O'Toole, Kelly and Hahn On Why Delaware May Be The Right Jurisdiction For "Smart" Orgs

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Matthew J. O'Toole, Christopher Kelly and David Hahn

Delaware May Be The Right Jurisdiction For 'Smart' Orgs

The Delaware limited liability company enjoys wide popularity as an organizational form for businesses. Limited liability, favorable tax treatment and contractual freedom stand among the numerous reasons for this preferred status. Delaware LLCs are used for a variety of business purposes, including operating enterprises, holding companies, special purpose entities and specific transaction vehicles.

As distributed ledgers and blockchains emerge as means for processing and recording corporate and commercial transactions, the Delaware LLC may even become an attractive organizational form for next-generation “decentralized autonomous organizations.”

What is Distributed Ledger Technology?

Distributed ledger technology has the potential to offer transformational benefits for transactional processing and recordkeeping — improving speed, accuracy, transparency and security. While the technology is complicated, the underlying concept is simple. A distributed ledger is an electronic database. It is “distributed” in that instead of a single party maintaining one copy of data in a centralized manner, numerous parties in a peer-to-peer network synchronize and maintain multiple copies, and each transaction or event is verified by a consensus of network participants before it is recorded. It is a “ledger” in that it permanently records each transaction or other event in a continuously lengthening list of every such transaction or event, immutably secured by cryptographic means.

A distributed ledger can take the form of a “blockchain,” wherein multiple transactions are recorded together in a single “block” and blocks of transactions are added one by one to an ever-growing “chain.” Distributed ledgers or blockchains may be open and public, like the Bitcoin and Ethereum networks, or they may be permissioned and private, as most enterprise-grade blockchains are or are expected to be. Transactions and other records may be validated by a variety of means for achieving consensus, such as “proof of work” and “proof of stake” models, or simply through verification by the transaction counterparties. A distributed ledger or blockchain may offer Turing-complete functionality, allowing for “smart contracts” (i.e., computerized, automated transaction protocols) to be encoded and executed on the network.

What is a DAO?

A “decentralized autonomous organization” or “DAO” is a form of smart contract — really more akin to a “smart organization” — that exists as computer code deployed on a distributed ledger or blockchain. The software code that implements a DAO largely automates its management and decision-making functions, to that extent replacing traditional governance rules such as corporate bylaws and human managers like directors and officers. Ownership in a DAO may be evidenced by tokens sold to investors in exchange for virtual currency used on the blockchain on which the DAO code has been deployed. The funds raised by a DAO through those token sales may then be utilized for blockchain-based commercial activities or investments. Because a DAO is software code and little more, it requires human “contractors” to build the products and provide the services from which it hopes to generate a profit. Contractors can submit smart contract-based business proposals to a DAO, and DAO token-holders vote, based on the number of tokens each controls, to accept or decline such proposals. A DAO may have one or more human “curators” who verify the identities of potential contractors and ensure that the software encoding the proposals will function properly; curators then will “whitelist” the proposals they find suitable for voting by token-holders. If enough DAO token-holders vote in favor of a proposal, the smart contract will be activated on the blockchain. Holders of DAO tokens may realize a return on their investment in the form of distribution of profits from the projects funded by the DAO and/or appreciation in the value of their DAO tokens.

“The DAO” Implosion

The concept of a DAO was memorialized in a white paper authored by Christoph Jentzsch, the founder and chief technology officer of Slock.it, a “Blockchain and IoT solution company” incorporated in Germany. The first implementation of the DAO concept, and the most well-known DAO to date, was “The DAO,” which was deployed by Slock.it on the Ethereum blockchain in late April 2016 as a crowdfunded venture capital fund. During an initial online fundraising period, The DAO raised more than $130 million worth of Ether, the virtual currency for the Ethereum blockchain. Unfortunately, however, an unknown party (apparently a fellow token-holder) exploited a vulnerability in The DAO’s code, making off with approximately $50 million of Ether. Due to The DAO’s code, that party was unable to move the Ether for a certain period of time. Following significant debate, a majority of the Ethereum community adopted a “hard fork” in the Ethereum protocol to return the diverted Ether to The DAO. Holders of The DAO tokens were then permitted to exchange their tokens for Ether to avoid any loss of their investments. In July 2017, the U.S. Securities and Exchange Commission issued an investigative report determining that The DAO tokens constituted securities under U.S. federal securities law.

What are the Possible Benefits of Delaware LLC Status?

The DAO concept presents many legal and regulatory issues that are beyond the scope of this article, including (given their decentralized nature) jurisdictional and international law considerations. That said, from a state law perspective, certain benefits could accrue to a DAO, as well as to its creators, curators, and token-holders, were it formally organized as a Delaware LLC. These include benefits that could arise from formal incorporation or organization as a legal entity in most jurisdictions, as well as benefits that could accrue specifically from organization in Delaware and as an LLC. The possible benefits from entity formation in Delaware include, among others:

• Limited Liability. The primary reason to formally organize a DAO as a corporation or LLC would be to try to insulate participants from its debts, obligations and liabilities. A DAO in its “native state” (i.e., absent organization as a corporation or alternative entity) might be viewed as a general partnership or unincorporated association, and its token-holders (and potentially its developers and curators as well) could be deemed partners. As a result, DAO token-holders (and other participants) could face personal liability for the debts, obligations and liabilities of the DAO, and could be held liable for the acts of other DAO participants with respect to its business. Formal incorporation potentially could limit their exposure to the amount of their investments and protect them and their personal assets from claims against the DAO.
• Equity Status. Funds raised in crowd sales of tokens or coins using blockchain technology have been described as free money. In fact, some “initial coin offerings” have been characterized as scams, while several cryptocurrencies are even expressly based on internet memes or jokes. Regulators may view cryptocurrencies, coins, and tokens as securities, commodities or currencies depending on the regulator and what the digital asset virtually represents. The SEC, for instance, appears to have stepped up its scrutiny of cryptocurrencies and initial coin offerings of late. Given the uncertainty surrounding digital tokens and coins, what (if any) legal rights, obligations and liabilities token or coin holders possess remains unclear. Were a DAO to formally organize as a legal business entity, these tokens potentially could represent uncertificated shares of corporate stock or alternative entity interests, and holders of such tokens potentially could be considered stockholders, limited partners or LLC members, potentially making their rights, obligations and liabilities determinable under existing law.
• Pass-Through Tax Treatment. The manner in which tax authorities in the U.S. and abroad would treat a DAO that is not formally organized as a legal entity is unknown. Indeed, given the many unanswered legal and regulatory issues arising from DAOs, including jurisdictional and cross-border considerations, even a DAO’s chosen form of entity might not be recognized for tax (and other) purposes by all (or any) jurisdictions. Nevertheless, the LLC might be an appropriate choice for a DAO in certain contexts; an LLC generally can qualify as a partnership for U.S. federal tax purposes, enabling pass-through tax treatment, whereas corporations typically face double-taxation (unless they qualify as S corporations) and limited partnerships require a general partner that does not enjoy limited liability protection. Recent U.S. tax reforms may affect this analysis going forward.
• Delaware Law for Internal Affairs. A DAO is a decentralized virtual organization, and DAO developers, curators and token-holders may reside in many different states and countries. As such, absent a DAO’s formal organization under a particular jurisdiction’s laws, uncertainty would surround the law governing the DAO’s internal affairs. The choice of law analysis could prove extremely difficult for any judge and, even with formal organization, any particular court’s answer to the question would be hard to predict. Were DAO participants to select Delaware as the jurisdiction in which to formally organize, the internal affairs doctrine arguably would require the application of Delaware law. For numerous reasons — including the flexible and enabling nature of its statutory law, the well-developed case law concerning the governance of its entities and the state’s highly regarded court system — DAO stakeholders might be best served to organize the DAO as an entity in Delaware.
• Fiduciary Duties? Software developers, miners, curators and others within blockchain communities can exercise considerable power and make important decisions that impact holders of digital assets. While the hallmark of a fiduciary relationship is control over another’s property, it is unclear whether these human decision-makers would be found to owe fiduciary duties to a DAO and its investors. To the extent a DAO were formally organized in Delaware, the state’s fiduciary duty law potentially could offer protections for investors and afford mechanisms to hold those decision-makers accountable when they act in their own self-interest or without sufficient care. For example, the application of fiduciary duties potentially might prevent or offer means to redress a “51% attack” (whereby a holder of 51 percent of a DAO’s tokens could make and approve a proposal to send all of the DAO’s funds to himself). Similarly, Delaware law in certain contexts could impose fiduciary duties on DAO coders and/or curators requiring that they act in good faith, with due care and in the best interests of the organization and token-holders when writing the code underlying the organization or selecting those smart contract proposals to “whitelist” for token-holder voting. Conversely, if the DAO were organized as a Delaware alternative entity, to the extent DAO participants wished to avoid the application of traditional fiduciary duties, they could avail themselves of the latitude provided by Delaware law to eliminate or limit such duties or liability for breach.
• The “Three-Legged Stool.” Formal incorporation conceivably could provide a DAO the ability to exculpate and indemnify certain participants and obtain liability insurance protecting them against internal affairs claims — i.e., the “three-legged stool” of “limited liability, indemnification, and insurance” established by Delaware to support corporate directors. By incorporating or organizing as a formal entity, a DAO arguably would have authorization under Delaware’s (and other states’) entity laws to:
  • exculpate corporate directors from duty of care breaches, or general and limited partners (and other persons) of limited partnerships and LLC members and managers (and other persons) from any and all fiduciary duty breaches;
  • indemnify expenses, judgments and other amounts, and advance attorneys’ fees and other defense costs, incurred by corporate directors and officers (as well as employees and agents), general and limited partners (and other persons) of limited partnerships, and LLC members and managers (and other persons); and
  • purchase and maintain insurance on behalf of corporate directors and officers (as well as employees and agents), general and limited partners (and other persons) of limited partnerships, and LLC members and managers (and other persons).

• The Implied Covenant. “The implied covenant of good faith and fair dealing embodies the law’s expectation that each party to a contract will act with good faith toward the other with respect to the subject matter of the contract,” and this covenant may be used to imply terms to “fill gaps in the express provisions” of a contract. “Precisely because gaps always exist” in contracts, “the implied covenant is a mandatory, nonwaivable aspect of every contract governed by Delaware law,” including alternative entity agreements. Because software coders, like transactional lawyers, cannot preconceive and specifically address every possible future situation (and determined hackers may find weaknesses in even the most secure blockchain networks), the implied covenant might serve a critical function for a DAO. The implied covenant conceivably might have caused the person who exploited the vulnerability of The DAO to think twice before using a bug in the code to arrogate one-third of The DAO’s funds or might have been used by other token-holders to redress that misdeed afterwards.
• Member Management. As described by Jentzsch in his white paper, a DAO is governed in a decentralized manner by the holders of its tokens, who cast votes weighted by the amount of tokens they control. While a DAO may have a curator, Jentzsch’s description of a curator’s role does not appear to be similar to the broad authority of a corporate board of directors or a general partner of a limited partnership. Rather, Jentzsch’s description of the governance of a DAO is substantially similar to the default rule that members manage a Delaware LLC in proportion to their respective ownership interests, with some delegation of limited management rights or powers to a curator in the DAO setting.
• Information Control. Blockchain communities such as Bitcoin do not involve public disclosure of personal identities. Rather, public key infrastructure cryptography allows virtual assets to be “owned” by whoever has the private key that corresponds with the public key that holds the assets, thereby enabling virtual currency transactions to be essentially anonymous. While Bitcoin and other cryptocurrencies have attracted criticism for arguably facilitating illegal conduct, there may be legitimate reasons for law-abiding persons to want to engage in private transactions in certain contexts. Conversely, in other contexts, transacting parties may need or want to know the identity of the parties with whom they are doing business. In Delaware, documents filed to incorporate a business typically do not disclose the names of stockholders, limited partners or LLC members or managers. As such, participants in a DAO LLC could enjoy a measure of privacy, while an operating agreement or stock ledger could list relevant parties for internal use as well as allow for disclosure to third parties when necessary or appropriate.
• The Delaware Rapid Arbitration Act. Participants in a DAO may live all over the world, making it difficult to resolve disputes among them in a speedy and efficient manner. Enacted in 2015, the Delaware Rapid Arbitration Act addresses many of the problems associated with conventional arbitrations. Generally speaking, the DRAA allows parties to arbitrate disputes anywhere in the world when at least one party is a Delaware business entity, neither of the parties is a consumer and the parties have signed an arbitration agreement governed by Delaware law and explicitly referencing the DRAA. Were a DAO to be formally organized as a Delaware entity, participants in that DAO finding themselves in a technical dispute involving software code, for example, might take advantage of the DRAA’s many benefits, including a unique provision therein that allows parties to select nonlegal experts as arbitrators. Further, parties who arbitrate under the DRAA can expect a speedy resolution, since arbitration awards typically must be made within 120 days of the date proceedings begin.

Conclusion

Distributed ledger technology offers potentially revolutionary benefits that can make corporate recordkeeping and commercial transactions more efficient, accurate, secure and transparent. But advancements in technology will not prevent all misbehavior or avoid all commercial disputes. Just as human transactional lawyers cannot contemplate every possible future scenario and draft contract provisions to specifically address the entire universe of contingencies, likewise human software programmers face limitations in writing code. Further, general terms frequently found in commercial arrangements — such as “fair and reasonable,” “best efforts” and “good faith” — do not lend themselves to deterministic code. Additionally, as anyone with a computer can attest, code can contain bugs. Accordingly, there will be gaps in distributed ledger technology, blockchain code and smart contracts that can be exploited by opportunistic actors, and those gaps will need to be filled by existing (or new) legal doctrines. Likewise, corporate and commercial disputes will arise regarding this technology that will require resolution mechanisms. For the reasons set forth above, Delaware may be the right jurisdiction, and the Delaware LLC could be the appropriate choice of entity, for a DAO.

This article was published on February 16, 2018 in Law360.

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Potter Anderson & Corroon LLP is one of the largest and most highly regarded Delaware law firms, providing legal services to regional, national, and international clients. With more than 100 attorneys, the firm’s practice is centered on corporate law, corporate litigation, intellectual property, commercial litigation, bankruptcy, labor and employment, and real estate.