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California Proposes Innovative Law for DAOs

On April 24th, a bill amending California’s Corporations Code passed the state’s assembly’s Banking and Finance Committee with 10 votes to 1. The bill, proposed by California State Representative Matt Haney (D) in February, creates a decentralized nonprofit association (DNPA) entity. While Rep. Haney stated that the legislation is technologically agnostic to account for other types of decentralized organizations, the bill is widely acknowledged as a legal framework tailored for decentralized autonomous organizations (DAOs). If passed, California will become the fourth state to enact DAO-specific laws, following Wyoming, Tennessee, and Utah.

However, unlike the three state laws, the California framework would not treat DAOs as limited liability companies (LLCs). Instead, the new DNPA entity is created within the statutes designed for Unincorporated Nonprofit Associations (UNAs). According to Rep. Haney, the UNA structure is appropriate for smart contract protocols, stating that UNAs are “philosophically consistent with DAOs.

What is a UNA?

A UNA is a group of individuals or organizations that come together for a nonprofit objective and are not formally incorporated. Importantly, UNAs are not prohibited from generating profits as long as these profits are used to support their primary nonprofit objectives. For example, a UNA that builds shelters for stray animals can operate an animal grooming business as long as the profits are directed toward building more shelters (or other similar purposes).

Another feature of UNAs is that they are not required to file formation documents with the Secretary of State, releasing them from Corporate Transparency Act (CTA) obligations that would require them to report beneficial ownership information to the Financial Crimes Enforcement Network (FinCEN). This preserves the anonymity of its members and is an important factor for anyone contemplating registering a DAO. For example, the same protections do not apply in the Wyoming, Tennessee, and Utah laws, as LLCs are not excluded from the CTA.

Requirements of the bill

The bill defines a ‘decentralized nonprofit association’ as “an unincorporated association consisting of at least 100 members with a primary common purpose other than to operate a business for profit whose governance and operations are reliant, in full or in part, on a blockchain or other distributed ledger technology.” Like other UNAs, DNPAs are allowed to engage in profitable businesses if the proceeds are used for nonprofit purposes. Additionally, profit allocation to DNPA members is prohibited, and members can only be compensated for their services.

The bill also requires DNPAs to appoint an agent for service of process, who will serve as the recipient of any legal action taken against it and is not required, under California's Corporations Code, to be a member of the association as long as they reside in California. Furthermore, the bill defines a role of an ‘administrator,’ who is responsible for performing certain administrative and operational tasks. The administrator must always act “at the direction of the membership.

The proposed legislation also allows for unrestricted transfer of membership and voting rights to another person. The introduction of unrestricted transferability of membership is notable because certain jurisdictions, such as Pennsylvania and D.C., mandate that this option must be elected in the association's governing documents. Thus, when members of DAOs, that are registered under the California framework, use governance tokens as proof of membership and transfer these tokens to another person, their voting rights will be transferred automatically without additional formalities.

Importantly, like the members of other UNAs in California, “a member, administrator, or agent of a decentralized nonprofit association is not liable for a debt, obligation, or liability of the association solely by reason of being a member, administrator, or agent.” Members of a DNPA will only be liable for a “contractual obligation of the association” if they assume personal responsibility for the obligation in writing, authorize or ratify the contract in writing, receive a benefit under the contract with notice of the contract, execute the contract without disclosing they are acting on behalf of the association, or execute the contract without the authority to do so.

Lastly, the DNPAs must have a governing document that can be a constitution, articles of association, or bylaws. While the governing document should outline certain aspects of the DNPA, the bill, unlike the existing DAO laws, does not impose any restrictive requirements. A DNPA has the freedom to choose the technology it uses and may specify whether it will operate on a public or private distributed ledger and whether the blockchain technology utilized by the DNPA will be fully immutable or subject to change. On the other hand, the Utah DAO Act mandates DAOs to only operate on permissionless (public) blockchains, while the Wyoming DAO and Tennessee DO laws prohibit smart contracts to be immutable.

What does this mean?

Representative Haney’s proposed bill might not be a suitable registration framework for for-profit DAOs, but it will offer a new option to nonprofit organizations such as “Collector DAOs” and “Protocol DAOs” that are currently limited to registering as LLCs. Collector DAOs are DAOs that use member resources to collect and display art (usually NFTs). As for the Protocol DAOs, these DAOs guide the development of smart contract protocols—e.g. a DAO overseeing the development of a decentralized exchange.

Registering as DNPAs can also preserve the anonymity of the DAO members, which can be particularly valuable for participants who are concerned for their privacy. As discussed above, the DNPAs will not be required to report beneficial ownership information to FinCEN. The CTA defines a beneficial owner as a natural person who has more than 25% of the ownership interest or “exercises substantial control” over a company. While some DAOs may not have members falling into the beneficial owner category, they would have to constantly evaluate their membership control allocation to avoid reporting to FinCEN.

Lastly, flexibility in choosing the underlying technology can be an important factor for nascent DAOs. As we have previously noted, the technology requirements of the Wyoming, Tennessee, and Utah laws can act as barriers for early-stage organizations. For example, the Utah DAO Act requires DAOs to have their smart contracts audited. While conducting security audits is generally a prudent practice, the cost of hiring an auditing firm might be excessive for early-stage DAOs, and act as a deterrent to their registration under the Act.

After the California State Assembly’s Banking and Finance Committee, the bill must pass the assembly’s Judiciary Committee, be voted in the assembly, move through the state Senate and be signed by the governor. While the bill has a long way to go until it becomes law, it is always encouraging to see experiments in DAO legislation on the state level.


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