Crypto companies cannot avoid legal liability by forming a DAO — Quartz

US federal regulators have just shot down one of crypto investors’ main strategies to avoid legal scrutiny.

On September 22, the CFTC sued blockchain company bZeroX, its founders and Ooki DAO, a crypto collective affiliated with the company, accusing them of illegally selling commodities and futures. bZeroX’s software allows crypto traders to buy and sell cryptocurrencies on margin – that is, using borrowed money.

It is the agency’s first case against a decentralized independent organization. DAOs first appeared in 2016, but became more popular during the recent crypto boom. Under the set-up, no members are responsible for decisions about how the organization should be run, which are instead taken collectively via voting.

But in the lawsuit, the CFTC treated Ooki DAO no differently than bZeroX, which was originally incorporated as a limited liability company. In August 2021, the founders transferred control to a DAO, first called bZx DAO and later changed its name to Ooki DAO. The government claims this was an arrangement to avoid legal liability.

“Margined, leveraged, or funded trading of digital assets offered to retail clients in the United States must occur on properly registered and regulated exchanges in compliance with all applicable laws and regulations,” CFTC Acting Director of Enforcement Gretchen Lowe said in a press release. “These requirements apply equally to entities with more traditional business structures, as well as to DAOs.”

The CFTC action is another sign from the US government that it will not allow wrongdoers to hide behind claims of decentralization – or their DAOs – to protect themselves.

You can’t hide behind a DAO

The founders of bZeroX believed that by creating a DAO they were protecting themselves and the company from legal liability. According to the lawsuit, one of the founders said the following in a conversation with users:

“It is very exciting. We must really prepare for the new regulatory environment by ensuring that bZx is future-proof. So many people across the industry right now are getting legal notices and lawmakers trying to decide whether or not they want DeFi companies to register as virtual asset service providers – and what we really need to do is take every step possible to make sure that when regulators ask us to comply, that there’s nothing we can really do because we’ve given everything to the community.”

But they were wrong. “DAOs are not immune from enforcement and cannot violate the law with impunity,” the CFTC wrote in its complaint. bZeroX and its founders could not immediately be reached for comment.

Rahsan Boykin, general counsel at DeFi trading platform Hashflow, said in an interview that the CFTC was right to send this message to the crypto industry. “Everybody knows you can’t trade derivatives in the United States without a license,” Boykin said. “To say you can do that just because you moved to a DAO is uninformed and dangerous.”

DAOs, which provide membership and voting rights with crypto tokens, see themselves as an emerging business structure in the crypto world, although it is not a legal method of incorporation. (In Wyoming and Tennessee, however, you can now form a DAO LLC to incorporate and limit individual liability.)

The CFTC’s lawsuit specifically involves all voting token holders in the Ooki DAO, a warning to anyone involved in or seeking to join a DAO that may be involved in illegal activity. According to data from Dune Analytics, about 1,200 crypto wallets contain Ooki DAO tokens, although one person can have multiple wallets.

A former CFTC attorney, who spoke on condition of anonymity, said what matters to federal regulators is the illegal activity, not the structure of the organization that commits it. “From the CFTC’s perspective, it doesn’t matter if it’s two guys on a corner, two guys under a crypto name, or a thousand people holding tokens in a decentralized organization,” the lawyer said. What is less clear, the lawyer added, is whether any individual token holders will be prosecuted in this civil suit since none have been specifically named.

Allegations of “regulation by enforcement”

Not everyone is a fan of the CFTC’s action. Summer Mersinger, a Republican who serves as one of the CFTC’s five commissioners, decried the enforcement decision because of the implications for individual DAO token holders. Mersinger called it “arbitrary” and an example of “regulation by enforcement,” unbound by case law. She said it “undermines the public interest by discouraging good governance in this new crypto environment.”

Budd White, co-founder of crypto compliance firm Tacen, said the CFTC’s enforcement decision makes sense but “shows a lack of nuance” in the commission’s understanding of DAOs. “Just look at some of the protections afforded to LLCs and other corporations under U.S. regulations today — it’s extremely rare to see CEOs or other individual employees of these organizations held accountable for broader wrongdoing,” White wrote in an e -mail to Quartz. “Shouldn’t DAOs and their members be afforded some of the same protections?”

White said the unique nature of DAOs should be considered as we are at a “crossroads to set the regulatory stage for years to come.”

Crypto’s two main regulators

There is a low-grade turf war over crypto development between the CFTC and the US Securities and Exchange Commission (SEC). While crypto advocates largely favor the CFTC as the chief regulator, believing it to be less disruptive and demanding, both agencies seem eager to regulate crypto. What is likely is that some crypto products will be considered securities and some will be considered commodities, and many crypto companies will have to comply with one or both of these regulators’ requirements.

SEC Chairman Gary Gensler recently said that he believes that almost all cryptocurrencies are unregistered securities, although he admitted that bitcoin is likely a commodity. He also indicated that ethereum may now pass the Howey test, a Supreme Court standard for determining what constitutes a security, given the recent changes in how it validates transactions.

Todd Phillips, director of financial regulation and corporate governance at the Center for American Progress, a left-leaning think tank, said the CFTC decision shows DeFi is not immune from regulators applying and enforcing existing financial laws. “If you facilitate derivatives transactions, whether you are a centralized exchange or a decentralized exchange, you are still expected to register,” he said. “I imagine the SEC expects the same for securities exchanges.”