Utah Legislature’s passage of its DAO (Decentralized Autonomous Organization) Act on March 1 vaults it into the lead in the race to regulate DAOs by granting them unprecedented recognition as legal entities. The Act, which goes into effect on January 1, 2024, recognizes DAOs as legal entities and offers these organizations limited liability protection. This groundbreaking legislation, which is formally known as HB 357, essentially grants DAOs legal personhood – separate from its members – similar to that enjoyed by traditional US corporations. Extending these liability protections to DAOs is a logical step, as they often are organized for the same purposes as corporations are formed, such as entering into contracts, acquiring assets, and performing revenue-generating services.
There are two main differences between typical corporations and DAOs. Firstly, DAOs are organized and automatically managed according to rules encoded on the blockchain rather than by corporate bylaws. Secondly, they are designed to be governed as a flat hierarchy without a central leader, with all members of the DAO voting on how the DAO is operated and managed. The blockchain code is transparent, with smart contracts written, proposed, and voted on by the DAO members. Once smart contracts are voted on by members, they automatically execute.
The legislation puts Utah at the forefront of the growing cryptocurrency and blockchain industry. Recognizing DAOs as legitimate, legal entities opens the door for greater innovation and growth within the sector. It also provides a level of legal protection and regulatory certainty to these organizations, which were previously operating in a nebulous legal environment.
Benefitting Utah and Furthering DAOs’ Missions
The Utah DAO Act is a transformative piece of legislation that has been crafted in response to the burgeoning interest in DAOs and their potential applications, particularly within the realm of Decentralized Finance (DeFi). The legislature, governor, and key industry participants came together to address the need for robust standards and protections for DAOs and token holders. By providing much-needed legal clarity and security, the Act reduces the potential for fraudulent activities and ensures a transparent and secure environment for DAO participants. This progressive move also demonstrates Utah’s willingness to set the standard for digital entrepreneurship. By embracing DAO innovations, Utah stands to attract innovative businesses and investments, further cementing its reputation as a leading financial hub. Other states keen on attracting crypto businesses and miners may soon emulate Salt Lake City’s recent legislative enactment.
As with any new law, the DAO Act will likely require amendments as technologies evolve and additional investor protections become necessary, but for now, Utah, along with other pioneering states such as Wyoming and Tennessee, has blazed a trail in the realm of blockchain law, providing the industry with much-needed legislative clarity and offering definitive legal protections to DAO members. The Act is a testament to what can be achieved when best practices from around the world are adapted to local circumstances and industry preferences.
Establishing DAOs’ Legal Status
By default, DAOs are not recognized as legal entities, a factor that has led to significant ambiguity in their operation and interaction with the existing legal framework. DAOs have had to opt for “legal wrappers” such as LLCs or unincorporated non-profit associations in order to operate and enter into contracts with other entities, despite these legal wrappers being ill-fitting for the DAO governance structure. Furthermore, in March 2023, a federal court in California held that DAOs could be considered to be general partnerships (Sarcuni v. bZx DAO). This is problematic for DAOs because it means there is a risk that members can be held personally liable for legal and financial issues with the organization. With Utah allowing DAOs to register as LLDs, however, the DAOs – rather than their members – secure the capacity to sue and be sued and carry out actions necessary or convenient to operate. It also means that the DAO can meet its liabilities through its assets, may be founded for any lawful purpose, and is to be considered an ongoing enterprise.
Under the new law, anyone who is endowed with governance rights in a DAO is considered a “member” of the Limited Liability Decentralized Autonomous Organization (LLD). This designation carries critical importance for maintaining privacy and minimizing liability. While these protections do not extend to individuals who involuntarily receive tokens giving them governance rights (unless they choose to exercise them through on-chain or off-chain activities), these non-managerial participants do receive other protections, as discussed in the next section.
To qualify as a Utah LLD, a DAO must meet and submit evidence of various technical and other requirements. These requirements include demonstrating that the DAO is deployed on a permissionless blockchain, has a unique public address for transaction review and monitoring, and that its software code is publicly available for review. The DAO’s code must also have undergone quality assurance and its smart contracts must be accessible via a graphical user interface that allows a person to read the value of key variables and monitor all transactions originating from, or addressed to, them. Furthermore, an LLD must have a publicly specified communication mechanism that allows a person to contact the registered agent of the DAO and provide legally recognized service. The LLD must also describe or provide a binding dispute resolution mechanism capable of resolving disputes with third parties through alternative dispute resolution.
Innovation and Accountability
The Utah Act imbues DAOs with the flexibility they need to deliver their inherent benefits while giving the government the assurance it needs in terms of financial reporting and consumer protection.
- Limited Liability – The limited liability status granted to LLDs ensures that the personal assets of organizers and tokenholders of DAOs are protected from the business’s liabilities. Similar to a limited liability company (LLC) or corporation, members of an LLD are not held personally accountable for the acts of the business. This means that the extent of a member’s financial liability is limited to their on-chain contributions to the DAO. In other words, if the DAO incurs any obligations or its assets are exhausted, members will not be held personally liable for covering the excess liability. This provides members with a layer of financial security, allowing them to participate in the DAO without risking their personal assets.
Additionally, the Act protects members from being held liable for the wrongful acts or omissions of other DAO members. This is crucial in a DAO setup where actions are typically governed by consensus and individual members may not have control over the actions of others.
Note that these protections are not absolute. If a DAO refuses to comply with an enforceable judgment, order, or award, members who voted against compliance can be held liable for monetary payments ordered. This liability is proportional to the member’s share of governance rights in the DAO. Furthermore, the Act’s limited liability protections do not cover a member’s personal liability in tort for their own wrongful acts or omissions.
- Anonymity – The legislation’s provision allowing DAO organizers and tokenholders to maintain their privacy while still operating within the confines of the law is a pivotal step toward fostering a conducive environment for DAOs. Only DAOs’ registrars must make themselves known to the state; the founders’ identities are redacted before any information is published. Although at least one individual organizer must be listed when a DAO’s bylaws are submitted, that person need not be a resident of Utah or even a United States citizen. This compromise enables DAO organizers and operators to remain anonymous while still providing the government with essential information about the entity.
The Act’s provisions that support anonymity work hand in hand with its limited liability protections. By enabling members to remain unidentified, the Act reduces the likelihood of them becoming entangled in litigation, whether meritorious or not.
Preserving DAO members’ anonymity has practical and financial benefits, as illustrated by recent court rulings. In cases like CFTC v. Ooki DAO and Sarcuni v. bZx DAO, it has been established that DAOs and their members could face litigation risk stemming from DAO activity. These cases highlighted that a DAO could be sued as an unincorporated association of its stakeholders under state law and that negligence claims could be made against not only the DAO itself but also against persons holding its tokens if they were alleged to be members of a general partnership.
- Taxation – The DAO Act promises to fundamentally change how DAOs operating within the United States handle their tax obligations. Before the Act’s passage, unregistered DAOs that paid US programmers for code development were required to file payroll tax returns and possibly apportion a portion of their revenues to the United States. This was due to the stipulation that any business with income effectively connected to a US trade or business must file a tax return, irrespective of whether the entity was legally organized within the United States.
The Utah DAO Act addresses this issue by allowing DAOs to formally organize themselves as legal entities. As a result, a DAO can now procure a US tax ID number and file its tax returns accordingly, thereby enabling it to operate legally within the country. This move not only legitimizes DAO operations but also helps them avoid accumulating large tax liabilities—an essential factor in ensuring the financial sustainability of these organizations.
The Act offers DAOs the flexibility to choose the type of entity that best aligns with their business plan, mirroring the options available to traditional LLCs. Just as an LLC can elect its tax treatment, now a DAO can do the same. This feature affords DAOs the ability to strategically manage their tax obligations based on their specific operational needs and financial goals.
“Essentially, the bill provides a way for DAOs to generate revenue for the state while protecting the DAOs from having an unlimited tax burden,” explains State Representative Trevor Lee, the law’s co-author. Hence, this landmark legislation not only benefits DAOs by offering them greater legal recognition and tax management flexibility but also benefits the state by generating additional revenue.
Implications for Other Jurisdictions
Utah’s decisive action positions the Beehive State as a competitive destination for Web3 development, akin to Delaware’s reputation as a haven for corporate entities. Lawmakers and task force members are hopeful that this legislation will not only attract domestic DAOs but also entice those from overseas.
There is optimism that the Utah DAO Act could pave the way for federal legislation. Often, federal laws are passed after enough states enact similar laws at the state level. The experimentation with DAO legislation in these “state laboratories” of blockchain law could benefit an industry seeking legislative and regulatory clarity and consumer DAO members seeking certain legal protections.
However, the proliferation of state legislation also risks fragmenting the approach to DAO regulation. In addition, the U.S. faces competition from offshore locales such as the Marshall Islands, which are making it easy and convenient for DAOs to set up in their jurisdiction. These locales offer DAOs the same limited liability protection as an LLC, extending to the assets of the DAO and its members.
Enthusiasm among some international DAOs is also tempered by concerns regarding regulatory uncertainty and potential legal repercussions stemming from U.S. securities laws. Many DAOs currently operate outside the U.S. due to this uncertainty. Some, both within and outside America’s borders, are concerned that the Utah DAO Act may conflict with federal laws promoting transparency. For example, the Corporate Transparency Act requires reporting companies to file a report identifying their beneficial owners. The Financial Crimes Enforcement Network (FinCEN) specifies that unless an exemption applies, reporting companies must provide detailed personal information for each beneficial owner. It remains to be seen whether an LLD member or DAO tokenholder will be deemed a “beneficial owner” under the terms of the CTA and the FinCEN Reporting Rule. The future of DAO legislation, therefore, lies in striking a balance between maintaining anonymity, ensuring legal compliance, and promoting transparency.
The Utah DAO Act represents a significant stride toward integrating DAOs within a more secure and recognized legal framework. This move is not just innovative but also distinct from initiatives undertaken by other pro-DAO jurisdictions. The Act’s provisions enabling Utah DAOs to register as cognizable legal entities, along with extending limited liability to their members akin to corporate shareholders and LLC members, are pivotal developments.
These measures have opened up new avenues for innovation, particularly in areas involving smart contracts, decentralized finance, and other applications. The use of blockchain tokens to maintain a highly liquid and negotiable membership registry further underscores the forward-thinking approach embodied by this legislation.
However, the path ahead is not without its potential challenges. The Act’s provision for anonymity in Limited Liability DAO membership could face hurdles in a world that increasingly demands transparency about entity ownership. The question arises: can the inherent anonymity or pseudonymity of blockchain tokens, which are central to determining membership and governance in DAOs, align with these legal requirements?
While it’s unclear how these issues will be resolved, it’s evident that the Utah DAO Act marks a bold experiment in reconciling blockchain innovation with traditional legal structures. Regardless of whether the world is ready for entities like the Utah LLD, such pioneering efforts by states to promote innovation are likely to shape the future landscape of DAOs and similar entities.
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