July 1 marks the first time individuals and organizations in the blockchain industry can create a legally recognized Decentralized Autonomous Organization (DAO) in Wyoming. Prior to the law, which passed in April, no formal legal recognition of DAOs existed anywhere in the world.
Wyoming’s DAO LLC legislation represents the boldest attempt to close the gap between formalized corporate structures and unincorporated groups governed by rules coded in smart contracts. Regulators around the world should consider passing equivalent laws in their jurisdictions to ensure legal protection for those developing and participating in DAOs.
Failing to do so will result in continued regulatory ambiguity and increased risk for those operating in the blockchain industry.
1. Regulating DAOs
DAOs are informal organizations of individuals who rely on smart contracts to enforce collective decisions without human error or manipulation. Today, DAOs are frequently deployed for many purposes such as decentralized finance (DeFi) governance, fundraising, exchanges and real estate lending, all powering billions of dollars in transactions without intermediaries. The opposite of a formalized corporate entity, DAOs disrupt regulatory frameworks for entity formation and governance due to the lack of a centralized individual and/or group operating the entity.
For example, Elon Musk controls Tesla, and has controlling authority over whether Tesla will accept bitcoin as payment for Tesla cars. Imagine if, instead, all Tesla owners had this decision-making power and voted on whether Tesla would accept bitcoin. This represents the shift from authoritative to DAO collective decision-making.
While industry advocates believe this shift is the next evolutionary step in corporate governance, prior to the Wyoming DAO Law, DAO developers stood in legal limbo, unsure of their liability for acts carried out by the DAO. That’s still the case outside of Wyoming. Under current laws, most states in the U.S. would treat DAO participants as “partners” in a common law partnership, which exposes a participant’s personal assets to the DAO’s lawsuit settlements and liabilities.
Now, the Wyoming DAO Law formalizes protection for DAO developers by prohibiting lawsuits against DAOs as general partnerships as well as enforcing the rights of DAOs as legal persons in state court, thereby protecting the developers individually. No longer do developers have to grabble with the uncertainty of whether they could be held personally liable simply by creating a DAO. Wyoming provides DAO members with the same limitations on individual liability afforded to members of limited liability companies (LLCs).
2. The need for expansion
The DAO should no longer be viewed as an experiment, and other jurisdictions should seek to promote the expansion of blockchain technology by codifying laws recognizing the DAO structure and protecting developers, users, and stakeholders. DAOs currently hold billions of dollars in assets, and operate in many different industries, from fintech to real estate. To foster innovation and development, regulators should take immediate steps towards legally legitimizing the DAO structure.
In 1977, Wyoming became the first U.S. state to recognize the LLC structure. Eleven years later, the IRS ruled an LLC would be treated as a partnership for tax purposes and states started to pass statutes recognizing LLCs as an official business form.
The LLC was an experiment created by Wyoming in response to the need for a flexible business entity stripped of rigid corporate formalities attending the corporate form. It borrowed the best of both worlds from the corporation and the partnership: limited liability for shareholders and informal procedures for decision making by partners.
While the Wyoming DAO law does not set forth a radically new structure, it takes the first steps towards formulating regulatory standards and practices for DAO-based corporate operations. This will open the gates to allow further legislation built off of the DAO Law.
For example, we anticipate Wyoming passing legislation in the future that will legally recognize DAO structures in corporations, foundations, trusts and other corporate entity structures. This is just the beginning of how innovative DAO legislation can be, and collaboration between foreign jurisdictions would lead to further development.
The Wyoming DAO Law not only protects stakeholders in the industry, it also allows the traditional judicial system to evaluate and verify blockchain transactions and smart contracts as legitimate proofs of ownership and transfer. For example, DAO developers and users are now able to prove transactional history, voting rights, and decisions made via the DAO in court. Without legislative recognition of the DAO structure, far more ambiguity would exist within the courts over verifying these smart contracts, costing additional time and resources.
3. DeFi compatibility
With the massive expansion of DeFi, the DAO Law could be revolutionary in solving the ever growing disconnect between regulators and decentralized protocols. Even the largest DeFi protocols have little to no formal legal structure in place, exposing protocol developers to increased liability.
Of course, DeFi protocols are intentionally lacking a formalized entity, but this is typically a byproduct of protocol developers championing technological innovation and hoping they fly under the regulatory radar. Unfortunately, this stifles innovation due to the carried risk that deters entities from launching similar protocol structures.
A formalized DAO structure could provide legal security to entities looking to innovate in the DeFi industry. Currently, regulators deter DeFi protocol development by solely focusing on anti-money laundering issues arising from the developer’s inability to prevent anonymous protocol usage in foreign jurisdictions. While this is certainly a legitimate regulatory issue, the current approach is reactionary rather than proactive.
Decentralization at its core conflicts with bordered regulatory requirements. However, detering innovation solely on the basis of the technology not fitting squarely within the current regulation should not be the norm. Unfortunately, the current state of the industry is just that: disconnected. Formalized legislation would allow for far more innovation in the coalescence of DAOs and DeFi Protocols by expanding regulatory recognition of these technologically unique structures.
4. Room for improvement
The law possesses limitations that other regulators should further clarify in subsequent legislation. It is unclear whether a Wyoming-recognized DAO would maintain its legal status in a United States federal court case.
Additionally, if the DAO has a threshold number of members, would the reporting requirements of Section 12 of the Exchange Act of 1934 become a factor? Unless an exemption applies, an issuer that is not a bank, bank holding company or savings and loan holding company is required to register a class of equity securities under that act if: it has more than $10 million of total assets and the securities are held by either 2,000 accredited investors, or 500 persons who are not accredited investors.
Such companies are referred to as “Reporting Companies” and are required to meet ongoing disclosure requirements detailing material changes in the financial condition or operations of the issuer. Reporting companies must file periodic reports on Form 10-K and Form 10-Q and current reports on Form 8-K with the SEC. Future legislation should address these issues.
These unknowns cannot be clarified by Wyoming regulators alone. Other jurisdictions, domestic and foreign, need to follow suit to establish full legal standards and best practices for DAO operations. Most importantly, the U.S. Congress and European Union should be looking to the Wyoming DAO Law for guidance on this issue.
Many other legal issues are likely to emerge over time as DAOs are formed and go through various stages in their corporate lifecycles. While legal precedent involving LLCs and their members will be instructive in resolving issues with respect to DAO governance, taxation, and disputes, case law addressing issues unique to DAOs will develop over time. Wyoming’s DAO law lays the first brick on a long path towards a complete regulatory framework and widespread acceptance for DAOs.