By Francisco Moran and Casper Xiao

Introduction

In the ever-expanding realm of technology, Decentralized Autonomous Organizations (DAOs) are challenging traditional organizational structures. For tech innovators, leaders, and those venturing into the multijurisdictional digital landscape, DAOs offer an enticing solution. They enable decentralized collaboration and decision-making. Nevertheless, the absence of a central authority and the unique nature of DAOs have left the legal status of these entities uncertain. The recent BzX/Ooki Dao Lawsuit sheds light on the question of whether DAOs can be sued as legal entities.

What is DAO?

A Decentralized Autonomous Organization (DAO) is an innovative organizational structure capturing the attention of tech and crypto startups. Unlike traditional entities, DAOs operate on blockchain technology, without the need of a central governing body. Governance in DAOs relies on collective, community-driven decision-making to act in the best interest of the entity. For example, MakerDAO utilizes the DAO structure to manage its “stablecoin,” a digital currency pegged to a fiat or stable currency. Think of it as a club where members collectively decide how to manage a pool of funds. All crucial decisions are made by members voting through an online portal, without the need for a central authority to make the decisions.

The evolution of the DAO landscape

The concept of Decentralized Autonomous Organizations (DAOs) promises a revolutionary approach to self-governance and digital asset management, offering a streamlined alternative to traditional systems and regulations. However, we must maintain a pragmatic perspective, considering how regulations will adapt to govern legal responsibilities and avoid the misconception that all legal obligations can be discarded in the face of innovation.

As with cryptocurrencies, we stress the need for caution amid the excitement surrounding DAOs. Particularly, the “no jurisdiction” and “limited liability” characteristics of DAOs and their business raise critical concerns. We regularly advise our clients that, by its nature, a DAO will likely fall under the categorization of a general partnership in most states – being defined as “an association of two or more persons to carry on as co-owners a business for profit” under the Uniform Partnership Act (UPA). This categorization carries a harsh reality: all “partners” bear joint and several personal liability not only for the actions of the DAO as a partnership but also for the actions of all other partners. In the case of a DAO, this liability may extend beyond governance token holders to encompass any token holder engaging in business or transactions within the DAO.

Given that DeFi has faced scrutiny from financial regulators like the Commodity Futures Trading Commission (CFTC) and the Federal Trade Commission (FTC) in the United States, it is essential to assess the potential financial liability that a single individual could incur for failing to establish a proper legal framework for an unincorporated DAO. The stakes are even higher when DAOs possess NFTs, which are unique crypto assets known for their high and volatile values. Further insights on NFTs and their legal considerations can be found here.

What the bZx/Ooki Story Teaches Us

Without delving too deep into the intricacies of the bZx Protocol, let’s set the stage. The bZx Protocol was initially created by Tom Bean and Kyle Kistner, who owned and controlled the protocol through their company, bZerox LLC. They operated the crypto FinTech platforms, Fulcrum and Torque via a separate LLC, also fully owned and controlled by Bean and Kistner.

So far, this setup seemed appropriately structured. However, once the owners decided to transition the entire operation onto a DAO, did issues start to arise. The owners erroneously believed that by relinquishing control to the community and by believing that a DAO is beyond jurisdiction due to its lack of incorporation and widespread acceptance as a legal structure, that they could evade regulatory obligations (i.e. providing trading/loan/financial services products without requiring the adequate licenses)  that normally apply to incorporated entities.

Reality check

The first reality check came from the CFTC  in September 2022. They determined that Bean and Kistner, bZerox LLC, bZx DAO, and its successor, the Ooki DAO, constituted an unincorporated association, thereby making them jointly and severally liable for offering financial services without a license and failing to meet regulatory requirements. This resulted in a $250,000 fine and mandatory compliance measures to be undertaken. It marked a milestone for regulators, emphasizing that crypto organizations are within their reach.

At the Core of the Issue?

Fast forward to March 2023, and the bZx DAO suffered a significant loss due to a phishing attack. Token holders sued bZx et al, and affiliates, for 1.7 million dollars.

Details of the case can be found here.

At the core of the legal dispute was whether bZx et al are jointly and severally liable as a general partnership, and whether duties around asset custody and other fiduciary duties, had been breached. The case brought key discussion points around DAOs, and whether they can be regulated or treated as entities that can be sued. 

The Class Action Result

The Court mostly denied the defendants’ motion to dismiss, arguing that bZx wasn’t a general partnership and owed no duties to token holders. It’s important to note that this legal opinion is not binding on any other court or judge, but nevertheless supports the motion that Courts can potentially construe a DAO as a general partnership (under California Law for now).

Regulator’s Separate Win against bZx

Furthermore, On June 08, 2023, U.S. District Judge William H. Orrick ruled in favour of the CFTC, and ordered that bZx pay a fine of US$643,542, permanently banned them from trading and ordered their website and content to be removed from the internet. The District Court in the case of the regulator against bZx did not consider the partnership issue, but rather found that DAOs at least constituted a “person” in the form of an unincorporated association, and thus were subject to the Commodity Exchange Act (CEA).

Despite bZx’s efforts to navigate around regulatory scrutiny by altering corporate structures and governance models, it found itself facing a highly unfavorable allegation from a liability perspective – being potentially treated as a jointly and severally liable general partnership and facing the full brunt of the CFTC’s penalties.

Where to now?

The landscape has changed, and the notion that DeFi and DAOs are beyond the hand of the law is no longer viable. Web3 is slowly becoming a mature industry with various companies operating under different structures, where regulation is starting to pick up steam. There are multiple tools available for business owners and DAO founders to structure projects while complying with jurisdictional requirements. From traditional incorporation methods to innovative approaches like the Wyoming DAO LLC, options abound. Governance tokens should be taken seriously, and DAO members should strategize their business within legal boundaries.

If you have questions or concerns, feel free to reach out. We have experience supporting project creators and are excited about the possibilities of blockchain. Ultimately, we are business lawyers, committed to helping your business thrive within the bounds of legal regulations. Reach out to us today!