Decentralised autonomous organisations and liability in litigation – Sarcuni, et al v bZx DAO, et al

Friday 28 April 2023

Lee Pascoe 
Norton Rose Fulbright, Melbourne

A recent ruling of the United States District Court in Sarcuni v bZx DAO, No 22-cv-0618 (S.D. Cal. March 27, 2023), has raised more than an eyebrow amongst many in the decentralised finance community who, until now, largely believed that decentralised autonomous organisations (DAO), and those that sit behind them, were outside of the traditional legal system and as such, not exposed to corresponding liabilities.

The Court in Sarcuni did much to dissuade such misplaced belief and has potentially opened a gateway to plaintiffs, especially in the context of class actions, to bring proceedings against a DAO and the parties behind the enterprise.  Specifically, the Court denied a motion to dismiss a class action originally filed by the DAO’s users.  In response to the motion, filed by members of the DAO, the Court found that a negligence claim may be brought against a DAO, as a general partnership, with the individuals forming that partnership being the token holders with governance rights in the DAO.

What is a DAO?

The DAO is no longer a novelty and is now the preferred business structure of players in the decentralised finance market.  Unlike conventional corporate structures, and in place of human management, DAOs rely on blockchain technology and smart contracts as their primary source of governance.  Practically, this means that most, if not all, of the DAO’s management decisions are self-executing via smart contracts, and without the need for human intervention.  

In simple terms, a DAO is established by coding smart contracts in a particular manner to prescribe how the DAO is to be managed, the project that it is to operate, and the criteria for particular actions to take place around the DAO’s management, operation and decision making.  Individuals then invest in the DAO by sending cryptocurrency to a unique wallet address in exchange for blockchain-based tokens representing that member’s contribution to the DAO.  The issued tokens confer rights on the participating members, including voting rights, similar to those of a shareholder, or may entitle the holder to a share in profits similar to a dividend.  The DAO’s governance is generally pre-determined by the rules of the underlying smart contract.  Decision-making is not reliant on directors.  Rather, the token-holding members, with voting rights, arrive at a consensus on decisions affecting the DAO using smart contracts on the blockchain.  Membership is open to individuals (as well as corporate or other legal persons) from around the world, subject only to the rules of the DAO itself.

The wallet(s) of the DAO hold the value of the investment made by the members.  Upon the occurrence of certain criteria programmed into the relevant smart contracts, a DAO may invest in projects and generate income for its members.  In this way, the blockchain-based tokens and smart contracts grant the members effective control of the organisation’s assets either directly or indirectly, subject only to the rights attributable to their tokens. 

The legal status of a DAO and the bZx class action

Although the legal status of a DAO is uncertain, in May 2022, users of a DeFi platform called bZx filed a class action against a DAO and related entities in a US federal court in California, seeking damages for negligence arising from a hack of the bZx protocol that resulted in losses totalling US$55 million.

The user plaintiffs had deposited cryptocurrency using the bZx protocol, which described itself as a DeFi platform for tokenised margin trading and lending. The bZx protocol was maintained by the bZx DAO, which in turn was controlled by those that held tokens in the bZx DAO.  Within the bZx class action, the DAO is named as a defendant but is not alleged to be a formal legal person or corporate entity.  Rather, the bZx DAO is said to be a general partnership formed by the defendant token holders.

Prior to the bZx class action, commentators tended towards the view that, in the absence of specific legislation, a DAO would likely be deemed a general partnership, with members of the DAO being jointly and severally liable for the DAO’s actions.  In Sarcuni v. bZx DAO, the US Court has now confirmed this view.

The DAO defendants in Sarcuni v bZx DAO argued the user plaintiffs had failed to demonstrate that the DAO operated as a general partnership.  However, after evaluating the operation of the bZx DAO, the Court found that the plaintiffs sufficiently alleged the existence of a general partnership amongst the members holding tokens in the DAO.

First, the user plaintiffs sufficiently alleged that the bZx DAO members had established an association of two or more persons operating as a business for profit.  The bZx DAO generated such profits through its margin trading and lending products.  Second, the Court found that the bZx DAO members possessed governance rights over the DAO and accordingly, carried on as co-owners of the DAO.  In particular, the Court considered that some or all of the bZx DAO members controlled the keys to the bZx treasury (and as such, the DAO’s funds), the bZx DAO members could also vote on governance proposals, including proposing to spend treasury funds and distribute DAO assets, comparable to passing a resolution to distribute dividends.  Finally, it was found that the bZx DAO members could share in the DAO’s profits.  Although such profits (and losses) were not shared equally, this did not compel a conclusion that a general partnership did not exist.

Using the criteria for participation in a general partnership, the Court further considered which of the named defendants were members of the DAO general partnership for purposes of the litigation.  Importantly, if a defendant held tokens in the bZx DAO, there was an automatic inference that such tokens entitled that defendant to participate in the DAO’s management and/or share in its profits.  Accordingly, all such defendants were deemed partners in the bZx DAO partnership.  A more detailed consideration of the general partnership criteria was only necessary if it could not be established that a particular defendant held the requisite tokens in the bZx DAO.

Liability of members of a DAO

Given that the Court in Sarcuni v bZx DAO has now confirmed the position, long believed by commentators to be the case, that in the absence of specific legislation to the contrary, a DAO is likely to constitute a general partnership (at least in common law jurisdictions where the definition of a general partnership is broadly similar), what is the liability position for the members of that DAO?  

First, a general partnership has no separate legal existence.  Second, at law, the DAO’s members are the partners, and notwithstanding that the underlying rights and obligations of members are encoded into the smart contracts constituting the DAO it is difficult to see how individual members could rely on those smart contracts to avoid legal accountability for the actions or failures of a DAO.  Practically, this could have serious implications for members of the DAO, as they are unable to rely on the principles of limited liability available to directors of incorporated entities. Consequently, the member’s personal assets may be exposed to claims for damages, such as those claimed in the bZx class action. 

Further, it would arguably be open to DAO members that are less involved in the DAO’s day-to-day governance and decision-making to assert claims against others who take a more active role in the operation of the business.  Such claims will give rise to questions around what duties DAO members have to one other and the scope of those duties. For example, the bZx class action revolves around a phishing attack on a single developer member of the DAO where the hacker successfully accessed the private keys, from that developer’s computer, permitting cryptocurrency to be drained from the wallets of bZx protocol users.  In such circumstances, it is plausible to suggest that other members of the bZx DAO may file cross claims against the subject developer asserting a failure to exercise a duty of care owed to them.

Clearly, following the decision in Sarcuni v bZx DAO there is much to be said for developers and investors proceeding cautiously with ventures couched in the form of a DAO in view of potential litigation.  If the Sarcuni v bZx DAO litigation becomes a model for class actions in the decentralised finance space, the exposure to liability for participants in a DAO will be considerable in the absence of legislation that regularises the business structure in a similar way to the protections afforded to directors and shareholders of a traditional corporate vehicle. 

It should be noted that amended pleadings are due to be filed in the Sarcuni v bZx DAO litigation later this year, as the proceeding moves toward final determination on the underlying substantive claim.