The New DAO Model: Legal Protections for Unincorporated For-Profit Associations

There are nearly 5,000 decentralized autonomous organizations (DAOs) in the world, which, collectively, have advanced the growth of the billion dollar Web3 market, led to experimentation with new models of economic cooperation, and catalyzed entrepreneurial activity in America. While these contributions are a boon for business dynamism, the unincorporated nature of DAOs has major flaws. One of those flaws is that DAOs are a corporate governance design nightmare. Without a formal entity structure that is legally distinct from a DAO’s membership body—members can be held personally liable for the wrongful actions of any member of the DAO. All it takes is one bad actor to taint the entire enterprise.     

The Commodity Futures Trading Commission (CFTC) exposed this design vulnerability in September 2022 when the agency filed a civil enforcement action against Ooki DAO in the U.S. District Court for the Northern District of California. Two reasons for the regulatory action, among other violations, included the founders’ failure to register the decentralized blockchain-based protocol (which effectively functions similar to a trading platform) and the failure to incorporate a customer identification program that screens out bad actors engaged in illicit finance. Without an appropriate legal entity wrapper, such as an “LLC” or “corporation” designation, Ooki DAO is simply classified as an unincorporated association, a default type of informal entity that has no legal personality and that is created when people join together and cooperate towards a common goal. Examples of this entity type in the non-Web3 world include a club or amateur sports team. 

The CFTC’s action against Ooki DAO is significant because it hurls the threat of unlimited personal liability, a key characteristic of unincorporated associations, into the face of several hundred, if not thousand, DAO members worldwide. The CFTC’s theory of liability rests on partnership law, which means that individual DAO members could also be treated as partners and held liable for the actions of other members regardless of their involvement in the misconduct. 

The Ooki DAO case raises several interesting legal and governance questions and underscores the immaturity of the architectural design of unincorporated DAOs. For example, without a designated registered agent, how can service of process be constitutionally delivered? Without centralized management, which member will prosecute or defend a lawsuit? Without knowing the names and identities of DAO members or how to contact them, how will regulators practically enforce fines or injunctions? If no one can be held responsible, then how is bad behavior deterred?  Other questions might arise with regards to compliance with federal regulations, the payment of taxes, and the enforcement of legal restitution. 

Since 2018, states have been working to address these issues. State legislatures are responsible for enacting statutes that authorize new organizational forms, a privilege that was historically granted under Roman law and by English kings. Vermont, Wyoming, and Tennessee, have enacted DAO-LLC statutes to provide an alternative LLC-style wrapper of limited liability for DAOs, similar to their traditional LLC counterparts. DAO-LLCs can be managed by members or smart contracts, but in some states, these alternative LLC entities have more corporate formalities than traditional LLCs. The DAO community has also repurposed other state incorporation statutes for its needs. For example, some DAOs use Colorado’s Uniform Limited Cooperative Association Act to form cooperatives, which allows members to distribute profits to active members and to prevent outside investors from participating in ownership. DAOs can also form as Series LLCs under the laws of Wyoming and Delaware, which is a popular option among DAO venture capital funds.

While these LLC-style DAO structures may suit the risk-adverse thanks to the attractiveness of the LLC’s limited liability status, in many cases the end result looks less like a DAO and more like a highly structured traditional company with advanced technology-enabled corporate governance. By contrast, many existing first-generation DAOs, like Ooki DAO, are entirely decentralized, have no legal status, exist virtually, and lack a physical location for their corporate headquarters. Unlike LLCs and corporations, the amorphous, unstructured model of unincorporated associations seem to be a more fitting legal wrapper for DAOs. 

With this in mind, how should the law for unincorporated associations be modernized to give greater protections to DAOs?     

One option is for states to enact customized statutes that protect unincorporated associations and their members from unlimited liability while also addressing some of the legal and governance questions raised by the Ooki DAO – CFTC showdown.  For example, state statutes could specify any combination of the following: whether DAOs are eligible to effect mergers, how many members constitute a DAO, how members can be expelled from a DAO, whether or not DAO members and administrators have liability to one another and third-parties, how service of process is served, and whether the DAO can transfer or hold an interest in real and/or intellectual property.  The state of Texas has been breaking ground on the development of a new DAO legal wrapper and has already introduced a statute (HB 3768) relating to the formation of decentralized unincorporated associations. The Texas statute addresses many of these novel legal issues.

Other than customized state law, the Uniform Law Commission’s Uniform Unincorporated Nonprofit Associations Act (UUNAA), which was last revised in 2011, may also provide answers. While the Act applies to unincorporated nonprofit associations, like garden clubs and political committees, the Act addresses many of the basic legal and governance issues that plague unincorporated for-profit DAOs. While nonprofit DAOs could certainly use the existing version of UUNAA to create a legal wrapper of liability protection without the hierarchical corporate formalities that a traditional 501(c)(3) requires, the UUNAA could also serve as a useful basis for crafting a new model Act that is geared specifically towards for-profit unincorporated associations. 

Pursuant to UUNAA, unincorporated nonprofit associations have legal entity status that allows them to own and convey property and sue and be sued in their name. The Act also provides personal liability protection to members and managers and sets out default voting and governance rules, unless the association has an established process to the contrary. The IRS also recognizes unincorporated nonprofit associations as tax-exempt entities. Despite these advantages, only a handful of states, including Arkansas, Iowa, Kentucky, Nevada, and Pennsylvania, and the District of Columbia have adopted the revised Act. Because many other state statutes govern unincorporated nonprofit associations according to a common law aggregate theory, the UUNAA fills an important gap in liability protection for unincorporated associations that desire a flexible, low maintenance entity model and amorphous structure.

The Uniform Law Commission and state legislatures should consider a uniform Act applicable to unincorporated for-profit associations and possibly even a specific version for DAOs. One default rule for these entities might be that liability is restricted to the DAO treasury, rather than DAO members. Other liability rules would have to be devised specifically for tort liability. For example, there could be a balancing test to determine whether there was a concentration of management that would exempt from shared liability any other members that more resembled rank and file employees. By providing entity status to an unincorporated association, individual members, if harmed, would also be able to seek recourse from the entity itself rather than the aggregate of all members. A model Act may be easier for other states to customize and adopt, while also providing greater clarity of legal treatment of unincorporated for-profit DAOs across the United States and possibly even globally.   

DAOs need novel business organization models—flexible enough to support decentralization and virtuality, with freedom from the constraints of traditional corporate formalities, like board of director requirements, and combined with liability protection that deters bad conduct while encouraging member participation. While the CFTC charges against Ooki DAO might seem appropriate, this example should prod us to think about how America might encourage collaboration and cooperation in our business and social dealings. States can play a lead role in this effort by rethinking corporate governance design and enacting statutes that craft and protect legal entities that support new ways of doing business.