As is the case with much of the blockchain industry, decentralized autonomous organizations (DAOs) are unique. The existence of a DAO does not necessarily imply the existence of a legal entity or an intent to share profits. Rather, a DAO is composed of a decentralized group of governance tokenholders who can direct the development of a blockchain ecosystem. While each DAO is different, DAOs frequently employ a set of smart contracts built into a blockchain protocol which allows holders of DAO governance tokens to participate in decision-making with respect to the DAO.
But with any novel structure come novel legal questions. A fundamental question when it comes to DAOs is what exactly is a DAO from a legal perspective? Is it a legal entity? A software platform? Something else?
And when something goes wrong, who is legally responsible for a DAO’s activities?
A recent ruling from the Northern District of California in Samuels v. Lido DAO, et al., is drawing attention throughout the industry, particularly proponents of decentralized governance. Lido DAO is a class action lawsuit brought against Lido DAO and several venture capital firms by Andrew Samuels, an investor who allegedly lost money purchasing LDO tokens on the secondary market.
Lido DAO follows in the wake of a default judgment obtained by the Commodities Futures Trading Commission (CFTC) against Ooki DAO in CFTC v. Ooki DAO, with the U.S. District Court in the Northern District of California ruling that the CFTC pleaded facts sufficient to show that Ooki DAO was an unincorporated association under California law. Prior to that, the U.S. District Court for the Southern District of California in Sarcuni v. bZx DAO noted that alleged governance tokenholders of the predecessor to Ooki DAO, bZx DAO, could be deemed members of a general partnership under California.
These cases highlight the possible liabilities for DAOs and their participants, including individual governance tokenholders and institutional investors. Though the contours of the potential legal risks and liabilities for DAOs have not been fully defined, this article explores the current legal landscape for DAOs and discusses steps that DAOs and ecosystem participants can take to reduce their exposure in the event of a lawsuit.
Lido DAO on Partnerships and Securities
The suit against Lido DAO and several of its institutional investors was brought by Andrew Samuels, an investor, alleging that Lido DAO sold unregistered securities in violation of federal law. Samuels purchased LDO tokens on the secondary market and incurred losses, prompting him to seek recovery under Section 12(a)(1) of the Securities Act of 1933 (Securities Act), which allows purchasers to sue persons who sell or offer unregistered securities.
Primary Issues and Court’s Reasoning
- Lido DAO, as a General Partnership, and its Partners’ Capacity to be Sued: Samuels’ complaint alleged that Lido DAO is a general partnership under California law. On a motion to dismiss, the court agreed that the plaintiff alleged sufficient facts such that, if found to be true, Lido DAO would meet the definition of a partnership under California law.
Cal. Corp. Code. § 16202(a) states that “the association of two or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership.” Samuels’ complaint alleged that Lido DAO’s founders formed it to run an Ethereum staking service that keeps a percentage of the staking rewards which would ultimately be distributed themselves and other tokenholders. The court found that these allegations supported that Lido DAO’s founders formed it as a business for profit. No explicit partnership agreement was required.
Dolphin CL, LLC, which appeared in the lawsuit to prevent a default judgment against Lido DAO, argued that Lido was merely autonomous software and not a legal entity. The court rejected this argument, stating that the plaintiff had alleged sufficient facts to support a holding that Lido’s actions were those of an entity run by people, not just software, and that the founders and tokenholders of Lido DAO were actively involved in governance and decision-making which contributed to the DAO’s legal status as a general partnership. This is significant because general partnerships do not provide liability protection, meaning tokenholders who actively participate in DAO governance may be personally liable for the DAO’s actions.
While the court admitted that it was unclear who exactly might be partners in the Lido DAO general partnership, it ruled that Samuels had alleged sufficient facts to keep the case alive against Lido DAO and many of its purported partners.
- Institutional Investors May be Considered Partners: The Lido DAO court considered whether institutional investors are members of the Lido general partnership and thus liable for its activities. The court denied venture capital firms’ motions to dismiss based on the fact that the plaintiff alleged that each firm “took an active role in [Lido DAO’s] management or intended to do so.” These denials were based on the plaintiff’s references to various statements made by each firm in press releases and tweets talking about their excitement to be involved in the project.
The court, however, granted one firms’ motion to dismiss the lawsuit as to its involvement in Lido DAO because the plaintiff failed to adequately allege that that firm’s involvement in Lido DAO.
The Ooki DAO Cases
Lido DAO follows the 2023 default judgment against Ooki DAO in CFTC v. Ooki DAO.
In Ooki DAO, the CFTC filed a lawsuit against Ooki DAO, alleging violations of the Commodity Exchange Act (CEA). The CFTC claimed that Ooki DAO provided a platform for retail commodity transactions without adhering to the necessary regulatory requirements, including registration with the CFTC and implementation of customer information and anti-money laundering procedures.
Throughout the litigation, Ooki DAO failed to appear in court. The court in 2022 ruled that the service of legal process via post on DAO discussion forums was proper. In the default judgment, the court noted multiple times that Ooki DAO made a calculated decision not to appear and that it had been given the opportunity to prepare and provide a defense. Exactly who should appear on behalf of a DAO in these situations is a continued point of tension as truly decentralized entities may lack a person or group who can represent the DAO and there is no legal incentive for an individual to appear on the DAOs behalf and run the risk of being held individually liable.
Ultimately, the court granted the CFTC’s motion for a default judgment against Ooki DAO, finding that the DAO violated the CEA by engaging in unlawful commodity transactions and failing to implement required regulatory procedures. The court issued a permanent injunction, imposed civil monetary penalties of $634,542, and ordered the removal of Ooki DAO’s website to prevent further violations.
Primary Issues and Court’s Reasoning
- Legal Status and Capacity to be Sued: The court determined that Ooki DAO could be sued as an unincorporated association under California law. This decision was based on the DAO’s structure, with the court noting that tokenholders had significant control over the protocol through their voting rights. Tokenholders could vote on governance decision, including updating code, pausing and suspending trading, and directing deposits and funds to users. The court also highlighted the role of Ooki DAO’s founders, who, it said, transferred control of the protocol to the DAO and continued to influence its operations. According to the court, the founder’s actions and the tokenholder’s voting rights demonstrated that the DAO was not merely autonomous software but an entity run by people.
- Jurisdiction and Service: The court found that it had personal jurisdiction over Ooki DAO because the DAO conducted business in the United States, and its founders and tokenholders engaged in activities within the country. Particularly, the court pointed to the availability of the protocol in the U.S., the fact that tokenholders resided in the U.S. during the relevant period and conducted business on behalf of the DAO by voting to govern and operate the protocol and to declarations from the CFTC indicating that the co-founders of Ooki DAO’s predecessor, bZx DAO, took actions on behalf of Ooki DAO while in the United States (these actions included advertising the Ooki Protocol on social media and engaging in governance actions).
Ooki DAO follows and makes explicit reference to Sarcuni v. bZx DAO, wherein the Southern District of California ruled that the plaintiffs had alleged sufficient facts which, if found to be true, would cause Ooki DAO’s predecessor, bZx DAO, to be a general partnership under California law.
In Sarcuni, a group of plaintiffs filed a class action lawsuit against bZx DAO; its founders, bZeroX LLC; and a group of additional defendants, alleging that the bZx DAO partnership had been negligent in allowing one of its developers to execute a phishing attack causing the plaintiffs to lose $1.7 million.
Similar to Lido DAO, the court in Sarcuni ruled that the participation in DAO governance was a key component to determining whether bZx DAO was a general partnership. The court noted that the alleged facts showed that every DAO tokenholder was plausibly a partner in bZx DAO given the alleged right of each of the tokenholders to share in DAO profits.
Legal Implications for DAOs
The legal landscape for DAOs is rapidly evolving. While much remains to be addressed with respect to the treatment of DAOs as partnerships and the liabilities faced by their tokenholders as a result of such treatment, both Lido DAO and the Ooki/bZx DAO cases have brought these issues into the spotlight.
- DAOs Have the Legal Capacity to be Sued: In each case that has addressed this issue, courts have determined that DAOs can be recognized as legal entities capable of being sued. This recognition signals that DAOs cannot evade legal liability simply by operating as decentralized entities. Courts may treat DAOs as general partnerships or unincorporated associations, making governance tokenholders and others potentially liable for the DAO’s actions.
Today, more DAOs are employing legal entity “wrappers” to provide legal protection for ecosystem participants. A legal wrapper also allows the DAO to take actions a traditional organization would, such as interacting with other parties, making grants, and entering into contracts.
- Institutional Investors Are Not Precluded from Partner Treatment: Institutional investors in DAOs may face increased scrutiny regarding their roles and responsibilities. The courts’ findings that institutional investors were general partners in Lido DAO suggest that investors who actively participate in governance and decision-making could be held liable for the DAO’s regulatory violations.
Some DAOs have employed insurance solutions to help mitigate the risk that governance tokenholders and other ecosystem participants could face legal exposure. Fenwick developed a specialized insurance solution for DAOs called REBA that is akin to directors & officers’ insurance but has been expanded to include coverage for DAO investors and participants in DAO governance.
- DAOs Must Consider Proper Governance and Control Mechanisms: The courts’ emphasis on governance and control mechanisms within DAOs highlights the risks of shirking any formal governance structure. DAOs should ensure that their governance mechanisms do not exposure governance tokenholders to undue legal risks.
Tokenholders may want to consider utilizing a limited liability structure to hold their tokens and participate in DAO governance.
By being proactive—whether through legal structuring, governance refinements, or risk assessment—Web3 entrepreneurs, investors, and tokenholders can continue to innovate while also safeguarding against potential liabilities.
