Decoding DAOs Amid CFTC Suit

Last month, the Commodity Futures Trading Commission (CFTC) filed suit against blockchain company bZeroX, its founders, and Ooki DAO, a crypto collective affiliated with the company, alleging that they allow crypto traders to illegally buy and sell commodities and futures on margin. It is the agency's first case against a decentralized autonomous organization (DAO). Earlier this week, Brown Rudnick filed an amicus brief in the case on behalf of LeXpunK, a collective group of lawyers and developers active in the crypto sector.  

"LeXpunK has an interest in this case and can provide the Court with important additional information and perspective with respect to the novel facts at issue here, in a case of first impression dealing with liability for participation in a so-called Decentralized Autonomous Organization or DAO," the filing said.

What is a DAO?

For the uninitiated, a DAO is a loose collective of people that interact with a smart contract, which is a software program of varying complexity that operates on a preset set of rules, for the purpose of running an organization that would otherwise be run by a corporation, or a partnership. The difference between a DAO and a corporation is that in a DAO many of the managerial decisions are taken by the smart contract following a vote of the collective membership of the DAO.

The smart contract’s terms are published on a blockchain, in a form that is freely available to all and in common with other blockchain applications, indelible and subject to change only in a transparent and collectively approved way.

DAOs can raise money by charging a fee to subscribe to the contract and pay out dividends or profits in accordance with the terms of the smart contract.

This organizational structure has several benefits: it is useful for all individuals who subscribe to know that the rules of the DAO are laid out plainly and that they will receive profits on the basis of those rules.

If a DAO is deemed a general partnership or an unincorporated association, each participant risks joint and several liable.

Many DAO subscribers are anonymous, outside the jurisdiction, or judgement proof for one reason or another. This leaves the burden of cleaning up the mess of a DAO to those subscribers who can be identified, as was the case in Ooki.

Isn’t there some way to protect DAO subscribers?

Yes, there might be. Two states, Wyoming and Tennessee, have recently passed legislation that adds DAO structures to their recognized corporate entities. These novel corporate structures allow for smart contracts, or “event driven contracts,” to govern much of the operations of the company and shield subscribers from liability in the case of a DAO failure.

This a double-edged sword, as it gives those who would contract with a corporate DAO even less protection than a standard DAO and makes it less likely that mainstream players will risk any serious capital on DAOs. It does however mean that investment by subscription is more likely as many subscribers will feel more secure in the knowledge that their losses will be limited to their subscription fees.

The Wyoming and Tennessee statutes purport to give them genuine legitimacy as corporate entities and all for their safe operation by swathes of people who would have previously been put off by the potentially unlimited losses that could occur as a result of being a general partnership.

However, these laws have not been fully tested or even analyzed in regard to bankruptcy and other failures of DAOs. Questions that have not yet been answered include:

• Will DAO corporate structures in Wyoming and Tennessee remain protected in event of a software failure in a smart contract? 
• Who can members sue in the event of such a failure? 
• Can a smart contract owe a fiduciary duty to the members? 
• Can the members act against their own interests?
• Will the corporate veil remain intact in those circumstances? 

Until these questions are answered and the risk landscape fully mapped, corporate DAOs will not achieve the kind of mainstream acceptance that we have seen in other parts of Web 3.0.

What’s the bottom line?

The CFTC action in Ooki has brought into sharp relief the need for a proper corporate scheme for DAOs, as it shows that the vulnerabilities of general members of unincorporated DAOs are real and not just a theoretical legal exercise.

However, presently, corporate DAO schemes such as those in Tennessee and Wyoming are not ready for primetime, as they have too many unanswered questions associated with them. While not dead on arrival, they are not fit for purpose until those states with more well-developed corporate regimes, such as Delaware and New York, embrace them.

DAOs are a potentially useful way for a group of loosely associated people to invest and subscribe to creative and other projects in a collaborative and transparent way, but they carry with them an inherent risk, for investors and counter parties alike. They are not, as many believe, immune from litigation and can leave a substantial dent in the lives of those that do not carefully guard their position.