[co-author: William de Sierra-Pambley*]
It is called the Cowboy state for a reason. With varied terrain and a hearty population Wyoming has long been a haven for independent thinkers and doers – pioneers. The Wyoming legislature recently underscored that truth with the first state law addressing governance issues for decentralized autonomous organizations or “DAO(s).” We are not talking self-driving vehicles here. Those will not work on Teton mountain road switch backs. This is all about future vision of decentralized digital finance. A new gold rush for the west for those states who embrace it and Wyoming is doing just that. This March it passed senate bill SF0038 which provides for additional protections similar to those offered to members of limited liability companies for members of a DAO.[1]
What is a DAO?
A DAO is an “organization” managed by rules encoded in computer code or “smart contracts” built on distributed ledgers such as a blockchain, rather than by a hierarchical management like say a board of directors who sit in a walnut paneled room “back east.” Smart contracts allow a DAO to automate organizational governance and decision-making in a trackable, predetermined manner.
Typically, the DAO governance is delegated to owners of DAO tokens that provide governance rights. A DAO’s financial and transaction records can be maintained on digital ledgers to track financial interactions without fear of forgery or alterations to those records. Oftentimes, the same developers who initially create these organizations are responsible for composing the underlying smart contracts. Usually, the developers initially will have a significant number of tokens and the associated governance rights. However, the developers eventually cede control as the number of tokens held by others increases. As a DAO grows and matures, with a more diverse base of token holders, it takes on a life of its own. Some DAOs also award tokens to individuals whose actions benefit the DAO—like developing code, or providing bandwidth to the network—which give the holders governance rights.
For DAOs to achieve mass adoption, technical limitations must be addressed. As a product of virtual construction, they are vulnerable to incompetent design, insecure smart contract systems, security vulnerabilities, and potential adverse consequences resulting from updates to the smart contracts. These are tough obstacles to overcome. A well-known example of such limitations is “The DAO,” which was initially designed for venture capital funding purposes. The DAO pooled members’ cryptocurrency assets in exchange of DAO Tokens representing their interest in The DAO. Additionally, members could monetize their DAO Tokens by re-selling them on various cryptocurrency exchanges. In 2017, the Securities and Exchange Commission issued a report stating that DAO Tokens issued by The DAO were securities subject to SEC regulation.[2] However, cyber-attacks exploited vulnerabilities in The DAO’s smart contracts to siphon funds away from investors, and The DAO is now defunct.
Wyoming’s Legislature Leads the Way with a New Law Governing DAOs.
Since 2017, people have continued to form and operate DAOs to capitalize on the benefits of blockchain technology. But DAOs have received little legal analysis or recognition until recently when Wyoming passed its Decentralized Autonomous Organizations Supplement in March, 2021 (SF0038). Regulators have been slow to respond because DAOs present a unique problem: Who is responsible when something goes wrong?
Actions taken by the SEC and the CFTC have addressed developer liability for cryptocurrency trading platforms. In 2018, the SEC brought an enforcement action against the creator of online cryptocurrency exchange, EtherDelta, for operating an unregistered national securities exchange.[3] The CFTC has also issued statements indicating that the appropriate question for developer liability is whether the developer could “reasonably foresee, at the time they created the code, that it would likely be used by U.S. persons in a manner violative of CFTC regulations.”[4]
DAOs are not currently recognized as a unique legal entities. Unless a DAO is organized as a corporation or LLC, they are likely subject to partnership principles. This means that a single investor, no matter how small their stake, could be liable for any harms the DAO causes regardless of his or her direct participation in the harmful events. This is a scary proposition if the DAO is organized in a state whose courts are prone to awarding large plaintiff judgments. Such unlimited liability also acts as a disincentive for investors looking to place a stake in the new frontier of digital finance. However, the limited liability inherent to corporate form could come at the cost of centralizing decisions to a few people, thereby undermining the decentralized goals of many cryptocurrency investors, particularly those interested in DeFi. Fortunately for potentially interested parties, Wyoming’s legislature has tackled these concerns head on by providing clarity and enhancing the state’s digital financial friendliness.
Back in 1977, Wyoming was the first state to authorize the creation of limited liability companies or “LLCs.” Today, LLCs are the single most prevalent business form in the United States. Time may have passed since then, but the pioneer spirit endures. With its DAO Supplement bill, Wyoming has become the first state to regulate DAOs, recognizing them as a distinct form of the limited liability company. This recognition endows DAOs with the multiple benefits characteristic to LLCs, including limited liability for its owners, a more flexible management structure than is permitted in other corporate forms, and potentially advantageous default rules.
The Wyoming bill also provides that a DAO’s articles of organization may define a DAO as member managed or algorithmically managed. An algorithmically managed DAO, which would truly be decentralized, may only form if the underlying smart contracts are capable of updates or modifications. To address possible conflicts between a DAO’s articles of organization, operating agreement, and the underlying smart contracts, the bill established a hierarchy. Through the creation of statute 17‑31‑115, the bill enounces that, “[w]here the underlying articles of organization and operating agreement are in conflict, the articles of organization shall preempt any conflicting provisions. Where the underlying articles of organization and smart contract are in conflict, the smart contract shall preempt any conflicting provisions of the articles of organization, except [in limited circumstances].” Thus, Wyoming’s bill expressly recognizes the smart contract as the primary document governing the rights of DAO members when organized under the new bill.
Wyoming’s governor signed the bill into law on April 21, and the bill becomes effective as of July 1, 2021. Wyoming’s recognition of DAOs will likely spur other states to play catch up and enact similar laws in the rush to attract digital financial investments to their jurisdictions. Individuals or entities that wish to form a DAO will need to stay up to date with the constantly shifting landscape as state regulators are pressured to begin recognizing this new form of business organization. For now though, early investors in a DAO may want to skip the scrapple out east, and saddle up to a steak in Wyoming. It’s a safer bet.
However, DAOs must remain wary of federal regulations. Although Wyoming now offers a streamlined method for forming a DAO and limiting liability for investors, the DAO’s operations could subject the developers, or managers to enforcement actions by the SEC or CFTC. The SEC has long applied the Howey investment contract test to determine whether an agreement is subject to federal securities laws. See S.E.C. v. W.J. Howey Co., 328 U.S. 293 (1946). Under that test, “every cryptocurrency, along with the issuance thereof, is different and requires a fact-specific analysis.” S.E.C. v. Kik Interactive Inc., 19 Civ. 5244 (AKH), *19 (S.D.N.Y. Sep. 30, 2020) (holding token at issue was subject to securities laws). SEC Commissioner Hester Peirce released a new safe harbor proposal for token sales on April 13, 2021.[5] If adopted, the proposal would provide a three-year safe harbor from SEC securities regulations for developers creating a decentralized network if certain conditions are met.
*William de Sierra-Pambley is a Law Clerk in our Finance & Bankruptcy Practice Group.
[1] Wyoming Decentralized Autonomous Organization Supplement, SF0038, 66th Leg., Gen. Sess. (2021). The bill creates Wyoming statutes W.S. 17‑31‑101 through 17‑31‑116.
[2] SEC, SEC Issues Investigative Report Concluding DAO Tokens, a Digital Asset, Were Securities, (July 25, 2017) http://www.sec.gov/litigation/investreport/34-81207.pdf [as of May 24, 2021].
[3] SEC, SEC Charges EtherDelta Founder With Operating an Unregistered Exchange, (Nov. 8, 2018) https://www.sec.gov/news/press-release/2018-258 [as of May 24, 2021].
[4] CFTC, Remarks of Commissioner Brian D. Quintenz at the 38th Annual GITEX Technology Week Conference, (Oct 16, 2018) https://www.cftc.gov/PressRoom/SpeechesTestimony/opaquintenz16 [as of May 24, 2021].
[5] Commissioner Hester M. Peirce, Token Safe Harbor Proposal 2.0, (Apr. 13, 2021) https://www.sec.gov/news/public-statement/peirce-statement-token-safe-harbor-proposal-2.0 [as of May 24, 2021].
