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Non-Fungible Tokens (NFT) Newsroom

How Do You Sue a DAO? These Recent Developments May Shed Some Light.

How Do You Sue a DAO?  These Recent Developments May Shed Some Light.

As we previously wrote, a DAO, which stands for decentralized autonomous organization, is an organization that operates as an Internet-based collective among its members using blockchain technology. DAOs operate on smart contracts (i.e., code), which lay the foundational rules, and the code and the DAO’s actions are recorded and publicly auditable on the blockchain. The structure of a DAO lacks any centralized leadership, and is driven by its members who obtain a stake usually by buying voting power through the purchase of tokens or NFTs. The operations of the DAO are collectively voted upon by its members, and only those that reach a certain level of consensus is enforced by the preset rules within the smart contract, thereby ensuring a democratic, community-based process (although it is not uncommon to hear that a DAO’s governance mechanism is compromised by one or more actors through a “hostile governance takeover”).

Yes, DAOs are unique and innovative, but their precise legal status is unclear, particularly when it comes to suing one in court. When a corporation or LLC is sued, there are specific service of process and jurisdictional considerations in initiating the lawsuit. For example, to serve process on a corporation, the summons must be served (among others) on its officer, director, managing agent, or on the State’s Secretary of State. A DAO has none of these things, and service through the Secretary of State is not possible unless the DAO is registered with the State (more on this below). Thus, the first hurdle in suing a DAO is to figure out whom to serve process upon, and whether the recipient is even authorized to receive process. A popular (untested) view in this regard is that a DAO is akin to an “unincorporated general partnership,” which “is deemed to have the citizenship of each of its partners.” Minard v. Pareto Partners, No. 04 Civ. 741 (CSH), 2005 WL 2206783, at *1 (S.D.N.Y. Sept. 12, 2005). If treated as such, service can be effectuated by delivering the summons on any of the DAO’s members, among other methods. See, e.g., N.Y. CP.L.R. 310(a).

And treatment as an unincorporated general partnership carries serious risks. Because it is unincorporated, there is no corporate shield to protect the partners’ assets like there would be for a corporation or a LLC. And each partner can be rendered jointly and severally liable, meaning that one partner can be made wholly liable for another partner’s debt. Thus, some DAOs, such as the Flamingo DAO, have used existing laws to register as a LLC in order to provide its members limited liability, although the barrier to entry for such DAOs may be higher given the limitations imposed on membership criteria, and the likely need to hire an attorney to review the operating agreement. Another way to mitigate this risk may be to participate in DAOs through a single-purpose entity, which could potentially expose the entity’s assets but should provide protection against the entity’s owner’s personal assets.

To counter these concerns, Wyoming became the first US state to enact a law that grants legal status to a DAO as a LLC, conferring it all the protections given thereunder if it is organized under the Wyoming Limited Liability Company Act. Under the law, a person need not reside in Wyoming to register a DAO, although the DAO must have a Wyoming registered agent. In this fashion, Wyoming has through legislative action “focused on providing legal clarity where ambiguity exists before the court needs to decisively weigh in.” New Jersey and Ohio are working on similar legislation. Other states may soon follow suit.

Another potential area of ambiguity is the court’s jurisdiction. A court must have jurisdiction over a case to exercise its power to hear and make a decision regarding the case. And a court may exercise jurisdiction over a person or entity who is the citizen of the state in which the court lies, and it may also exercise jurisdiction over non-domiciliaries under certain statutorily-prescribed circumstances. Determining the citizenship of an unincorporated DAO is an open question (although one logical place to start may be the state where the DAO was formed). And here again, the treatment of a DAO as a general partnership could potentially affect a plaintiff’s ability to sue in federal court, because unless the dispute arises under federal law, and aside from meeting a $75,000 monetary threshold, the law requires the plaintiff and defendant to be citizens of differing states (known as diversity jurisdiction). A DAO with many members could easily share the same state of citizenship as the plaintiff.

Thanks to the recent surge in crypto and NFT trading (and unfortunately for the DAOs involved), lawsuits against DAOs have started popping up, which may help to clarify their legal status. In Halston Thayer v. Matt Furie et al., 22-cv-01640-AB-MRW, plaintiff sued comic artist Matt Furie and his company, Chain/Saw LLC, as well as the “PegzDAO” in the Central District of California over an NFT auction gone awry. Plaintiff alleges he was promised a one of a kind NFT of “Pepe the Frog” (a quirky image of a smiling frog with his behind exposed) for which he paid over $500,000, only for defendants to subsequently give away 46 other NFTs of the identical image for free. Plaintiff asserts numerous state law claims and alleges that diversity jurisdiction exists by virtue of his citizenship in Nevada and the defendants’ citizenship in California, and with respect to PegzDAO, he alleges that it is owned and operated by Furie and/or Chain/Saw who reside in California. While Furie may have founded PegzDAO, its community appears to include others in “the Pegz owner community.” It will be noteworthy to see how the members of the Pegz community will organize and respond to the complaint’s allegations. Its answer is due today.

Another recent filing in the Southern District of California is explicit about the DAO’s classification as a general partnership. Fourteen plaintiffs, all citizens outside of the US, have filed a class action on May 2, 2022 in Christian Sarcuni v. bZx DAO et al., 22 CV 0618 BEN DEB, alleging that they deposited their cryptocurrency with the bZx DeFi platform for tokenized margin trading and lending. According to the complaint, contrary to bZx’s claimed security features, the protocol was hacked, and $55 million worth of crypto were stolen as a result of a phishing attack on a bZx developer, which happened because the protocol had not yet executed the touted security measures to protect their funds. While the bZx DAO (and its successor Ooki DAO) has promised to fully compensate those who lost, the complaint alleges that the proposed repayment plan does not benefit plaintiffs or its class members, and that repayment will take thousands of years. Plaintiffs allege that DAOs are general partnerships among tokenholders and are asserting joint and several liability. Additionally named as defendants are the DAO’s individual founders and its corporate investors, who are also alleged to be members of the DAO. If plaintiff’s theory succeeds, each of the DAO’s members (including the individual defendants) can potentially become on the hook for the entire $55 million. The case has obvious implications for unincorporated DAOs going forward.

Stay tuned for more news about DAOs from the NFT Newsroom.

By: Mioko C. Tajika