DAOs obligations and liabilities

Brief notes on DAOs obligations and liabilities

There are many unresolved questions regarding the obligations of Decentralized Autonomous Organizations (DAOs) members (i.e. token holders) and managers (if they are not also members).

First, it would be appropriate to identify the liability discipline of the managers, if they do not coincide with token holders (a possibility that the doctrine moreover discusses), and of the token holders to the association, in the event that their conduct results in harm to the same. In particular, the possibility of applying fiduciary obligations (i.e. duty of care, duty of loyalty) or general clauses (i.e. good faith) is discussed.

Moreover, should the menagers be subjects outside the participants of the organization, we would return to the discussion of those problems arising from the agency relationship that the DAO, by its definition, would (also) be directed to eliminate or mitigate.

Second, a matter of central importance is the regulation of liability for obligations undertaken by the organization.

In this regard, it’s important to notice that «as long as DAOs are not legally recognized, they also do not have limited liability protection. This means that contributors to a DAO can be held personally liable for the debts and obligations of the DAO».

Consequently, the solution depends on the legal status given to the organization. In this sense, limited liability is a typical characteristic of corporations.

In order to have an overview of the regulation of DAOs all around the world, see “DAOs’ current form of regulations: an overview”.

The lack of limited liability has many disadvantages, such as:

• the fact that DAO members are not incentivized to take risky business decisions as any business mistakes may lead to the seizure of their personal assets, thus stifling the innovation potential of such DAOs;
• the deterrence of many potential contributors from participating;
• the difficulty to raise capital since most investors would be unwilling to put their assets at risk.

The decision of a U.S. court

According to what has been said, a U.S. court in California has ruled in favor of plaintiffs, who initiated a class action in May 2022 and who alleged that the bZx protocol, and governance token-holding members of its decentralized autonomous organization (DAO), were negligent and liable for losses resulting from a hack that drained its treasury. The decision implies that DAO members might be held liable for negligence, potentially undermining the already challenged decentralized nature of DAOs, while providing a defense for founders who have seen their creations accused of wrongdoing[4].

More precisely, a group of nineteen, named Plaintiff, brought this putative class action against the members of a general partnership (collectively, the “Defendants”) for one count of negligence. Plaintiff alleged that each Defendant is a general partner of the bZx DAO, a purported “Decentralized Autonomous Organization”, and that they wew injured by Defendants’ negligence after a developer working for the bZx DAO was successfully targeted by a phishing attack which occurred on Nov 5, 2021 and which led to the theft of millions in cryptocurrencies. On Nov 21, 2021, the bZx DAO approved a compensation plan for those impacted by the hack, but the FAC (First amended Complaint) alleged complete repayment will take thousands of years. In May 2022, the Plaintiff initiated the class action and in June they filed their FAC.

In deciding the issue, the Court first identified the legal backgrounds:

• «a claim is plausible if the factual allegations supporting it permit “the court to draw the reasonable inference that the defendant is liable for the misconduct alleged”»;
• «In order to establish negligence under California law, a plaintiff must establish for required elements: Duty; Breach; Causation; Damages».

• «“In California, the ‘general rule’ is that people owe a duty of care to avoid causing harm to others and that they are thus usually liable for injuries their negligence inflicts”. However, “liability in negligence for purely economic losses . . . is ‘the exception, not the rule.’” “The primary exception to the general rule of no-recovery for negligently inflicted purely economic losses is where the plaintiff and the defendant have a ‘special relationship.’”».

Plaintiffs’ theory of liability is premised on the existence of a general partnership among all persons holding BZRX tokens. The FAC contends Defendants are partners of the purported bZx DAO general partnership, and, therefore, jointly and severally liable for Plaintiffs’ injuries. The Leveragebox Defendants argue the FAC fails to plausibly demonstrate the existence of a general partnership. Additionally, they argue the FAC doesn’t sufficiently allege Defendants are members of the purported general partnership.

The Court considered

1. whether the FAC includes sufficient factual matter to plausibly allege that the bZx DAO is a general partnership (bZx DAO General Partnership Formation);
2. whether the FAC sufficiently alleges that each Defendant is a partner in such a partnership (Partnership Allegations Against Each Defendant).

BZx DAO General Partnership Formation: California law provides that the “association of two or more persons to carry on as coowners a business for profit forms a partnership, whether or not the persons intend to form a partnership.” According to the Court, there is a general partnership among the BZRX token holders, because, among other reasons:

• the organization is controlled by the token holders, who have governance rights in the DAO;
• token holders can share in the DAO’s profits;
• token holders can vote to distribute treasury assets to token holders, like how corporations can authorize dividends.

Partnership Allegations Against Each Defendant: according to the Court, Plaintiffs’ allegations are sufficient to permit the reasonable inference that the defendants hold governance tokens.

Under California partnership law, «all partners are jointly and severally liable for partnership obligations».

The Court found that Plaintiffs’ injury is fairly traceable to the bXz DAO general partnership and that they have standing to sue the alleged general partners.

---

[1] A. Stanescu & T. Velea, SLV Legal, The emergence of DAOs: From legal structuring to dispute resolution, in Blockchain & Cryptocurrency Regulation 2023, Fifth Edition, Global Legal Insight, 2023, p. 207.

[2] Legal aspects of decentralized autonomous organisations (DAOs), available at https://nomoretax.eu/legal-aspects-of-decentralized-autonomous-organisations-daos/

[3] A. Stanescu & T. Velea, SLV Legal, The emergence of DAOs: From legal structuring to dispute resolution, in Blockchain & Cryptocurrency Regulation 2023, Fifth Edition, Global Legal Insight, 2023, p. 207.

[4] S. Reynolds, The Liability of DAOs and Their Founders Has Been Put to the Test in Court, Mar 29, 2023, available at https://www.coindesk.com/business/2023/03/29/the-liability-of-daos-and-their-founders-has-been-put-to-the-test-in-court/