Sue Or Be Sued: California Courts Lead Way Testing DAO Rights

The Bottom Line

• To date, only California courts have tackled thorny questions about the capacity of decentralized autonomous organizations (DAOs) to participate in litigation.
• DAOs have faltered when they haven’t argued their capacity to sue or be sued.
• There are concrete steps a DAO can take to shield and empower itself, and avoid jurisdictional complications.

As the cryptocurrency industry matures, inconsistencies remain as to the treatment of decentralized autonomous organizations, or DAOs, in regulatory proceedings and civil or criminal litigation. To date, the issue has only been litigated in California federal courts applying state law, and has yet to reach a full, merit-based disposition.

In no instance has a court issued an opinion on a DAO’s capacity to sue or be sued in an action in which the DAO appeared or had direct representation in the proceedings.

This article will review factors that help determine a DAO’s capacity to sue and be sued for alleged violations of US law, and will demonstrate how it has become increasingly clear that they should have the foresight to create a structure to sue or be sued and actively litigate the question of capacity.

What Is a DAO?

DAOs are self-governing organizations managed through smart contracts that rely on blockchain technology to accomplish voting, financial operations, and other business. Membership in the DAO is typically established by holding the DAO’s native or governance token, which grants voting rights and possibly other benefits to holders.

The work of the DAO is accomplished through voting on proposals via smart contracts recorded on a public blockchain, which affords DAO members special benefits in operating an organization in this form, including smart contracts that streamline and automate processes, minimize the need for intermediaries and generally lead to faster execution on decision; increased community participation via empowering all members with voting rights; global accessibility to diversify participation and enhance remote collaboration; and greater transparency, auditability and accountability because all conduct takes place on a public blockchain.

At the same time, DAOs have certain drawbacks: consensus-based voting can slow decision-making; without delegated authority, the absence of clear leadership can make it more difficult for DAOs to adapt to changing circumstances; reliance on blockchain technology and smart contracts makes DAOs susceptible to hacking attempts and requires robust security measures; and the legal status of DAOs is often unclear given the absence of uniform regulations, caselaw or guidance on how to determine jurisdictional issues.

Accordingly, how a DAO is structured beyond the smart contracts can be critical to determining whether it can minimize the inherent drawbacks to operating as a DAO; the structure should be determined with a view to the services and functions the DAO wishes to accomplish and its community goals as there is no one-size-fits-all.

Capacity for Litigation

In US federal court, the capacity to sue or be sued is governed by Federal Rule of Civil Procedure 17(b). For entities other than individuals or corporations, capacity is a function of the applicable state law; for partnerships and unincorporated associations with no capacity under state law, capacity must be determined under federal common law.

The caselaw makes plain that variability in a DAO’s structure has important implications for determining whether a DAO can sue or be sued.

The determination of a DAO’s capacity to sue or be sued often focuses on whether the DAO is an unincorporated association or a general partnership, or was established with a specific corporate wrapper, such as a Wyoming limited liability company.

All definitions of an unincorporated association require two or more persons joined by mutual consent, but don’t necessarily require that all its members be identifiable.

Under the common law of a jurisdiction, an unincorporated association arises from the voluntary actions and agreements of the individuals in the association, and thus an unincorporated association may be created inadvertently. Importantly, only unincorporated associations recognized at common law have the capacity to be sued under Rule 17(b)(3)(A).

On the other hand, a general partnership is usually an association of two or more persons to carry on a business for profit.

The existence of a general partnership is governed by state law, which outlines the characteristics and obligations of general partnerships and their partners. As a default rule, general partners have unlimited joint and several personal liability for the debts and obligations of the partnership, and profits and losses are passed through to the individual partners’ personal tax returns.

Whether a DAO is an unincorporated association or general partnership is a mixed question of fact and applicable law. Difficulty establishing mutual consent to a common purpose and, in some jurisdictions, the absence of an identifiable membership will undermine finding that a DAO is an unincorporated association.

On the other hand, the absence of a well-defined control structure through which actions taken by the DAO can be identified to specific actors (including DAO delegates), an inability to identify DAO members who agreed to operate a business and share profits and losses, or mandatory dissolution of an alleged DAO partnership upon departure of any member will undermine finding that a DAO is a general partnership.

In addition, a DAO’s structure may not meet either organizational form.

DAOs Gone Wrong

To date, no court has found on the merits that a DAO, in any form, has the capacity to be sued under the Federal Rules of Civil Procedure or the capacity to sue to enforce rights. However, DAOs have failed to avoid suit when they haven’t litigated their capacity to be sued, erroneously assuming that courts would deem DAOs to be smart contracts that lack capacity and are immune from liability.

The first US court to substantively grapple with the question of whether a DAO has capacity to be sued was the US District Court for the Northern District of California in Commodity Futures Trading Comm’n v. Ooki DAO. In that case, the US Commodities Futures Trading Commission alleged that Ooki DAO—to which bZeroX LLC, operators of the underlying bZx Protocol, had transitioned control of the bZx Protocol—violated the Commodity Exchange Act “by enabling users to engage in retail commodity transactions without abiding by CEA requirements, including registering its ‘platform’ and conducting certain customer due diligence.”

The CFTC brought a motion for alternative service after it was unable to serve the DAO via traditional means, arguing the DAO was an unincorporated association. In response to the CFTC’s motion, several amici curiae submitted briefs in opposition, arguing, inter alia, that Ooki DAO wasn’t an unincorporated association and therefore lacked capacity to be sued under Rule 17(b).

The court agreed with the CFTC, finding that the complaint adequately pled that Ooki DAO was an unincorporated association under California and federal law. The court rejected the argument that the DAO was “a technological tool” because the CFTC alleged the DAO was comprised of individual token holders who were persons.

The court also found that the complaint adequately alleged that two or more persons (the two bZeroX founders) joined Ooki DAO by “mutual consent,” rejecting the argument that “different persons casting different votes at different times does not constitute mutual consent.” The court also found the CFTC sufficiently demonstrated a “common lawful purpose” of “governing the DAO . . . through the use and distribution of funds from its central Treasury.”

When the CFTC moved for a default judgment, the court reaffirmed its finding that Ooki DAO was an unincorporated association under California and federal law and therefore had capacity to be sued.
In Sarcuni v. bZx DAO, another California court concluded that a DAO that didn’t appear to defend itself in the action had the capacity to be sued.

Plaintiff alleged various individual token holders were jointly and severally liable as general partners of the DAO. The DAO didn’t appear in the case, and the general partner defendants moved to dismiss the suit for failure to properly allege the DAO was a general partnership or that they themselves were general partners.

The court found the complaint satisfied the test for a general partnership under California law, which required pleading facts to demonstrate that the DAO was “(1) an association of two or more persons (2) carrying on as co-owners of (3) a business for profit.” The participating litigants didn’t dispute the first or third prongs and found the second prong had been met because the BZRX token afforded holders governance rights over the DAO and token holders may share in the DAO’s profits.

In the face of a result that potentially exposed all token holders to joint and several liability, the court reasoned that the decision by the DAO’s creators to avoid corporate forms that limited liability was intentional, pointing to evidence that the co-founders of the LLC who had originally controlled the bZx protocol transitioned to the DAO to “future-proof” the protocol from liability.

Other California courts have reached similar findings in lawsuits in which a DAO didn’t appear to defend the claims against it.

Courts have similarly permitted DAOs to protect their interests in court.

For example, in PleasrDAO v. Shkreli, PleaserDAO, which presented itself as an “exempted foundation company” under Cayman law, sued to enforce its intellectual property rights against businessman Martin Shkreli in connection with the DAO’s purchase of the sole copy of a music album and its associated intellectual property rights for more than $4.7 million.

Shkreli had purchased the album subject to an 88-year prohibition on making copies or exploiting the album, but had played portions of the recording on the internet, boasted that he maintained MP3 copies, and distributed copies on numerous occasions. The court issued a permanent injunction ordering that Shkreli produce the remaining copies of the recording and identify those who received copies.

Structuring For Certainty

Protecting DAO members and certainty regarding a DAO’s capacity to sue and be sued should motivate structuring a DAO to establish affiliated entities to control certain DAO activities. While there may be jurisdictions in which a DAO that has no obvious corporate form might escape liability because capacity can’t be established, this is unlikely to be true in every jurisdiction in which the DAO wishes to operate.

Therefore, failing to attend to capacity to be sued could lead to inconsistent assertions of liability against the DAO and its members across jurisdictions. Further, it is unlikely that a DAO lacking capacity to be sued in a jurisdiction could simultaneously assert claims against others in the same jurisdiction.

Accordingly, if a DAO hasn’t taken steps to form a partnership, unincorporated association, or some other corporate form (adopting the corporate form that is most advantageous to the functioning of the DAO), its token holders or participants may be liable, as natural persons, for any legal obligations that may accrue to their activities, including tort and tax liability.

On the contrary, if the organizers of a DAO ensure that the DAO either directly, or through an affiliate, opts-in to an entity form, this enables the DAO to engage in conduct that furthers the DAO’s purpose, such as engaging counsel to protect the DAO’s interests in court.

For example, a DAO could designate a special purpose entity to instruct legal counsel and act as the DAO’s representative for the purpose of making decisions about a lawsuit in which the DAO has been named or that it wishes to pursue, and thereby establish a privileged relationship to represent the DAO and preserve the DAO’s interests.

If a DAO doesn’t attend to a corporate form that is most advantageous to the DAO ecosystem, the DAO exposes itself to costly litigation concerning the DAO’s capacity, potential default judgments against the DAO, and the risk of inconsistent judgments across jurisdictions.

An appropriate organizational form that takes into consideration jurisdictional advantages, tax treatment, and appropriate limits on liability benefits the DAO and its members by affording them the protections of state and federal corporate law, and can set the path toward engaging in the full range of commercial activities necessary to achieve the DAO’s purpose.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

James Walker is partner at Perkins Coie and is the firmwide co-lead in fintech compliance and enforcement.

Gene Lee is partner at Perkins Coie, co-chair of the firm’s regulated gaming group, and is an intellectual property litigator.

Stephen Hogan-Mitchell is an associate at Perkins Coie in New York.

Emily Cooper contributed to this article.

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