The “DAO Jungle” Chronicles: Federal Court Allows DAO to be Sued as a Partnership
This post was primarily authored by Daniel Zarchy, a “Rising Star” for five of the past six years who is a litigation attorney at Patton Sullivan Brodehl LLP.
In a prior post — The DAO Jungle? — we recapped the State of Wyoming’s new legislation extending LLC protections to Decentralized Autonomous Organizations (DAOs). Under that Wyoming law, a DAO could register as a LLC and its members would presumably obtain the limited liability benefits that LLCs offer — notably, protection from individual liability.
The legal landscape surrounding DAOs continues to unfold, as shown by a recent federal case, Sarcuni v. bZx DAO.
What is a DAO?
As cryptocurrency protocols continue pushing into the mainstream, enthusiasts and regulators alike are keeping a close eye on how the courts will treat DAOs under the law.
DAOs are an increasingly popular format for crypto protocols to self-govern. They allow groups of like-minded holders of a specific cryptocurrency, or “token,” to emulate a number of functions of corporate governance – such as voting on how to use DAO resources – all while remaining anonymous and decentralized. However, there has been a great deal of uncertainty about how courts would treat DAOs in the absence of clarifying legislation.
That picture became a bit clearer in March when a federal judge in California denied a motion to dismiss, allowing a complaint to proceed against a DAO on the theory that the DAO was operating as a general partnership.
Token holders sue after a hack
In the Sarcuni case – which is pending in the U.S. District Court for the Southern District of California – a collection of 19 plaintiffs brought a class action lawsuit after the crypto protocol bZx was hacked, resulting in the theft of millions in cryptocurrency. The plaintiffs alleged that the defendants – including the bZx DAO, a group of individuals within the DAO, and the limited liability company bZerox LLC – had transferred control of the protocol from the LLC to the DAO, which operated the underlying protocol and was controlled by holders of bZx’s own BZRX token.
According to the complaint, the creators of the bZx protocol made claims to token holders that bZx was secure and that there was no chance of a hack or that their funds would be stolen. However, bZx’s developer was later successfully hacked through a phishing email which contained malicious software and allowed the hacker to transfer approximately $55 million out of the protocol, resulting in a $1.7 million loss to the plaintiffs.
Elements of a general partnership
The complaint, which included a single cause of action for negligence, was premised on a theory that all holders of BZRX tokens were members of a general partnership, which would make the defendants jointly and severally liable, meaning that the defendants would be responsible for all of the plaintiffs’ lost funds.
In its holding, the court noted that California law has consistently held that the existence of a partnership depends on the actions, rather than the intent, of the parties, meaning that a partnership can exist even if the parties never formalized their relationship or even intended to form a partnership. Generally, factors that may suggest the existence of a partnership include: (1) the right of the purported partners to participate in the management of the business; (2) the sharing of profits and losses among the purported partners; and (3) contributions of money, property, or services by the purported partners to the partnership. In the specific case of the bZx DAO, the court held that the plaintiffs needed to plead that the DAO was (1) an association of two or more persons (2) carrying on as co-owners of (3) a business for profit.
Given that the bZx protocol operated to generate profits through margin trading and lending products, the court held that the complaint adequately alleged that the DAO was an association of two or more persons who were operating a business for profit.
As to the second prong of carrying on as co-owners, the plaintiffs argued that this was met because BZRX token holders had governance rights and shared in the profits and losses of the protocol.
To the first point, the plaintiffs argued that holders of the BZRX token had a number of governance rights, such as the ability to propose and vote on actions such as hiring employees, changing goals and policies, and distributing treasury assets to holders. Despite the defendants’ argument that the governance rights were limited, the court agreed with the plaintiffs, noting that the fact holders’ governance rights were limited did not refute the existence of a partnership.
Second, as to sharing profits, the plaintiffs argued that the BZRX token holders ability to vote to distribute treasury assets to themselves, like a corporate dividend, supported the argument that a partnership existed. The court agreed, noting also that the Commodity Future Trading Commission’s preexisting litigation against bZeroX, LLC described that bZx generated fees from liquidity providers, and granted those providers interest-generating tokens and BZRX tokens in exchange. Given that BZRX holders could profit either through a vote to distribute treasury assets to themselves, or by owning an interest-bearing token, the court held that token holders shared in bZx’s profits.
As all three prongs were met, the court held that the complaint sufficiently alleged a general partnership existed among all holders of the BZRX token, and therefore the plaintiffs could assert their negligence claim against the defendants as partners.
What this means for your DAO
As the first case to decide this issue, the ramifications of this decision remain to be seen. However, the court noted that crypto protocols that follow proper formalities may not fall into the same trap. When control of the protocol moved from bZerox LLC to the DAO, the protocol’s developers decided not to register as a limited liability company or any other limited liability entity, stating publicly that by not registering, they would be able to evade oversight and accountability. Instead, it seemingly had the opposite effect.