Abstract
ATX DAO’s general position is that small modifications to the existing LLC statute language would fully encompass the needs of decentralized autonomous organizations (DAOs). We also believe that the main goal behind recommendations for DAO legislation should be to provide legal clarity for DAOs and send a resounding message to the rest of the country that Texas is open to crypto business. Our research is focused on two primary topics:
- New technologies: Recognizing common concerns from legislators in regard to DAO legislation, we highlight new technologies that can offer transparency. We believe these technologies should be part of the DAO legislative language hereafter. Namely, we discuss the benefits of reusable KYC, Zero Knowledge proofs, and Ricardian contracts.
- Anonymity: We explain how DAOs could operate under the current LLC statute, and why anonymity is important for DAOs, especially regarding the financial privacy of members and minimizing security vulnerabilities..
In addition, we illustrate how new technologies may be used to address issues that both DAOs and regulators may have with the current framework, and also highlight the many benefits to transparency that arise from the use of blockchain technology for social organization.
To close, we discuss some concerns that arose during our research of the LLC statute as a framework of operation for DAOs. We analyze the sections that create those tensions and suggest simple language changes that could be implemented to mitigate said concerns.
Thank you for the opportunity to present our research for consideration to the Texas Work Group on Blockchain Matters.
Introduction
Published in 2014 by Vitalik Buterin, the Ethereum whitepaper contains perhaps one of the best and simplest descriptions of the differences between Ethereum and Bitcoin, and the myriad use cases that it may facilitate.
It reads:
“Satoshi Nakamoto's development of Bitcoin in 2009 has often been hailed as a radical development in money and currency, [...]. However, another, arguably more important, part of the Bitcoin experiment is the underlying blockchain technology as a tool of distributed consensus. [...]. What Ethereum intends to provide is a blockchain with a built-in fully fledged Turing-complete programming language that can be used to create "contracts" that can be used to encode arbitrary state transition functions, allowing users to create any of the systems described above, as well as many others that we have not yet imagined, simply by writing up the logic in a few lines of code.”
The genius of Vitalik and the Ethereum team was to look at the blockchain not just as a means to solve the double-spending problem, but as a tool of distributed consensus upon which myriad applications and use cases could exist.
People quickly caught up to this idea and, as several applications, tokens, and NFTs emerged on the platform, the community realized that the blockchain could also be used as a means of decentralized governance and decentralized operations. On April 30th, 2016 the Ethereum Decentralized Autonomous Organization (“The DAO”) launched and raised $168M in a matter of weeks. Albeit being hacked for $55M not even two months after the launch, and leading to the infamous Ethereum hard fork, “The DAO” set a movement in motion.
Six years later, this DAO movement has grown to unimaginable proportions. Decentralized Autonomous Organizations are democratic representations of a collective mission, functioning independently to achieve that mission.
DAOs have become the de-facto organizational structure for many crypto projects, have spread to several use cases - from investment to politics to space exploration and more -, and have expanded to virtually every blockchain that supports smart contracts. DAOs now drive technological and economic innovation, social and governance research, and, as it pertains to this testimony, legal discussions.
ATX DAO is dedicated to making Austin, and Texas, the crypto capital of the world. We do that by educating and promoting crypto projects with local artists and businesses, connecting the crypto communities of Austin and Texas, and advising local and state governments on crypto policy.
Under the context of crypto policy, we appreciate the opportunity to testify in front of the Texas Work Group on Blockchain Matters on the topic of DAO law and relevant new technologies. We will highlight the following topics:
- ATX DAO’s general position on DAO Legislation
- Introduction to new technologies relevant to the discussion: Ricardian Contracts and Reusable KYC
- Explanation of the importance of anonymity for DAOs and how existing DAOs might operate under the existing LLC framework.
- General considerations on the current LLC statute for DAOs
We do not make these statements as legal professionals. We are technologists, business owners, engineers, and other professionals who are interpreting our understanding of and challenges we experience within the existing legal framework for operating businesses in the state of Texas.
On DAO Legislation
DAOs have become the cornerstone of blockchain development and catalysts of governance, economic, and social innovation. Texas and its citizens would not only benefit from the innovations DAOs would bring, but would also financially benefit from the franchise tax or other revenue streams from these organizations.
Hence, categorically, if Texas wants to become a model for blockchain innovation in the United States and beyond, it must start considering explicitly recognizing DAOs as legal entities in the state. Nonetheless, we do not believe that further establishing Texas as a blockchain hub needs to come at the expense of legal pragmatism, as it may have in other states.
Many of the existing legal structures for corporate entities in Texas enable individuals to engage in business practices with limited liability. These structures need not be reinvented for web3, at least in the first instance.
When it comes to DAO legislation, we believe that the most impactful approach for the state, its economy, and its vibrant crypto ecosystem is to focus on providing legal clarity for DAOs and sending a resounding message to the rest of the world that Texas is here, and we are open to crypto business. In encouraging such business in Texas, we should be careful not to implement solutions that look enticing on paper but don’t work in real life. It is critical that any laws or regulations implemented in Texas be grounded in pragmatism, scalability, and clarity.
We believe this can be accomplished with small amendments to the existing LLC statute language to explicitly encompass DAOs. We see this as an excellent first step, which makes meaningful progress towards our goal without sacrificing practicality. Showing leadership in this way will establish Texas as a decisive innovator in the changing Web3 landscape.
While we initially suggest some changes for consideration to the existing LLC statute, we still believe that certain additional items need to be part of the discussion regarding DAO legislation from here on out. Specifically, the discussions that the work group will have ahead of its final recommendation, and the subsequent discussions carried out by legislators and their offices must include new relevant technologies, member anonymity, and membership expectations - all of which we go into detail in this document.
New Technologies
Two of the biggest concerns that are often brought up when discussing the recognition of DAOs as legal entities are, first, Money laundering, and, second, how to ensure that the smart contract that codifies the DAO on the blockchain matches the legal agreement that all the parties involved initially entered.
Leaving aside, for now, the precise legal means to recognizing DAO entities - whether that comes from an entirely new corporate structure or via small changes to existing statutes - there are two new technologies that address those concerns directly.
Reusable KYC
To understand the use case of reusable KYC (know your customer) in crypto, one must first understand the current on-ramp and off-ramp infrastructure in the space. Any system that enables a user to exchange fiat for crypto is considered an on-ramp and, conversely, anything that enables a user to exchange crypto for fiat is considered an off-ramp.
Currently, most systems that provide on/off ramp solutions require some form of KYC practice or, in the few cases where those requirements don’t exist, severe limitations on transaction amounts are implemented. The KYC process includes collecting customers’ personally identifiable information, and official government ID, and comparing this information against official databases that contain information on sanctioned individuals.
For outsiders and many regulators, crypto has a negative image of being used for criminal activities. Although this has been proven to be a myth, that negative perspective still influences KYC/AML discussions in the space today. Although many crypto purists believe that KYC is antithetical to the ethos of the crypto ecosystem, there is no doubt that good KYC practices can help limit illegal activity in the industry and drive mass adoption.
The issue is that the current KYC ecosystem is fully dissociated and the management of the data is subject to the terms of service of each one of these corporations - which is no different than the current “web2” landscape. This is where reusable KYC can help. Reusable KYC systems enable a crypto user to go through the KYC process once, receive a verifiable attestation for it, and reuse said attestation in different instances where KYC is needed, all while remaining in control of their data.
The idea of reusable KYC uses a special kind of NFTs as a technology primitive. At their very core, NFTs represent unique pieces of data on the blockchain and can be used to represent ownership of digital art, property, collectibles, or, in the case of reusable KYC, can serve as attestations.
KYC systems utilize soulbound NFTs. The term “Soulbound” was coined by Vitalik Buterin, the founder of Ethereum, to represent NFTs that, once created into a given wallet, do not have the functionality to be sold or transferred. Reusable KYC solutions utilize these untransferable tokens as attestations of a successful KYC/AML verification.
After being collected, a user’s personal data is stored off-chain (in a conventional, non-blockchain database), with all the traditional security practices. Upon successful verification of the user’s information, the soulbound NFT would be created within the user’s wallet, which they can later use to attest that they have undergone the KYC process, and that they are a unique human not targeted by sanctions. Lastly, if a given wallet that underwent the reusable KYC process is found to be involved in illicit activities, the entity that issued the KYC verification can then be subpoenaed for the identity of the owner of said wallet.
Reusable KYC is promising because instead of needing to verify their identity each time they interact with an application, users would need to do so only once. As such, they have the ability to stay anonymous to the services they interact with, while staying compliant. This is possible because the organization that collected their KYC information and issued the attestation takes liability for the KYC, and can provide the underlying information as necessary to government regulators and law enforcement. Some of the most prominent groups pioneering this concept (with different levels of liability for their KYC) include KYC DAO, Netki, and Synaps.
Zero Knowledge Proofs
In coming years, we may even see fully decentralized and fully compliant reusable KYC implementations arise through the use of Zero Knowledge Proofs (ZKPs). In essence, a ZKP is a cryptographic method by which one party can prove to another party that a given statement is true while not revealing any additional piece of information apart from the fact that the statement is indeed true. This is possible through the use of mathematical proofs that demonstrate the consistency and correctness of a logical process without revealing the information being processed. For example, using ZKPs one may prove to be a resident of Texas and not a sanctioned individual, without having to reveal private government-issued identification.
This is an ongoing and active area of research, with startups just now starting to develop products. These solutions would avoid the issues of trusting an organization to keep control of one’s data, while giving the user the possibility to cryptographically proof a piece of information, all the while ensuring that governments and law enforcement are still able to access said information.
Ricardian Contracts
Invented in 1996, Ricardian contracts were envisioned as a way to capture the intent behind legal contracts, transform this intent into machine-executable parameters, and securely link the contract to other systems, as a way to ensure that said systems act according to what the legal contract originally stated.
To illustrate, say two parties enter a contract stating that Party A agrees to pay Party B $10 dollars upon the completion of a given task X. This contract would then be cryptographically hashed, securely stored, with its parameters extracted (the $10 payment and the completion of task X), and linked to the systems responsible for verifying that task X was completed and performing the $10 transfer from A to B upon said completion.
This technology emerged completely independent and much earlier than blockchain technology, with the whole focus of making legal contracts both human-readable and machine-readable. Progress with Ricardian contracts stalled for a few years due to the fact that it was either very hard to link the contract to the systems that could verify and enforce the agreement, or such systems didn’t even exist yet. This changed in recent years with the advent of blockchain technology and, especially, with smart contracts.
Any action that is carried out on the blockchain can be systematically verified. And, through smart contracts, logic can be written to perform those verifications and carry out certain actions upon them.
In summary, Ricardian contracts under the context of blockchain technology can be used to, from a human-readable and legally recognized contract, derive a machine-readable smart contract to verify and perform those actions on the blockchain.
Under the context of DAOs, we do not believe we are far from being able to use Ricardian contracts to codify the entire company agreement of a DAO (or any corporation for that matter) into a set of smart contracts. As a matter of fact, there are prominent DAOs already exploring this, such as LexDAO. In this way, one can be sure that the company agreement is easily accessible, secure, and unique via its hash function, remains transparent through the use of readable text for legal prose, and matches the legal intent to the actions to be performed on the blockchain.
New technologies - Conclusion
Blockchain technology moves extraordinarily fast, and the legal landscape must evolve quickly to keep the pace of innovation and change.
Six years ago, most people had never heard the words “cryptocurrency”, “smart contract'', or “DAO.” Today, Wyoming and Tennessee have explicitly recognized DAOs as legal entities. Other states, like Vermont, have proto-DAO laws specifically tailored for blockchain-based companies. Across the country and the world, legislators and regulators are just beginning to formalize these new systems for social organization and coordination.
While it may be early to implement reusable KYC, Zero Knowledge proofs, or Ricardian contracts as part of regulatory requirements, these technologies have seen great progress in recent years and should become part of the legislative language when constructing DAO law.
Anonymity
There are multiple business organizations currently available for DAOs, depending on their structure, purpose, and jurisdiction. For instance, several DAOs in Wyoming operate under the Wyoming DAO LLC, many DAOs in Colorado operate under the Co-Op structure, and many other DAOs operate as Unincorporated Non-Profit Associations (UNA). Additionally, DAOs may choose to incorporate off-shore in an ownerless foundation or special purpose trust.
Just like centralized organizations, there is no one type of DAO. As such, multiple legal frameworks are necessary to account for different structures and use cases. These purpose-built frameworks each have their pros and cons, but the problem of creating a balanced, general, and high coverage framework, much like the LLC did for traditional companies, remains unsolved.
One of the current challenges with traditional LLC frameworks for the administration of a DAO lies in anonymity. As requested by the workgroup, we outline below why anonymity matters for DAOs, how they might operate under the current LLC framework in Texas, the consequences of removing such anonymity, and the benefits that tokenized membership interests bring to transparency and the democratic governance of the company.
DAO membership under the LLC framework
Before attempting to explore this subject, it is important to draw a linguistic distinction between “members” as defined under the Business Organization Code Statute (See Title 1, Chapter 1, Section 002), meaning members of the LLC; and “members” of a DAO, colloquially defined as owning a token that gives one access to the DAO. To err on the side of clarity, any reference to “member” hereinafter will be clarified in parenthesis as to whether it refers to a listed LLC member or DAO member (sometimes also referred to as a “token holder”).
Most decentralized autonomous organizations define their membership via the possession of a digital bearer asset. This is usually in the form of an ERC-20 (fungible) token or ERC-721 (non-fungible) token. These tokens are held under custody in user wallets and grant the bearers access to privileged communications on chat servers, access to in-person events, and, crucially, the ability to vote on key governance decisions for the organization.
The tokens being used by most DAOs - whether they are fungible (ERC-20) or non-fungible (ERC-721) - can be transferred in an unrestricted and permissionless way between wallets on the blockchain. All of these transactions are open, verifiable, and public.
In many ways, this is akin to what the Business Organization Code defines as “Membership Interest” on Sec. 1.002(54), which is further expanded upon in Subchapter C of Title 3 of the Business Organization Code. Sec. 101.104(a)(1) states that:
(a) The company agreement of a limited liability company may:
(1) establish within the company classes or groups of one or more members or membership interests each of which has certain expressed relative rights, powers, and duties, including voting rights;
And, in fact, this is the framework under the LLC structure that many DAOs currently use to operate: At least one of their members (read DAO members or token holders) is represented as listed members of the LLC, while their tokens represent a class of membership interest (See Sec. 101.104(1)), which grants the bearer voting rights and the ability to participate in the management and affairs of the company.
This class of membership interest must be explicitly defined in the Company Agreement (See Sec.101.104 (c)), for, if it doesn’t, it leaves the bearers of membership interest no legal standing to demand voting rights or the ability to participate in the affairs of the company, as stated in Sec. 101.108(b)(2):
(b) An assignment of a membership interest in a limited liability company:
(2) does not entitle the assignee to:
(A) participate in the management and affairs of the company;
(B) become a member of the company; or
(C) exercise any rights of a member of the company.
To illustrate:
This practice of using membership interests as a vehicle to represent DAO membership (read token holders) as opposed to making all the members of the DAO (read token holders) true members of the LLC has several advantages. Some of which include anonymity, flexibility, and practicality. Nonetheless, there are also some considerations of this framework that should be part of DAO legislative discussion, which we highlight in the last section of this testimony.
Anonymity for DAOs under the LLC framework
The issue of anonymity within DAOs is multi-faceted, as such, we approach the issue from two perspectives: that of membership interest assignees (DAO members/token holders), and true LLC members.
Anonymity for DAO members (membership interest assignees)
First, it is important to highlight that, as the LLC statute stands, there is no requirement for the bearer of a membership interest to report its sale (other than for Tax purposes) or for the LLC to track the full list of membership interest assignees. This is supported by the Secretary of State's Management and Ownership FAQs, the definition of Membership interest (53) and Ownership interest (64) under the Business Organization Code, and Sec. 3.151.
For DAOs operating under the LLC framework and defining DAO membership (read token holders) through membership interests as described previously, we interpret this to mean that the organization is not required to track nor report a list of token holders (membership interest assignees).
In fact, given current technology, it would be infeasible for a DAO to do so. As such, we believe that this established precedent for LLCs should be preserved for DAOs operating under the same framework. If a DAO were required to keep a list with information on current members (read token holders), this would create two records of ownership: one on-chain record of token (read membership interest) ownership which updates in real-time, and a redundant off-chain record with personally identifiable information for each token holder (read membership interest assignee) which must be manually updated by the LLC. It would be entirely possible for one to change without the other source reflecting the change. A member could leave an organization without selling their token, and a member could sell their token without updating the organization’s membership record.
This is not a problem unique to DAOs, but rather applicable to any LLC using digital assets to represent membership interest. Trying to reconcile these two records would be extremely complex, and requiring them to be kept current with each other would place an undue burden on the operations of the organization by significantly increasing administrative overhead. Fortunately, we believe that this is already accounted for under the current framework, and only highlight it in order to illustrate the significant challenges which would arise as the result of the precedent being altered.
Anonymity for DAO LLC members (members of the LLC)
Given that DAO members (token holders or membership interest assignees) are able to remain anonymous under the current LLC framework, the discussion of anonymity then focuses on those DAO members (read token holders) that are listed as true LLC members.
As stated in Section 3.010:
the certificate of formation of a limited liability company must state:
(1) whether the limited liability company initially has or does not have managers;
(2) if the limited liability company initially has managers, the name and address of each initial manager of the limited liability company; and
(3) if the limited liability company does not initially have managers, the name and address of each initial member of the limited liability company.
This means that the members of an LLC with no managers must be listed in the certificate of formation. Or, for an LLC that has managers, a list of all managers should be provided upon formation.
Further, as stated in Sec. 3.151(a)(3):
(a) Each filing entity shall keep:
(3) a current record of the name and mailing address of each owner or member of the filing entity;
And those records ought to be made available to anyone with a membership interest in the LLC upon request, as seen in Sec. 101.502(a)(1) and Sec. 101.109 (a)(4), which states:
(a) A person who is assigned a membership interest in a limited liability company is entitled to:
(4) make, for any proper purpose, reasonable inspections of the books and records of the company.
Further, as stated on the official Comptroller page and on the Secretary of State management and ownership FAQs, every LLC in the state of Texas is required to file the entity’s Public Information Report (PIR) as part of its annual franchise tax report. This PIR must include information for all the managers and, if the company is member-managed, it must list all of its current members (read LLC members).
Hence, as things stand under the current LLC framework, there will always be a subset of DAO members (read token holders) who cannot remain anonymous (read LLC members). These DAO members are either the true members of the LLC (as per Sec. 3.151(a)(3)) and, if the LLC has managers or officers, the managers and officers of the LLC (as the public information report of the annual franchise tax filing).
Importance of Anonymity
To understand why this lack of anonymity is problematic, one must first understand how most DAOs manage treasury funds. Currently, as a security practice, the digital assets of a DAO are often held in custody via a technology called multi-signature wallets (hereinafter referred to as multi-sig). Essentially, these multi-sig wallets can be thought of as a specific type of joint checking account in the traditional sense.
In short, a multi-sig is a wallet like any other crypto wallet, with the caveat that it has multiple owners, and requires multiple signatures from an established number of those owners to approve transactions. For example, a multi-sig wallet may have 10 owners, each owner managing their own keys in their own personal wallets. Transactions from that multi-sig wallet will only be approved upon the signature of, say, 6 of those 10 members.
To illustrate a completed transaction from the collective treasury:
There are three important things to highlight in the current usage of multi-sigs. First is that multi-sigs are not only used for DAO treasury management. They can also be used to secure personal funds. In this case, a single user could set up a signal multi-sig using 5 different wallets, all of which they control. This improves security by ensuring that if one wallet is lost or compromised, the collective group will still maintain control over the funds stored in the multi-sig.
Second, since there are multiple use cases for multi-sigs, the quorum of the wallet (the minimum number of signatures needed to approve transactions) can be defined by the creator of the wallet. There are no current regulatory requirements for a minimum quorum when using multi-sigs for DAOs.
Lastly, in the case of DAOs, the addresses on the multi-sig wallet usually belong to a small subset of the DAO members (read token holders). This is useful due to the fluid nature of DAO membership and lack of member engagement. If all the DAO members were required to be on the multi-sig, the management of the wallet and approval of transactions would become a significant operational burden, similar to the issues of maintaining off-chain membership records as outlined above. Consequently, it is usually the DAO leaders or committee heads who have their addresses listed as owners of the multi-sig as they tend to hold a long term interest in the DAOs success and are often democratically elected by DAO members (read membership interest assignees).
Personal financial privacy
Taking the following image from the Bitcoin whitepaper, one can easily see how the traditional financial system differs from the crypto-enabled system in regards to privacy.
A blockchain achieves decentralization because, unlike the traditional banking system, all the transactions are made public. Under such conditions, if there is no identity privacy, there is no financial privacy. Requiring members, managers, or officers of the DAO LLC to be reported in the PIR, listed in the certificate of formation and an updated list of members to be kept as part of the LLC records takes away this privacy.
To reiterate, usually, DAO leaders or committee heads are listed as owners of the DAO treasury multi-sig. This group of people often overlaps with the LLC members, managers, or officers that must be reported in the manners listed above.
Membership and management information of an LLC is publicly searchable. And, since the multi-sig of a DAO lives on the blockchain, it is also publicly searchable. With a basic understanding of blockchain technology, wallets, and name services, the persons listed as LLC members on the Certificate of Formation can be traced back to personal wallet addresses on the blockchain. This may expose those LLC members to personal risk that was never explicitly consented to.
As blockchain adoption increases in the coming years, having instances where one’s personal identity is unintentionally revealed becomes a progressively greater concern. If we want to incentivize people to engage in the innovation that comes from being part of a DAO, this cannot be an inadvertent side effect.
Social attack vectors
The second point as to why the explicit disclosure of DAO member (read LLC member) identity is problematic is that it opens a social attack vector.
In the traditional banking system, custody of assets is delegated to trusted institutions that have checks and balances to prevent hacks, facilitate recovery, and protect the customer. In the blockchain world, the burden falls on an individual person to prevent hacks, build recovery systems for their own accounts, and protect themselves via good key management practices. This is a natural consequence of the removal of intermediaries that follows decentralization.
There is a lot of work that still needs to be done to protect new users (e.g. social recovery of wallets, wallet-level security, etc). And, as such, several actors with ill-intent are constantly looking for vulnerabilities to exploit blockchain applications, users, or DAOs.
It is undeniable that the open nature of blockchain technology has led the ecosystem to be plagued with scams, hacks, and phishing attempts. Most of these attempts are usually contained when they target single unaware users. Nonetheless, when the affected entity is a protocol or a DAO holding a significant amount of funds, the consequences are aggravated.
As many of the members (read LLC members) listed in the certificate of formation of the DAO are also listed as owners on the multi-sig, this poses a huge security risk to the individuals and to the treasury of the DAO.
A few examples of attacks include:
- Axie Infinity exploit for $600M, where one of the game developers was tricked by a fake job posting. This is an example of how social engineering on key members may comprise an entire community.
- EasyFi hack in 2021 for over $70M, caused not by exploiting the code but as a consequence of the wallet of an admin, whose identity was known, being compromised.
- Nexus hack for $8M, in which the machine where the CEO (whose identity was also known) stored his private keys, was compromised.
Like these, there are myriad examples of hacks that have been facilitated by the team’s lack of anonymity. Steady State Finance is a Texas-based blockchain company building risk assessment models for blockchain applications. Steady State has compiled data on hundreds of hacks, to find that those teams whose identity was known were, on average, exploited for five times more than those teams who remained anonymous.
Some of the biggest DAOs today have billions of dollars under treasury management, which makes them targets for bad actors and potential exploits. This puts a huge risk on any member who either sits on the multi-sig, writes code, or has any sort of higher responsibility within the organization. Said members must remain anonymous for their personal safety and the safety of the broader community they represent.
Anonymity - Conclusion
Blockchain technology is great at what it does: it helps us reach consensus in a distributed way, allowing us to build complex systems without the need for intermediaries or centralized sources of truth. Blockchains achieve this by making all the transactions public to all the participants of the network, making it possible to agree on a given state. The open and public nature of the blockchain makes anonymity far more important than under the traditional system, for which the LLC statute was originally envisioned.
Preserving anonymity in the context of AML and new technologies
We understand that there exist significant money laundering concerns from legislators in regards to DAO anonymity. These risks are real and must be mitigated via regulation. Nonetheless, we envision a future in which, through the new technologies mentioned in the previous section, DAO membership (read LLC membership), anti-money laundering practices, and anonymity can coexist.
Zero-knowledge proofs may be used to prove pieces of personally identifiable information (PII) without PII being publicly disclosed. Future amendments to the LLC statute may require, for DAOs incorporating under an LLC framework, a valid reusable KYC attestation from all listed members of the LLC. The data underpinning these KYC attestations could be investigated if a wallet is identified to be engaging in malicious activity.
Transparency despite anonymity
Lastly, we would like to discuss the ways in which tokenizing membership interests (read DAO tokens) of an LLC offers far greater transparency than would traditionally be the case. For instance, a full list of all the wallet addresses which own a membership interest, and how much membership interest each wallet owns, is now publicly available thanks to the open nature of the blockchain.
Not only can anyone see the present distribution of membership interest, they can also see all the transactions in which those tokens changed hands since the DAO’s formation. One can see if a particular wallet is trying to buy up as much as they can, consistently voting against the interests of the group, or other behaviors that may suggest a motive other than the betterment of the DAO. From a regulatory oversight perspective, this transparency results in easier ways to detect insider trading, wash trading, and other illegal activities if it were to occur.
All of this data is publicly available and freely accessible on the blockchain, dramatically increasing transparency both inside and outside an organization. This makes it much easier for members (read token holders) of a DAO to self-police and enforce strong social norms, while providing more data for prospective members and law enforcement about allegations of mismanagement or fraud.
Due to Nakamoto’s so-called “new privacy model”, blockchains provide a means of transacting and governing independent of our names and physical addresses, and we take seriously the concerns that arise from the anonymity that it produces. But at the same time, we strongly believe that the benefits of financial transparency, traceability, and democratic social organization represent substantial improvements over existing systems.
With well-crafted laws and regulations, the proliferation of blockchain technology and DAOs in Texas will result in significantly increased transparency and opportunities for coordination, further cementing our great state’s place as a world leader in technological and economic innovation.
General Considerations on the LLC Statute for DAOs
We believe that, with minimal amendments to the statute language, most DAOs can operate under the existing LLC framework in the state of Texas. The scope of this testimony was to speak to the importance of member anonymity for DAOs and how new technologies may enable said anonymity while addressing legislators’ concerns.
While researching the current LLC code, some factors emerged regarding the framework described in “DAO membership under the LLC framework” that deserve further discussion and consideration. We believe it is important for the work group and legislators to be aware of these points for discussions related to DAO law in Texas.
The main concerns revolve around the definition of membership interest, as defined in Sec. 1.002(54); the classes or groups of membership interests, as defined in Sec. 101.104; the rights (or lack thereof) that membership interests assignees are entitled to, as stated in Sec. 101.108; the expectations of people when becoming DAO members (read token holders); and the impact of this framework on securities law.
These concerns, and the considerations that follow, must be top of mind when drafting DAO legislation, and may themselves be a starting point for the legislative body on the language changes needed in the Business Organization Code to encompass DAOs.
Sec. 1.002 DEFINITIONS
This section defines membership interest as:
(54) "Membership interest" means a member's interest in an entity. With respect to a limited liability company, the term includes a member's share of profits and losses or similar items and the right to receive distributions, but does not include a member's right to participate in management.
Much of the confusion of current DAOs considering operating under the Texas LLC framework stems from this definition and the fact that it is completely unclear whether a digital asset (either an ERC-20 or ERC-721 token) is a legally compliant form of membership interest.
For a DAO, the very definition of membership relies on the possession of a digital asset or token. As such, there must be an explicit definition of digital assets, and a definition of membership interest that includes these digital assets as legal membership interests categories.
For instance (bolded below):
(XXX) “Digital asset” means a representation of economic, proprietary, or access rights that is stored in a computer-readable format and is either a digital consumer asset, digital security, or virtual currency.
(54) "Membership interest" means a member's interest in an entity. With respect to a limited liability company, the term includes a member's share of profits and losses or similar items and the right to receive distributions, but does not include a member's right to participate in management.Membership interests may be tokenized as fungible or non-fungible digital assets.
Sec. 101.104 CLASSES OR GROUPS OF MEMBERS OR MEMBERSHIP INTERESTS and Sec. 101.108. ASSIGNMENT OF MEMBERSHIP INTEREST
Section 101.104 (omitting subsection d) states:
(a) The company agreement of a limited liability company may:
(1) establish within the company classes or groups of one or more members or membership interests each of which has certain expressed relative rights, powers, and duties, including voting rights; and
(2) provide for the manner of establishing within the company additional classes or groups of one or more members or membership interests each of which has certain expressed relative rights, powers, and duties, including voting rights.
(b) The rights, powers, and duties of a class or group of members or membership interests described by Subsection (a)(2) may be stated in the company agreement or stated at the time the class or group is established.
(c) If the company agreement of a limited liability company does not provide for the manner of establishing classes or groups of members or membership interests under Subsection (a)(2), additional classes or groups of members or membership interests may be established only by the adoption of an amendment to the company agreement.
(a)(2), additional classes or groups of members or membership interests may be established only by the adoption of an amendment to the company agreement.
This section gives enough flexibility to the company agreement to define the rights, powers, and duties of bearing a digital asset as a class of membership interest. This works perfectly if the legality of this practice is explicitly stated in the definition of membership interest.
Nonetheless, the need to explicitly define this class of membership interest in the company agreement, plus the fact that assignees of membership interest are not entitled to participation in management and affairs of the company as described in Sec.101.018(b)(2), directly clashes with the expectation of a DAO member (read token holder). The aforementioned subsection states:
(b) An assignment of a membership interest in a limited liability company:
(2) does not entitle the assignee to:
(A) participate in the management and affairs of the company;
(B) become a member of the company; or
(C) exercise any rights of a member of the company.
When an individual chooses to join a DAO (read, purchase membership interest) there is a very clear expectation that said membership interest will give this individual the right to engage in the affairs of the company and, most importantly, entitle them to voting rights in the DAO.
This (entitlement to voting rights and engagement in the affairs of the company) currently happens in DAOs at the operational level. Meaning that there is an implicit social (and, for some actions, cryptographically enforced) agreement that the DAO will behave as its members (read token holders) decide.
Nonetheless, there may be a situation in which the true members of the DAO LLC (listed in the certificate of formation or in the annual PIR) can choose to go against a community vote. Let’s say that DAO LLC did not explicitly state in its company agreement that the membership interest class for its tokens granted their assignees voting rights. If a situation like this makes it to court, the DAO members (read token holders) have absolutely no legal standing to argue upon.
The current LLC statute delegates the responsibility to the user joining the DAO. They must read the company agreement to ensure that the token they purchased grants them the rights to vote and participate in the company. The issue is that this expectation of voting and engagement is so widespread, and the knowledge of DAO LLC legislation is so little, that it is unreasonable to expect everyone joining a DAO to be aware of such vulnerability or have the competency to protect themselves against it.
While this remains unaddressed in the law, there will continue to be a dissociation between the daily operations of a DAO via on-chain voting, and its legal representation via an LLC. This is not a problem so long as the DAO behaves as it is supposed to, but represents a significant legal vulnerability in the presence of bad actors.
We believe that the law should explicitly protect token holders as the growth of DAO participation continues to accelerate, which could be achieved with a new subsection under Sec. 101.108(b) such as (bolded below):
(b) An assignment of a membership interest in a limited liability company:
(2) does not entitle the assignee to:
(A) participate in the management and affairs of the company;
(B) become a member of the company; or
(C) exercise any rights of a member of the company.(3) if and only if the membership interest assigned falls under the category of a digital asset, the assignee is automatically entitled to receive voting rights and engage in the affairs of the company or DAO.
Impact of membership interest on securities law
One of the biggest concerns and threats to the broad crypto ecosystem is the regulation of tokens as securities. There are circulating tokens that definitely may qualify as securities under the Howey Test, but there are others that are categorically not. A one size fits all security regulation for crypto would be devastating for the entire space and the future of blockchain innovation in the United States.
Although securities law is primarily a federal matter, ‘Blue Sky’ laws make this a relevant discussion at the state level as well. As such, we highlight that a commonly brought-up concern of DAOs operating under the LLC statute via membership interest is that of securities law. The tokens that lead to membership in many DAOs could hardly be classified as securities. As mentioned previously, the common expectation of an individual joining a DAO is to have voting rights and the ability to engage in the affairs of the DAO - not of profit derived from the effort of others.
Given most membership interests of a traditional LLC are viewed as securities under state and federal law, we fear that an overly broad approach to defining DAO operations under the LLC statute, where DAO membership is defined via assignment of membership interest, may subject DAO tokens to the same classification. Such an argument would be catastrophic for the DAOs and blockchain innovation in general.
Nonetheless, we believe these risks may be mitigated by a new subsection under Sec. 101.104, stating that the expectations and rights of a membership interest class that qualifies as a digital asset are voting and engagement rights, not profit.
Conclusion
We hope this testimony proves helpful in guiding the discussions surrounding DAO legislation hereafter. We believe that the existing LLC statute can fully encompass DAOs and provide much-needed guidance for DAOs wanting to incorporate in our state. We hope that the technologies presented in this document will be taken into consideration when providing recommendations to legislatures. We hope the importance of anonymity is understood, considered, and addressed in future DAO legislation.
ATX DAO’s Public Policy Think Tank offers our resources to the work group, legislators and their offices to further clarify any points in this testimony. We also make ourselves, and our unique industry expertise, available to advise on any current or future blockchain legislative discussions regarding DAOs, stablecoins, or more.
We believe that the state of Texas and its citizens will benefit greatly from the economic, social, and technological innovations that follow from passing crypto-friendly policy. We thank the work group for the opportunity to provide testimony and are in full support of the positive government’s stance on blockchain regulation and its willingness to listen to industry experts.
ATX DAO Public Policy Think Tank
08/17/2022