How LCAs are changing Web3
If you found this post, you’re likely at least vaguely familiar with the concept of decentralized autonomous organizations, or DAOs. What you’re also probably aware of is that very few, if any, DAOs start out as decentralized or autonomous. It takes an enormous amount of momentum and market trajectory to reach escape velocity for a successful “exit to community.” DAOs like MakerDAO, Gitcoin and others were able to achieve this in the heady bygone era of 2019-2021, but in the current regulatory climate and market conditions it’s a tough task. Trying to get to sufficient decentralization in today’s market is like swimming to an island through shark infested waters, and the swim is getting longer and longer. We believe there are better options out there. You shouldn’t have to go to another continent to build in web3.
The regulatory environment in the United States shifts under our feet every day as leadership at the SEC constantly expands its view on what is and is not a security interest, and who’s at fault. If you’re issuing a token through the lens of the Wahi Coinbase suit, the Howey test appears to have been reduced to, first: did you have a management team and second: did you market your token. Token suits are everywhere, recently vanquishing projects like LBRY and Ooki DAO. Founders and Members of DAOs need to get smart about protecting themselves from legal liability to respond to increasing pressure from the SEC & CFTC.
Putting the token and security issues aside for a moment, there are practical reasons to organize and limit liability. Why is this such a fraught issue? The reason is that under current laws in the United States, if a group of people starts a common enterprise, they are deemed a general partnership by default. As a result, all the partners in a general partnership are jointly and severally liable (everybody for everything everyone else does), which is bad. The solution, until crypto-native regulations improve, is to provide a “legal wrapper” for a DAO. DAO founders have unsuccessfully argued that they only exist on-chain as protocols, but legal wrappers help tie together members in an entity with limited liability in the real world. It’s also important to note that right now, there’s no good precedent verifying that smart contracts are legally enforceable. Code is not law quite yet.
But rejoice! There’s hope. From the beginning, humans on earth have cooperated with one another to accomplish tasks they could not do alone. Evidence of this is seen in the remains of many anthropologic studies throughout the world. No one knows when the first formal cooperative organization was formed, but it occurred centuries ago. Today the best iteration of this principle is enshrined in law as the Uniform Limited Cooperative Association Act, which created the Limited Cooperative Association, or LCA. Recently the LCA has gained traction with well known projects in the ecosystem, including Collabland.
We at NATION have been doing deep work on this topic for the better part of a year. Our team comes from web3 and fully supports DeFi and the aspirations of the DAO. We just don’t want Wells notices or subpoenas. So we took a deep dive into some of the key works of our forefathers at Paradigm and Andreesen Horowitz, overlaid that across the ever changing regulatory landscape, and settled on the limited cooperative association as the future of the DAO. Importantly (hard to overstate this), LCAs also benefit from a federal securities exemption. There are still considerations to make at the state level, but we believe this is an incredible advantage for DAOs looking to share profits with members. We think it’s relevant to even go a step further and begin to discuss these organizations as On Chain Entities, an evolution or subclassification of the DAO. We’ve been quietly building the infrastructure to support these organizations from incorporation to governance to treasury management, and we’re looking for partners looking to build.
So what is an LCA? A limited cooperative association, particularly the Colorado cooperative, or co-op, model we implement at NATION is one of those rare gems in the legal structuring handbook. In the past, these rare gems, like the Guernsey Trust, or the Cayman Foundation, or the Swiss Verein, were only used for obscure legal arrangements. However, these structures are great for holding capital - not raising capital or even working enterprises. Enter the cooperative.
The LCA has its roots (no pun intended) in agriculture (ok yes pun intended), helping producers collect and share profits effectively for years. Some DAOs have tried unsuccessfully to move operations to a foreign jurisdiction, like Panama, just to find out that having US token holders opens them up to the SEC and other enforcement actions, no matter where they’re based. Many others have tried to work the DAO into the LLC structure. Some have been more successful, particularly the Ricardian LLC or the Wyoming DAO LLC, and we’re excited about state legislators working on getting it right. But these still seem like round pegs in square holes to us. We believe there’s another option. This is where Colorado stepped up in adoption of the Uniform Limited Cooperative Association Act (CULCAA), a law enacted in 2011. Other states that have adopted the act are Washington, Utah, Nebraska, Oklahoma, Kentucky, DC and Vermont, but Colorado’s model is the best for DAOs in our opinion because they have a history of successful cooperatives and specific provisions that offer additional flexibility (like REI). The Colorado cooperative has not received its due.
Fundamentally it is a community based organization that is mandated to share profits amongst its members, who can also hold different roles in the cooperative. Sound familiar?
There are plenty of DAOs who don’t require their token to moon (but still want to return profit to holders), don’t want to deal with accredited investors, and definitely don’t want to be filing a million things with the SEC. They just want to do cool stuff together as a collective enterprise without going to jail or getting fined.
We worked with Jacqueline and Yev from JWPC, one of the most sophisticated law firms in the Colorado cooperative space, to deepen our understanding of DAOs and LCAs and get our first project off the ground. “The LCA is a hybrid between a limited liability company (LLC) and a corporation. It is an entity built on the law of unincorporated entities. Like LLCs, it allows for investor members, returns on investment to patrons and non-patrons, and voting rights for investors, while adhering to cooperative principles. Where it differs from an LLC is in the distribution of financial returns based on patronage activity, voting based on membership (one-member, one vote) or based on patronage, which allows for the integration of DAO based governance principles, such as rage quitting and quadratic voting.”
That second part about distribution of financial returns is important. LCA interests are non-transferable. That means you will never have liquidity for your token, so it can never moon on an exchange. However, LCAs can distribute dividends and royalties and other financial interests to token holders, so you can still have a healthy profit and financial upside. It also means you’ll never have opportunistic traders violating your lockup clause on sketchy exchanges and getting you into hot water with regulators. Additionally, you don’t need to reside in CO or even the US to form a Colorado LCA.
We’re working with projects focused on community, compliance and collective knowledge who want to build what they love and do well. If you want to build in web3 without having to move to Panama, we’d love to learn more about what you’re working on.
If you’re interested in working with us at NATION, please reach out.
Gerald Gallagher is NATION’s General Counsel. He spent five years investing and helping healthcare and fintech companies navigate complex regulatory environments before transitioning full time into web3.