New Tennessee law recognizes DAOs as business entities

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On April 20, 2022, Tennessee became the second state in the United States to create a Specialized Business Entity for Decentralized Autonomous Organizations (DAOs), an emerging collaborative management structure for legal entities using blockchain technology.1

The new legislation amends Title 48 of the Tennessee Code to allow Tennessee Limited Liability Companies (LLCs) to register as “decentralized organizations” by including new elective language in their bylaws.2

According to the bill’s sponsor, the new law aims to make Tennessee “a beacon for blockchain investments, new jobs, and investments.”3 Indeed, some have observed that DAO assets under management could reach US$1 trillion over the next decade.4 DAO proponents have attempted to illustrate this inevitable growth by making the analogy that “DAO is to LLC what e-mail is to mail.”

By offering limited liability protection to decentralized organizations, Tennessee has removed a significant barrier to the wider adoption of DAOs as business entities.

CONTEXT ON DAOS

There are several types of organizations that can be called DAOs;5 most have in common the collaborative management of digital assets using technological tools derived from public network blockchain systems. For example, a DAO might be a business organization governed using tools derived from a Web3 or other distributed ledger environment. As the name suggests, the management of a DAO is intended to be “decentralized” in the sense that there is no requirement for a centralized governance authority, such as a board or director, and its members agree to manage the DAO by voting using “smart contracts”, rather than traditional corporate voting procedures. The DAO can use smart contracts to automate certain management and economic processes, with members providing only the necessary information to the entity, making the entity nominally “autonomous” or, where members have voting rights, “quasi-autonomous” in the sense that the DAO uses the code to effect the decisions of its constituents.

Among many potential applications, DAOs have been used by companies where there is a perceived benefit for “community decision-making” and a strong desire to avoid censorship of other members’ ideas or expressions. For example, a DAO based partly in Nashville, Tennessee, operates a group chat forum where users can monetize their discussions. Still other DAOs have been structured as investment holding companies or groups of investors who wish to organize for a single investment purpose. These entities may contract with a management organization to oversee certain investment functions and perform due diligence on potential acquisition targets. Similarly, a DAO could be affiliated with an operating company for the purpose of rewarding and incentivizing service providers.

THE NEED FOR LIMITED LIABILITY PROTECTION

The predicate of many DAOs is the collective management of an asset or business, such as a business or other valuable asset (tangible or intangible), in which each member may hold a fractional interest. Yet, in addition to the risks associated with regulation and securities laws, whenever valuable assets are invested and held by an organization, the risks and liabilities associated with owning those assets and operating of the company must be adequately proportioned between the participants of this organization.

Earlier this year, a case in the Southern District of California tested whether a decentralized organization, which delegates decision-making to a computer program, would provide de facto limited liability protection to its members. In May 2022, plaintiffs in Sarcuni et al v bZx DAO et al., filed a federal lawsuit in the Southern District of California against bZx DAO, which operated a decentralized finance (DeFi) protocol for “trading and symbolic margin lending”.6 Despite claims to its members that the DeFi protocol was secure, a hacker was able to gain access to private software keys in a bZx developer’s wallet through a phishing attack. The hackers were then able to modify bZx’s DeFi protocol, which resulted in the theft of US$55 million worth of cryptocurrency from bZx.seven In their complaint, the plaintiffs argued that:

Since Protocol has not reimbursed what was taken as a result of Protocol’s negligence, all of these defendants are jointly and severally liable to repair plaintiffs. Indeed, the bZx protocol claims to be a so-called DAO, or Decentralized Autonomous Organization, devoid of any formality or legal recognition. There is another term in US law for this kind of arrangement: general partnership. This means that each of the partners is jointly and severally liable towards the plaintiffs and must reimburse the total amount of their debts.8

As the bZx case illustrates, without a statutory framework providing limited liability protection, a court could infer an entity from the members of an unincorporated or “legal” DAO, such that any given member could be liable. debts, obligations and liabilities of any other member, all members, or for “the DAO” itself.9 Fortunately, properly trained DAOs in Tennessee can enjoy the same limited liability protections afforded to members of an LLC.ten

THE STATUS OF TENNESSEE

Tennessee law, Tenn. App Code 48-250-101 and. seq., provides a basic framework for creating a DAO under state law. Following this framework, a properly organized DAO in Tennessee will be able to offer its members the same limited liability protections afforded to a traditional LLC. In summary:

  • At least one member must sign and deliver the articles of association to the Secretary of State for filing. The person forming the decentralized organization does not need to be a member of the organization.

  • A DAO’s governing documents must contain a statement that “the company is a decentralized organization”.

  • Alternatively, DAOs can be formed as an LLC and then later converted to a DAO through an amendment to the LLC’s articles of association.

  • Certain notices regarding potential restrictions on rights and transfers in a DAO, and how those restrictions may be materially different from those in an LLC, should be included in organizational documents.

  • A DAO’s registered name must include the words “DO”, “DAO”, “DO LLC”, or “DAO LLC” to indicate its status as a decentralized organization.

  • The DAO’s bylaws should define whether it is a “member-driven” or “smart-contract-driven” DAO. If a DAO is not specified to be managed by a smart contract, the presumption will be that the DAO is managed by a member. The smart contract, if any, must be able to be modified and a publicly available identifier of a smart contract directly used to manage, facilitate or operate the decentralized organization must be included.

  • The organization must be based in the United States and its territories.

Whether Tennessee will become the “Delaware of DAOs” remains to be seen.11 DAOs may not be suitable for all types of corporate organization, and governance through smart contracts does not guarantee better decision-making compared to conventional corporate governance procedures. Yet, as digital currencies continue to gain market acceptance and regulatory enforcement becomes more transparent and predictable, the prevalence of member-run DAOs enabled by automation-driven smart contracts and the democratization of corporate governance is likely to be a growing trend for certain types of companies. .


FOOTNOTES

1 Tenn. Coded. Ann 48-250-101 et seq.; HB 2645, https://www.tba.org/docDownload/1943411

2 https://www.tba.org/?pg=Articles&blAction=showEntry&blogEntry=73474

3 https://www.nashvillescene.com/news/pithinthewind/tennessee-becomes-seco…

4 https://www.businessinsider.com/crypto-venture-fund-cofounder-dao-vc-ass…

5 See usually https://blog.ethereum.org/2014/05/06/daos-dacs-das-and-more-an-incomplete-terminology-guide/ initially offering the term applied to distributed enterprises operated on blockchains; the legal and legal daos described here are closer to entities classified as DAC by Buterin.

6 Sarcuni, et al., v. bZx DAO et al., No. 22-cv-618, Complaint (SD Cal. May 2, 2022)

seven ID.

8 ID. to 3 (emphasis added).

9 See, for example, https://www.coindesk.com/markets/2016/05/19/the-law-of-the-dao/. For a discussion of the disadvantages of organizing via a “legal dao”, see https://jcl.law.uiowa.edu/sites/jcl.law.uiowa.edu/files/2021-08/Hinkes_F… , at 884-885

ten See Tennessee Code § 48-250-109

11 https://www.nashvillescene.com/news/pithinthewind/tennessee-becomes-second-state-to-pass-dao-legislation/article_ecbd4cbe-b5e2-11ec-abe0-77a2385be512.html

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