Arm Yourself With Info On DAOs + Legal Entities

This week at Judica, we’ve been meeting with you all to learn more about what features are most important to you in Decentralized Autonomous Organization (DAO) software. We’re excited about what you want to build on the Judica VM, and want you to be as informed as possible while forming your communities. We’ve been listening, and a common question from the DAO curious is “does my DAO need a business entity?” While we can’t give you legal advice, we can help you arm yourself with the knowledge to make the best choice for you and your community.

At this point, you might be wondering “what is a business entity anyway?” and that’s a good question! A business entity in the simplest sense is an organization created by one or more individuals to conduct business or engage in trade, whether for profit or not. Depending on where you are in your DAO journey and the questions you have, the following readings might be helpful:

• What I Wish I Knew Before Talking to Lawyers about DAOs - lessons on choosing and setting up a legal structure for a DAO. If you’re wondering why a DAO might want to have a legal entity (or not) this is a good place to start.
• Decentralized Autonomous Organizations: Beyond the Hype - a high level overview of what DAOs are, their pros and cons vs traditional business entities, and some practical considerations in launching and managing DAOs.
• Legal Wrappers and DAOs by Chris Brummer and Rodrigo Seira - a comprehensive survey of legal structures available to DAOs, discussion of the relationship between legal structures and DAOs, and an exploration of when each might be appropriate.
• Paradigm’s DAO matrix or Very Detailed DAO Matrix - a more visual representation of the above article.

Think the point of a DAO is not to engage in the legacy legal system (including business entity formation)? You’re not alone, but let’s explore what might happen without formally creating a DAO legal entity. There has been recent chatter in the U.S. about DAOs and “general partnerships.” If you’ve asked a lawyer what a DAO is in traditional business entity terms, you most likely heard that a DAO most closely resembles a general partnership, an association of two or more persons to carry on as co-owners a business for profit. There may also have been thoughtful consideration of an “unincorporated association,” a group of people who act together in a common enterprise and for a common purpose. Why these in particular? Because they are entity types that exist by default when individuals behave in certain ways. You can think of this as “if you don’t tell us what you are, we’ll assume you are the thing that offers you the least protection,” or at least that can be the practical effect. While there may be fewer compliance requirements for these default entities, they involve risks like personal liability for the partnership or association’s actions.

Two California cases involving bZx DAO and its successor Ooki DAO are testing the general partnership and unincorporated association definitions as applied to the Protocol management DAO model. While we wait for more guidance from the outcomes of those cases, the parties’ perspectives on the relationship between DAOs and business entities are worth examining. Let’s start with general partnerships.

Sarcuni et al vs. bZx DAO et al (S.D. Cal) is a class action lawsuit brought by token holding members of the bZx DAO against bZx DAO (yes you read that right) and others over loss of funds arising from a phishing hack. The Complaint alleges that BZRX (now OOKI) token holders and investors are in a general partnership with one another because they formed an association by acquiring tokens, and the for profit business they co-own is the DAO, with profits being defined as the right to funds in the DAO treasury.¹

Among the named defendants in Sarcuni is Leveragebox LLC who by their own definition “…participated in creating an open-source, publicly-available web-based interface that allowed Plaintiffs to access software on the internet known as the bZx Protocol…”² Levargebox points out that the complaint does not allege facts showing it, among others, intentionally agreed to form or join a partnership “together with anyone and everyone” who held tokens to operate the bZx Protocol for profit and that there is no case law holding that owning common digital assets constitutes formation of a general partnership.³

Putting aside Levaragebox for a minute, it is worth considering whether all these token holders could intentionally agree to carry on a specific, well defined business as co-owners. Personal experience dictates that the larger a group of individuals becomes, the harder it becomes to reach consensus on anything. Consider how divergent individuals’ definitions of a business could be and still be defined enough to form a partnership. Where would you draw the line?

Meanwhile, the CFTC is suing Ooki DAO for violation of CFTC regulations and the Commodity Exchange Act (CEA) in the Northern District of California. The Complaint hinges on defining the Ooki DAO as an “unincorporated association,” presumably to make the DAO subject to the CEA.⁴ The CFTC, however, couldn’t figure out how to serve all the members of the alleged unincorporated association, so the Court granted its request to use an alternative service method - by posting in a help chat bot and web forum on a site allegedly associated with the DAO.⁵ If this seems suspect to you on its face, you aren’t alone.

Attorneys at Paradigm and LexPunk think this service method is wildly insufficient, but more relevant to our discussion here, that the alleged need for alternative service highlights fatal deficiencies in the CFTC’s Complaint. An unincorporated association is “(1) a group of persons who (2) join through mutual consent to (3) pursue a common objective.”⁶ Paradigm points out that different token holders casting different (often opposing) votes on different issues at different times is a far cry from mutual consent to an agreed upon purpose. One group of token holders could vote on issue A and time X, while another group could vote on issue B at time Y with no overlap between the groups. Can a common objective exist when different token holders vote for different or conflicting proposals and purposes?

Similar to a general partnership, existence of an unincorporated association hinges on a common objective. From the CFTC’s perspective, Ooki DAO’s objective includes operating and governing the Protocol, or software. LexPunk’s Amicus Brief clarifies that while OOKI token holders participate in some governance, “such governance is highly limited, technologically constrained, and not like “governance” as it exists in traditional corporate structures.”⁷ Nor do token holders run the software as a business for the benefit of its users. Rather the software is run by a globally distributed network of independent blockchain nodes, and token holders’ votes represent their personal preferences on how that software should operate based on personal objectives.

These issues are worth tracking as there’s potential for a hasty ruling to unintentionally expand liability (or a Federal agency’s jurisdiction). Imagine extending the idea that by voicing an opinion on the direction of a software project, an individual might be joining a business or other organization focused around operating that software. How far down the slippery slope from the CFTC’s position does this hypothetical live? If you open an issue or make a pull request on an open-source project, would you expect to be personally liable for something that results from the operation of that software?

My personal take away from these cases is that there is significant difficulty shoehorning protocol DAOs like bZx into a traditional business entity definition, because it is not clear that DAO members agree on a business purpose, and that there was no “meeting of the minds” in the traditional sense. However, I can imagine a DAO with a clearly defined business purpose and little conflict between members more closely resembling a general partnership. One way to get around this mess is proactively exploring whether your DAO could benefit from forming its own legal entity. If you decide you want to talk to an attorney, please reach out and we’ll do our best to connect you with someone equipped to advise you in this space.

Still reading? Inspired by legal writing to form a DAO or have some fresh ideas about what you could do with the JudicaVM? There are still some spots open next week for DAO conversations! Really like being in the weeds on the legal stuff? Check out the citations and authorities the parties reference in their various pleadings, but beware - cited authorities have cited authorities, and so on, and so on…

Finally, if there’s one thing I learned as a practicing attorney, besides how to answer every question with “it depends”, it is to be as transparent as possible. To that end, I must emphasize that nothing in this post is or should be construed as legal advice from me or from Judica, nor are we endorsing any content linked to in this post. We just want you to be able to draw your own informed conclusions, and make good choices out there.

Cheers!