The DAO & Legal Liability

On September 22, 2022, the Commodity Futures Trading Commission (CFTC) filed suit against Ooki DAO alleging that Ooki was operating an unlicensed retail commodity interest exchange (leveraged crypto trading). Having failed to respond to the CFTC’s complaint, a default judgment was entered against Ooki — an unincorporated association, on June 9, 2023.

Crypto media has jumped on the default judgment as if it were legal precedent that DAOs cannot escape legal liability. However, a default judgment entered in a US District Court is not precedent and there are indeed many more layers to this that necessitate further analysis.

What is a DAO?

A Decentralized Autonomous Organization (DAO) is an organizational structure that operates autonomously through smart contracts and blockchain technology, without the need for a central authority or hierarchical management. It is designed to function transparently and democratically, with decision-making processes driven by a consensus of its participants.

In a DAO, the rules and operations are encoded in smart contracts, which are self-executing agreements with the terms of the organization’s functions. These smart contracts are typically built on blockchain platforms such as Ethereum, and they define the DAO’s governance, voting mechanisms, and distribution of resources.

The overwhelming majority of DAO’s — like Ooki, operate as unincorporated entities.

DAO as a General Partnership

By default, most DAOs take the form of a general partnership. A general partnership is a type of business structure where two or more individuals or entities come together to carry on a business for profit. In a general partnership, the partners share the profits, losses, and management responsibilities of the business.

One significant aspect of a general partnership is that the partners have unlimited personal liability for the partnership’s debts and obligations. This means that if the partnership cannot meet its obligations, the partners’ personal assets can be used to satisfy the debts. Notably, in the matter of Sarcuni v. bZx Dao — Ooki DAO’s predecessor, a series of investors filed a class action alleging that bZx was a general partnership and therefore ALL of the DAO members were joint and severally liable for the obligations of the DAO.

In Sarcuni, the US District Court, interpreting California state law, the court noted that the California Corporations Code makes general partnerships a default rule. That means that absent any registration as an LLC or some other business organization, when two or more persons associate with one another as co-owners to carry on a business for profit, that association risks being classified as a general partnership under California law, regardless of whether the parties intended to form a partnership. While important, the context of the decision is important — and often misquoted in crypto media. First, the order was made in response to a motion to dismiss in which the Court must accept the plaintiffs’ factual allegations as being true. Second, this was only a preliminary order in the US District Court.

Nevertheless, there is a strong legal argument to make that an unincorporated entity DAO is likely to be interpreted as a general partnership — which would leave all DAO members joint and severally liable for the obligations of the DAO.

The Wyoming DAO LLC & Other Frameworks

The Wyoming DAO LLC is a newer type of entity introduced in March 2021 through the enactment of a DAO Supplement in the Wyoming Senate. To be recognized as a DAO LLC under this supplement, an LLC must include a statement in its articles of organization indicating that it is a DAO. An LLC is a business structure commonly used in the United States and globally, providing owners with protection from personal liability for the company’s debts or obligations.

The establishment of a DAO LLC offers several benefits. It helps safeguard DAO members from unlimited liability concerning the actions of the DAO. It also facilitates the DAO’s engagement with the external, off-chain world, enabling activities such as entering into contracts and managing the DAO Treasury in a compliant manner.

Other countries have limited regulation and structures available that would potentially limit liability of individual DAO members. For instance, The Marshall Islands has proposed a unique approach to establishing legal entities for DAOs. Instead of following the common practice of establishing DAOs as foundations, they propose a non-profit corporation in the form of a limited liability company (LLC). However, the DAO must not distribute profits to its members, officers or directors.

DAOs and Legal Liability for Violations of Securities Laws

The argument for DAOs not being subject to legal liability for securities law violations is based on the decentralized and autonomous nature of DAOs and the distinction between the actions of the organization itself and those of its individual participants. This includes:

1. Lack of Centralized Control: DAOs operate without a central authority or management structure. Decision-making and governance processes are typically driven by consensus among participants. As such, it can be argued that the actions of the organization cannot be attributed to any specific individual or entity.
2. Participant Agency: DAOs rely on voluntary participation from individuals who choose to interact with the organization. Participants may engage in various activities within the DAO, such as voting, contributing funds, or proposing initiatives. It can be argued that these actions are undertaken by autonomous individuals and should be treated as separate from the actions of the DAO as a whole.
3. Smart Contract Automation: DAOs often rely on smart contracts to automate their operations. Smart contracts are self-executing agreements that define the rules and functions of the DAO. Supporters of the argument may contend that the execution of these smart contracts is a technological process rather than a deliberate act of the organization itself.
4. Lack of Promoter Activity: In traditional securities law, the concept of a “promoter” refers to individuals or entities actively involved in the promotion, issuance, or marketing of securities. It can be argued that DAOs, being decentralized and typically community-driven, do not have a distinct promoter who is responsible for the sale or distribution of securities.

Ooki DAO seemingly has relied on the above bases (mostly derived from elements of the Howey Test) to exempt both the DAO and its members from legal liability. I call this the “listless ship” argument in that it contemplates that the DAO founders and every member thereof are simply acting subject to a nebulous lines of code and haven’t any responsibility therefor. In my opinion, it is truly impossible to obtain finite decentralization as somewhere, somehow, DAO promoters or members have had to contribute resources — and at some point management, to the DAO. Put another way, how can a DAO start being truly decentralized with, for example, 10,000 members all acting contemporaneously in concert with each other?

Conclusion

Without question, the unincorporated DAO is a poor decision. Given the $100 cost to incorporate a DAO LLC in Wyoming, promoters have a responsibility to future DAO members to insulate them from potential legal liability. As to whether the DAO LLC itself cannot be held liability for violation of securities laws is not (despite what you may read) settled legal precedent. However, the “listless ship” argument is likely not something that will pass legal review.

As always, be sure to reach out to me with any questions or book a meeting here.

About Adam Tracy

Adam Tracy is a payments expert and entrepreneur who specializes in payment systems, blockchain technology, digital currencies, and other emerging technologies. He is the founder of Blockrunner, LLC that provides consulting services to clients in the blockchain, payments and cryptocurrency arenas.

Tracy has been involved in the payments industry as an attorney, consultant and entrepreneur since 2005, while he was become an expert in blockchain and cryptocurrency since its advent in 2013. Tracy has worked with a wide range of clients, including startups, established businesses, and investor — both in the United States and worldwide. He has advised clients on a wide range of compliance, legal and operational issues related to payment transfer systems, crypto token generation and architecture, cryptocurrency exchanges, regulatory licensing, smart contracts, and other blockchain applications.

In addition to his consulting work, Tracy has founded several companies in the payments, blockchain and cryptocurrency space, including a digital asset hedge fund, licensed electronic money institution and a blockchain-based tokenization platform. He is also a proponent of decentralized finance (DeFi) and has been involved in various DeFi projects.

Tracy is also a frequent speaker and writer on blockchain and cryptocurrency topics. He has been featured in a wide range of publications, including Forbes, Hollywood Reporters, CNBC, Reuters, CoinDesk, and Bitcoin.com.

Find Adam: https://linktr.ee/adamtracy

Blockrunner, LLC., is a financial services match-making marketplace and consulting company. We are not a bank, FI/NBFI, Payment Service Provider, deposit taking institution, trust, or money services business of any kind. We are not regulated by any financial regulator. Banking, Payment, Processing, and Licensing services are provided by our participating members. This website is for informational purposes only and does not constitute legal advice. If you need legal advice, please consult a licensed attorney in your jurisdiction.

Originally published at http://adamtracy.io on June 12, 2023.