Commentary-5

Limited liability of shareholders, while being a defining and important feature of the modern corporation, has not always been an attribute of corporations. According to Harris, limited liability evolved since the 1600s over three distinct periods from a system of no limited liability (circa. 1600-1800) to a multiplicity of hybrid liability regimes (circa. 1800-1930) to 'strong' owner shielding in the twentieth century.[^22] It was only in this third period that creditors were granted legal priority over equity holders in claiming corporate assets.

There are several legal and economic grounds for why limited liability became a uniform attribute of the corporation. With the growth of large, complex corporations in the United States with dispersed shareholding structures, it became apparent that it was untenable for individual shareholders to have 'moral culpability'[^23] for the actions of corporations, as they lacked the power and control mechanisms to discipline errant management. At the same time, limited liability allows risk-averse persons to take business risks that they may have otherwise avoided, thereby enhancing the chances of gaining a lucrative return, as the risks of a poor investment are shifted onto creditors and other third parties.[^24] Ordinarily, shareholders that enjoy limited liability only stand to lose what they have invested in the event of insolvency. As a consequence, shareholders are also able to invest in multiple corporations without having to closely monitor any of them.[^25] This is a clear example of how corporate legal requirements evolved to address the inherent trade-offs underlying public policy goals to enhance or enable political and social economies afforded by implementation of such rules. Voluntary creditors are able to, however, protect themselves from the moral hazard of shareholders by imposing higher interest rates on any loans extended to the corporation and by negotiating limitations on actions that a corporation can take without creditor approval. Involuntary creditors, such as tort victims, may seek to pierce the corporate veil so as to satisfy the claims they may have against individual shareholders or parent companies, but globally such efforts at veil piercing are generally unsuccessful outside of cases of fraud.

As a corollary to this, there are legal and economic grounds for why unlimited liability is less favored by contemporary corporate entities, although certain corporate entities have unlimited liability as a mandatory rule (e.g., in general partnerships) or as a default rule (e.g., cooperative societies in some jurisdictions). While unlimited liability would offer voluntary and involuntary creditors some solace that shareholders would be jointly and severally liable for any claims that remain unsatisfied by the corporate entity, this would be poorly suited to the interests of members of an entity that has potentially thousands-if not millions-of anonymous members and aspires towards participatory governance, such as a DAO. It is the combination of these two attributes, among other things, that makes the governance of a DAO distinct from that of an archetypical Berle-Means corporation.

It could be argued that, as with other business organizations with unlimited liability, the ability of Members to participate in governance would be sufficient to ameliorate vertical (principal-agent) and horizontal agency problems (majority-minority principals). However, the fact that many of the other Members are unknown would, in principle, heighten the apprehension of Members that Tokens could be sold to poorer third parties and thereby increase their collective risk.[^26] In other words, in the absence of limited liability, DAOs would have to adopt a rule similar to general partnerships, that to sell their membership-conferring Tokens on a secondary market would require unanimous consent of all Members[^27]―a requirement that would be cumbersome and costly for DAOs, as it would decrease the liquidity of their tokens. For voluntary and involuntary creditors,[^28] joint and several liability may also lose its appeal when confronted with the reality that they would potentially have to pursue individual claims against several, dispersed Members. It is arguable that it is even unfair that creditors be able to arbitrarily pursue actions against individual Members, based on the accessibility of the Members' jurisdiction or wealth. At the same time, it creates social costs as it is society that has to bear the costs related to the public enforcement of these liability claims.

The above summarizes some of the main advantages of an entity having limited liability and the central disadvantages of having unlimited liability, so as to explain why the Members of a DAO should be extended limited liability. In addition to the aforementioned legal and economic benefits of limited liability, the absence of such protection for Members would discourage participation in a growing market and stymie the development of innovative financial and non-financial products. While limited liability can be privately ordered―for example, by having representatives of the entity negotiate contractual clauses where creditors agree to waive any claim on Members' assets―this is an expensive exercise prone to moral hazard.[^29] Instead, we seek limited liability to be granted to DAOs compliant with other requirements articulated in the Model Law, as it has been in the past with a multitude of other corporate entities[^30] and as it has recently come into force in the State of Wyoming.[^31]

Understandably, there may be concerns regarding the abuse of limited liability. This may be addressed by DAOs by introducing a requirement for Members to make a financial contribution to a reserve fund or towards the premiums of an appropriate insurance policy for the benefit of limited liability. Such a bond in exchange for limited liability has been advocated by Robert Rhee and Abraham Singer.[^32] Some DAOs may decide to sequester some of their On-Chain Assets in a specially designed Smart Contract, which will pay out in case of liability. Insurance customised to the needs of a DAO may be able to cover a larger share of potential future liabilities, however, the novelty and riskiness inherent in this sector make such coverage prohibitively expensive. Nonetheless, we have included this voluntary option with the view that insurance providers will gradually emerge to respond to the needs of this space, as can be seen with the example of Nexus Mutual.[^33] In addition, the veil piercing option in Article 5(3) further mitigates risks of abuse of Members' limited liability, while Article 5(3) ensures Members cannot simply refuse to pay a judgment against the DAO. Note that Articles 5(1) and (3) does not make Members liable for excess liability the DAO is unable to pay from its Assets, but only for an outright refusal by the DAO to respond to judgment against it.