DAOs: A Game Changer in Need of New Rules

September 30, 2022 – A decentralized autonomous organization (DAO) is a relatively new structure gaining popularity in the blockchain community. DAOs are community-governed entities built on a blockchain using smart contracts with no central leadership and no restrictions on the geographical location of their members, potentially resulting in an international organization.

DAOs appear to be transparent and their lack of central leadership is attractive to many. What DAO members often don’t realize is that they can unwittingly expose themselves to personal liability for being members of a DAO.

Unlike shareholders or members of more traditional legal entities, DAO members do not enjoy personal liability protection for the DAO’s actions, unless there is a state law that offers such protection.

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In this article, the authors examine the risks of DAO membership and recent examples that demonstrate the urgent need to create federal and state regulations that are public and transparent, as opposed to regulation through enforcement.

bZerox DAO | Ooki DAO

Earlier this month, the Commodity Futures Trading Commission (CFTC) imposed a $250,000 civil penalty on bZerox (bZx) DAO, which illegally offered leveraged and margined retail commodity trading in digital assets to its members in violation of commodity exchange requirements. Act (CEA) and CFTC regulations. These margin retail commodity transactions were required to take place in an established contract market, but did not.

The CFTC also initiated a federal civil action in California against Ooki DAO (Ooki), a successor in interest to bZx, which has the same members and operates the same software protocol, alleging violations of the same laws.

Importantly, the CFTC’s settlement order also held bZx co-founders Tom Bean and Kyle Kistner personally liable, having transferred control of bZx’s software protocol to Ooki. Even if the DAO’s conduct was found to be illegal, finding the owners personally liable based solely on their status as owners of the Ooki DAO’s voting token should raise concerns among DAO members.

The CFTC’s approach to deciding who is liable for violations has been the subject of internal debate within the CFTC. CFTC Commissioner Summer K. Mersinger issued a dissenting statement, calling the decision to prosecute bZx’s co-founders “arbitrary” and “based on a legal theory that is unsupported by enforcement as federal and state policy evolves.”

As he noted, there are three grounds on which the CFTC may rely in support of prosecuting a person for a violation of the CEA and CFTC rules committed by another person or entity: (1) principal-agent liability, (2) aiding and abetting liability and (3) controller liability.

However, the CFTC based its decision on California contract and tort law precedents, which hold that individual members of a for-profit unincorporated association are personally liable for the association’s debts. Commissioner Mersinger emphasized that the CFTC appeared to have exceeded its authority by acting in a manner not intended by Congress.

He noted that the CFTC is dealing with regulation that will have far-reaching policy implications. In particular, the Commission’s settlement order and complaint arbitrarily define the Ooki DAO unincorporated association as consisting of those who vote for proposals with Ooki tokens.

This definition creates an unequal distribution among token holders based on whether they vote or do not vote with the token. According to the CFTC definition, a token holder who votes on any matter becomes a personally liable member, and a token holder who is unable to vote for any reason is not considered a member and exempt from liability. This definition discourages participation in voting in DAO governance.

Commissioner Mersinger explained that the CFTC has better ways to begin establishing public notice and comment rules on how DAO members should be identified and who the CFTC can hold personally liable for DAO violations. This process would allow for public input from interested parties and would highlight the possible implications of the Commission’s approach to DAOs.

In addition, Commissioner Mersinger opined that the CFTC could achieve the same result by using the aiding and abetting standard in holding Bean and Kistner personally liable, rather than relying on new legal theories that could have far-reaching implications for DAOs. .

Sarjuni v. bZx

bZx’s civil problems earlier this year, Sarjuni v. In bZerox and others, it began when members of bZx filed criminal charges against The DAO, its founders, and investors after a successful “phishing” attack resulted in the theft of $55 million in funds. from the platform. The plaintiffs claimed that the theft was possible due to the lack of security features on the platform.

The defendant-founders filed a motion to dismiss, arguing that it was improper to impeach them because the stolen funds belonged to DAO. The claims argued that since bZx was owned and operated by the DAO itself, only the DAO could be held liable. Although the plaintiffs were members of the DAO, they argued that they were not “meaningful” members and lacked sufficient control to impose any liability.

The court’s decision in Sarjuni is expected to set the standard for founder and manager liability for the actions or omissions of a DAO. Unlike many other DAOs, bZx DAO is a limited liability company under Delaware law.

In addition, bZx Holding Corp., incorporated in the state of Wyoming. there is a holding company named The court must consider LLC status and whether Delaware law provides protection for the founders.

Regulation of DAOs

bZx’s failures and their consequences highlight that the status of DAO members is uncertain, that regulation and enforcement are not uniform, and that there is a serious need for clarity regarding the status of DAO members and the risk of personal liability.

Most DAOs lack the legal protections afforded to limited liability companies. Members could face personal liability simply for using their tokens for simple voting, possibly unrelated to any subsequent DAO actions that might result in liability.

Several states, such as Vermont, Wyoming, and Tennessee, have enacted legislation that provides some protections to DAOs and their members. While these laws have yet to be tested by the judiciary and have been criticized as out of touch with the realities of DAOs, they are at least a start.

Wyoming passed a law in 2022 to protect DAO members from personal liability by allowing DAOs to obtain legal status as limited liability companies. The charter defines DAO voting and quorum requirements and allows DAOs to determine their own quorum (the previous statutory membership quorum requirement of 50% was difficult to achieve with a fluid membership of DAOs and perhaps thousands of owners). No member has a fiduciary duty under the charter.

Vermont has also passed its own blockchain-based statute. Vermont legislation does not specifically address DAOs, but does allow for the creation of a new type of business entity – the Blockchain Based LLC (BBLC). A BBLLC is allowed to customize its governance structure. The operating agreement must define the rights and responsibilities of each participating group within the BBLLC.

Tennessee is another state that provides protection for DAOs within its statutes. Under Tennessee law, unless otherwise provided in the articles or operating agreement, the management of a DAO may be member-directed or managed by contract.

There is no requirement for a DAO to have centralized management or managers. Furthermore, the law does not even require the person creating the DAO to be a member. The DAO specifically states that members have no fiduciary duty to the DAO.

The biggest criticism of current DAO legislation is that it imposes additional burdens on DAOs without providing real benefits in return. This comes from not understanding how DAOs work. The CFTC order also emphasizes the need to clearly define who is a member or controller in a DAO.

Analysis and conclusion

bZx DAO was established in 2019 before two of these laws came into force. They merged in Delaware, traditionally the most corporate-friendly state. The CFTC’s Complaint alleges that bZx’s rebranding to Ooki was done solely to avoid regulatory enforcement, but that the new organizational form exposed members of the unincorporated association to personal liability.

Most DAOs are unincorporated associations, and many are not registered in Wyoming, Tennessee, or Vermont, and so their members are similarly at risk of personal liability for the DAO’s actions.

DAOs typically have thousands of members. Each member has the opportunity to vote on the management of the DAO. While the CFTC acknowledges that DAOs can be used for good governance, the CFTC order is a warning to DAOs and their members that good actors can be innocently punished for the actions of bad actors within a DAO.

DAOs have the potential to change the way businesses govern themselves—how companies operate—and give members a voice in decisions that affect their companies. Companies will use blockchain technology to improve themselves and their relationships with their customers.

The CFTC is the federal agency responsible for overseeing digital assets, including cryptocurrencies such as Ethereum, Solana, Polygon, and more. Most DAOs use these tokens to allow members to enter the community and participate in its governance. Members of DAOs that do not have a proper jurisdiction or governance structure to protect members leave themselves open to personal liability.

In light of the CFTC ruling, DAOs will need to reexamine their governance structures and consider how best to insulate members from unplanned personal liability. In addition, DAO members should review their insurance coverage, as they may find that their personal and business policies do not have coverage for DAO liability exposure.

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The opinions expressed are those of the author. They do not reflect the views of Reuters News, which is committed to integrity, independence and freedom from bias in accordance with its Principles of Trust. Westlaw Today is owned by Thomson Reuters and operates independently of Reuters News.

Jana S. Farmer

Jana S. Farmer, a partner in Wilson ElserMoskowitz Edelman & Dicker LLP’s White Plains, New York office, leads the firm’s art law practice and is a member of the firm’s intellectual property and technology practice. He advises clients on legal issues arising in the technology space, including non-fungible tokens and blockchain technology. He can be reached at jana.farmer@wilsonelser.com.

John Cahill

John Cahill is an associate at Wilson ElserMoskowitz Edelman & Dicker LLP, focusing on general loss and liability. Based in White Plains, New York, he assists clients in risk and crisis management during the pretrial phase of potential claims and specializes in the emerging field of cryptocurrencies. He can be reached at john.cahill@wilsonelser.com.

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