the DAO’s conduct.

Currently, only Wyoming, Tennessee, and Vermont specifically allow for DAOs to be formed as a species of an LLC. However, to avoid having to comply with US securities laws, many DAOs have chosen to organize offshore in places like the Cayman Islands where corporate regulations are more lax and tax impacts are limited as compared to US jurisdictions.

We have also seen a rise in DAOs forming under flexible LLC laws, particularly in Delaware. Formation as an LLC has been rejected by some in the DAO community, in part because the inherent government intrusion and regulation runs counter to the ethos of decentralization. However, by forming under a state’s LLC laws, DAO members will have increased certainty regarding liability.

The emergence of DAOs as a corporate form presents significant legal issues for lawyers advising traditional corporate clients, including those looking to do business with or invest in DAOs:

  • Where does the buck stop? In more conventional corporate models, the board or executive officers are publicly identified and accountable for the conduct of the organization. Shareholders can demand a review of leaders’ actions or file lawsuits. But with most DAOs it is unclear who, if anyone, bears the burden of accountability. In fact, it may be difficult or even impossible to determine the identity of the token-holding members. Promoters, founding members or those with larger roles within the DAO may have more exposure to such claims, but this remains untested.
  • Who’s the fiduciary? Unlike the clearly defined fiduciary duties within corporations, DAOs do not have specific legally defined duties for token holders who are taking actions on behalf of the DAO. This creates opportunities for self-dealing and other problems that stem from conflicts of interest.
  • Is it capable? When DAOs lack a formal legal personhood (like an LLC), it is unclear whether and to what extent they have the ability to take actions like entering into contracts, hiring employees and suing in their own name. If you enter into a contract with a DAO, it will likely be difficult to know your contract is “authorized” unless it’s specifically approved through a vote of the token holders, leading to potential delays and added steps to doing business.
  • Who am I dealing with? Companies typically perform due diligence and Know-Your-Customer reviews on business partners. This presents unique challenges for DAOs when it’s impossible to know the actual identity of many members.

These are but a few of the many issues that arise when forming or dealing with a DAO. While in their infancy now, DAOs could be the 2020s equivalent of the LLC in the 1990s, effectively changing the landscape of corporate organization and stakeholder liability.

As DAOs become more prevalent in the United States, it will be interesting to watch how they will be treated in the courts, potentially as “pseudo partnerships,” with each token holder liable for the actions of the rest. Only time (and judges, of course) will tell whether DAOs are the corporate equivalent of a digital revolution or merely a flash in the pan relegated to textbooks as an interesting but not widely adopted concept.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Andrew Gilbert is a partner with Croke Fairchild Morgan & Beres, where he focuses his practice on private M&A transactions, venture capital, and business counseling.