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April 4, 2023

Court Ruling Could Affect the Future Direction of DAOs

Alexander Drylewski, Stuart Levi
Skadden, Arps, Slate, Meagher & Flom LLP
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Skadden, Arps, Slate, Meagher & Flom LLP

A March 27, 2023, decision by a California federal court in a
putative class action, Sarcuni v. bZx DAO, has brought into focus how
courts might construe the legal existence of decentralized autonomous
organizations (DAOs).

The bZx DAO case concerns the same decentralized finance (DeFi)
protocol, bZx, that was the subject of an earlier Commodity Futures
Trading Commission (CFTC) enforcement action. There, too, the CFTC
action asked a court to consider how to construe a DAO, arguing in
the context of proper service that the DAO should be considered an
unincorporated association akin to a general partnership.

Background

The bZx DAO operated the bZx Protocol, which allegedly offered
cryptocurrency margin trading and lending products. When the bZx
Protocol was first created, it was controlled by bZerox LLC, which
was co-founded and controlled by developers Tom Bean and Kyle
Kistner. In August 2021, the bZx Protocol announced plans to
transition control of the protocol from bZeroX LLC to the bZx DAO, a
DAO controlled by individuals and entities holding BZRX tokens, a
cryptocurrency issued by the DAO.

The bZx DAO was charged with "maintaining the protocol, building new
products, marketing the brand, and managing the community." Token
holders had the right to suggest and vote on governance proposals
that, if adopted, would be implemented by the bZx Protocol. bZeroX
LLC then transferred all of its assets to the bZx DAO and dissolved.

In November 2021, a hacker successfully executed a phishing attack
against one of the bZx developers, obtained the developer's private
key and stole $55 million in cryptocurrency. The bZx DAO approved a
compensation plan for those impacted by the hack that would
compensate anyone who lost BZRX tokens with replacement BZRX tokens
that vested over time. The plan also provided "debt tokens" that
would gradually be repurchased to make the hack victims whole.

In December 2021, users of the bZx Protocol were encouraged to move
their transactions to a successor platform called the Ooki Protocol.
The Ooki Protocol is controlled in the same manner as the bZx
Protocol, except the controlling DAO is called the Ooki DAO and the
governance tokens are called OOKI tokens. Many BZRX token holders
transferred their tokens for OOKI tokens.

The Class Action Complaint

The plaintiffs in bZx DAO brought a putative class action against
Kistner, Bean and their original LLC, bZeroX LLC; two investors,
Hashed International LLC, and AGE Crypto GP, LLC; bZx DAO; and its
successor, Ooki DAO.

The plaintiffs alleged they lost $1.7 million in the cyberattack and
that the repayment plan would take thousands of years to make them
whole. Significantly, the plaintiffs alleged that the bZx DAO is a
general partnership comprised of all holders of BZRX tokens and that
each defendant, as a BZRX token holder, is therefore jointly and
severally liable for the losses arising from the cyberattack.

The General Partnership Issue

Are DAOs General Partnerships?

The California federal court began its analysis of the general
partnership question by laying out some basic partnership principles
under California law:

  * A partnership exists when there is an "association of two or more
    persons to carry on as co-owners of a business for profit,"
    whether or not the intent was to form a partnership.
  * Unless persons associated to do business together establish a
    formal entity like a corporation, the association may be deemed
    to be a partnership (again, regardless of the parties' intent).
  * Persons may unintentionally create a partnership where their
    actions and behavior demonstrate an intent to engage in business
    together.

According to the court, a plaintiff can plead the existence of a
partnership by making specific factual allegations demonstrating:

  * The right of the purported partners to participate in the
    management of the business.
  * The sharing of profits and losses among the purported partners.
  * Contributions of money, property or services by the purported
    partners to the partnership.

Taking the bZx DAO plaintiffs' allegations as true (as the court was
required to do at the pleading stage), the court concluded that the
plaintiffs had properly alleged each of these factors with respect to
the bZx DAO -- specifically, that it was an association of two or more
persons (the token holders and the investors) that generated profits
through the Protocol's alleged margin trading and lending products.
The court also held that the plaintiffs adequately pleaded
co-ownership through the governance rights that came with ownership
of the BZRX tokens.

The court rejected the argument of certain defendants that BZRX token
holders only possess "limited governance rights relating to a narrow
set of parameters of the protocol." According to the court, a
partnership can still exist when individual partners only control a
part of the enterprise.

The court also rejected the argument that the complaint merely
"speculated" that BZRX token holders could share in the profits,
concluding instead that allegations in the complaint that token
holders had the right to vote to distribute DAO treasury assets to
token holders was akin to how corporations authorize dividends, and
therefore sufficient.

The court also took judicial notice of the CFTC's finding that the
bZx Protocol liquidity pool's assets were supplied by liquidity
providers who, in exchange, had received interest-generating tokens
as well as BZRX tokens. According to the court, this reinforced the
bZx DAO complaint's allegations that token holders can share in the
DAO's profits either by voting to distribute treasury assets among
themselves or via an interest-generating token.

The court similarly rejected the argument of certain defendants that
the plaintiffs had failed to allege that BZRX token holders had
agreed to share any losses, concluding that an agreement to divide
profits implied an agreement to also divide losses.

The court also rejected the defendants' policy argument that finding
that every BZRX token holder could be a co-owner of a business with
unlimited personal liability for losses would constitute a "radical
expansion and alteration of long-standing principles of partnership
law."

Here, the court focused on statements by the bZx Protocol developers
that creation of a DAO would insulate the Protocol "from regulatory
oversight and accountability for compliance with U.S. law," a point
the CFTC had focused on as well. Citing California precedent, the
court noted that attempts to take on the advantages of a partnership
without the corresponding liabilities will be treated as a general
partnership.

Being Deemed a General Partner

As noted, in Ooki DAO, the CFTC had focused on whether individual DAO
members had actually voted, using their tokens as the test for
whether an individual could be liable for the DAO's liabilities.
Here, the court allowed to survive the plaintiffs' claim that merely
holding a BZRX token made a person a partner in the partnership, and
that plaintiffs had, with respect to most defendants, either directly
alleged such token ownership or had alleged participation in
decision-making (which created a reasonable inference of token
ownership).

The court found that no such allegations were made with respect to
Leveragebox LLC or bZeroX LLC, however, and dismissed the complaint
with respect to those defendants.

Do The Plaintiffs Have a Conflict of Interest as Members of the DAO?

In one of the more interesting arguments that could impact future
claims against DAOs, the defendants moved to strike the class
allegations, arguing that the plaintiffs could not be adequate class
representatives since they themselves were BZRX holders. Based on the
plaintiffs' own theory of general partnership, the defendants argued
that the plaintiffs had a conflict of interest because they were
members of the very DAO they were claiming had acted negligently.

The court denied the motion to strike on the ground that there was no
evidence, at this stage, to demonstrate that the plaintiffs were BZRX
token holders. Citing the wording of the complaint that none of the
plaintiffs or proposed class held "meaningful stakes" of BZRX tokens,
the court effectively side-stepped the issue by holding that no
"meaningful stake" could be interpreted to mean the named plaintiffs
held zero BZRX tokens, and therefore the conflict was not evident.
The court did state that the defendants could renew their motion if
the fact of the plaintiffs' holdings was established.

Takeaways

The bZx DAO opinion is not binding on any other court or judge. It
nevertheless creates case law supporting the notion, albeit only in
the context of a motion to dismiss, that the manner in which a DAO
operates can constitute a general partnership under California law.

The fact that the court held that allegations of mere ownership of
governance tokens -- whether they were used to vote or not -- is
sufficient to overcome a motion to dismiss, is notable, and DAO
governance token holders should consider its potential importance.

Whether this decision causes more DAO members to seek to impose a
corporate structure, such as an LLC under the "DAO LLC" laws of
Tennessee, Wyoming, Vermont or Utah, remains to be seen. And the
question remains whether the court would reach a different result if
it turns out that the named plaintiffs hold BZRX tokens. That could
mean those plaintiffs are fatally conflicted from pursuing their
claims, as they would effectively be both plaintiffs and defendants
under their theory of the case.

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DISCLAIMER: Because of the generality of this update, the information
provided herein may not be applicable in all situations and should
not be acted upon without specific legal advice based on particular
situations.

(c) Skadden, Arps, Slate, Meagher & Flom LLP | Attorney Advertising

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