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Introduction to Decentralized Autonomous Organizations
Web3.0 and the rise of decentralized technologies such as
blockchain, cryptocurrencies, and non-fungible
tokens raise new and complicated legal issues. As
discussed in more detail in our prior post on decentralized
governance, smart contracts on a blockchain network like Ethereum,
use a decentralized autonomous organization (“DAO”) form
of governance. This is an emerging legal structure where there is
no central governing body and the members share a common goal to
act in the best interests of the entity. The DAO token holders
participate in management and decision-making of an entity, by
collectively casting votes. All votes and activity through the DAO
are posted on a blockchain which provides public transparency of
its users’ actions. Unlike a traditional legal entity that acts
through a central authority, in a DAO the collective participants
act as the governing body. This article discusses some emerging DAO
legal and tax issues and highlights a recent court order that
permitted serving a DAO with a summons.
Emerging Questions on Legal and Tax Status of DAOs
There are emerging and novel legal questions about how a DAO may
be subject to regulatory or legal action. DAOs lack legal status in
most of the United States, and, as a result, may be considered, by
default, as a general partnership, with each member potentially
having unlimited liability for its actions. DAOs unlike their
traditional legal entity counterparts are only recognized as legal
entities in three states: Vermont, Wyoming, and Tennessee. Each of
these states allows the DAO to register as a type of LLC.
The lack of legal status in most of the United States is a
significant liability risk to the DAO’s participants.
Additionally, because it lacks legal status it is unclear if a DAO
may enter into a contract or conduct traditional business
activities. It is also unclear on what basis and how a DAO should
be taxed. Should the IRS treat this emerging legal entity, by
default, as a partnership? If so, how would Schedule K-1’s be
issued since one of inherent features of a DAO is token holders
anonymity? Absent a centralized structure, how would each
participant receive aggregate information regarding the DAO’s
activities (and their share thereof to be reported on a tax
return)? Finally, there are basic litigation issues under Federal
Rules of Civil Procedure such as how can a party serve the DAO with
a summons, discovery, notices, or motions?
Service of Process on a Decentralized Autonomous Organization:
CFTC v. Ooki DAO, C.A. No. 3:22-cv-5416
A federal district court has answered one of these foundational
legal questions: a DAO can be served with a summons. On October 3,
2022, the United States District Court for the Northern District of
California entered an order (the “Order”)
granting the United States Commodities Futures Trading
Commission’s (“CFTC”) motion to serve members of the
“Ooki” DAO (formerly d/b/a/ bZx DAO) with a summons
through online communications. Specifically, the court granted the
CFTC’s motion for alternative service on Ooki DAO and ruled
that the CFTC effectively served Ooki on September 22, 2022, when
the CFTC provided a copy of the summons and complaint through
Ooki’s DAO help chat box as well as contemporaneous notice by
posting the summons on Ooki’s online forum. The CFTC sued Ooki
on September 22, 2022, alleging that the DAO, through its
decentralized blockchain-based software protocol, illegally offered
leveraged and margined retail commodity transactions in digital
assets, engaged in activities that only registered futures
commission merchants can perform, and violated the Bank Secrecy
Act.
The CFTC’s lawsuit and the Order approving alternative
service on the DAO through online communications undermines the
idea that DAOs are not subject to regulation or legal liability.
The CTFC’s complaint seeks to impose legal
liability on each Ooki DAO token holder that voted as part of the
Ooki DAO’s governance process. Note that the CTFC did not
pursue a potentially broader group of actors which could have been
defined as any recipient of a token as it would be very difficult
to prove that receipt of a token (which may happen for any number
of reasons) was tantamount to participating in illegal activity.
The CFTC also did not make a distinction between token holders that
specifically voted to engage in alleged illegal activities and
those who did not. The CFTC’s target in the lawsuit is any
token holder that voted as part of the governance process. The
legal theory is likely that the exercise of the right to vote is an
indication that the token holder participated in the governance of
the DAO and if that governance resulted in illegal activity, that
token holder should be held individually liable for their role in
the collective DAO governance decision. That is a broad standard
that can have significant consequences to the DAO and its members
if it were applied outside of the regulatory context and instead in
traditional litigation.
Ooki DAO has until October 13, 2022, to respond to the complaint
otherwise the CFTC may win a default judgment against the token
holders that voted as part of the Ooki DAO governance process. If
this happens, another novel legal issue that will emerge will be
how will the government enforce the judgment on the DAO? If it can
determine the identities of the token holders would it seek to
enforce the judgment on only U.S. token holders since they have
assets in the United States that could be available to satisfy any
judgment or would it pursue all token holders regardless of whether
they were U.S. persons?
The DeFi Education Fund (“DEF”), a Washington,
D.C.-based lobbying group that is focused on decentralized finance,
and LeXpunK, a collective of lawyers and developers that are active
in the crypto space have filed motions with the court for
permission to file Amicus Curiae briefs regarding the
CFTC’s motion for alternative service. DEF’s motion can be
found here and LeXpunK’s motion can be
found here. Both amicus curiae
briefs argue that the CFTC’s service of process was inadequate
and violates due process. As of the date of this writing, no
counsel has entered a notice of appearance on behalf of Ooki
DAO.
Implications to Decentralized Autonomous Organizations and
Other Decentralized Technologies
The Ooki DAO case may have significant implications for all
DAOs. While decentralization may provide many technological
benefits it comes with significant risk as it may introduce
unlimited legal liability for any token holders that participate in
the DAO governance process. This may be a headwind to the
proliferation of Web3, DAOs, and other technologies that rely on
decentralization. Additionally, the outcome of the Ooki case may
spur additional state legislation to recognize DAOs as a subset of
an LLC to limit the potential liability of token holders that
participate in a DAO’s governance.
It is important to note that a different federal district court
outside of the Northern District of California may be confronted
with a similar fact pattern for a different decentralized
organization or DAO and may rule differently than the United States
District Court for the Northern District of California (as it would
not be bound by the Order). The legal and tax implications of DAOs
are rapidly developing areas of the law. As this technology becomes
mainstream Courts will inevitably have to address many tax and
legal issues of first impression. One thing is certain, in the
United States District Court for the Northern District of
California members of a DAO can be served a summons through online
communications by posting a copy of the summons and complaint in
the help chat box and by posting it on the DAO’s online
forum.
Cryptocurrency, Digital Asset, and Blockchain Attorneys
Do you have DAO, Cryptocurrency, Digital Asset, or Blockchain
Issues or questions? Freeman Law is an innovative
thought leader in the DAO, cryptocurrency, digital asset, and
blockchain space. DAO, blockchain, and virtual
currency activities take place in a rapidly evolving regulatory
landscape. Freeman Law is dedicated to staying at the forefront as
these emerging technologies continue to revolutionize social and
economic activities. Contact Freeman Law to Schedule a consultation or call (202) 936-3569
to discuss your DAO, cryptocurrency and blockchain technology
concerns.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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