How can insiders sue an amorphous crypto collective? They can’t, says the bZx defendant

(Reuters) – The emerging blockchain industry has created a new type of business organization that openly rejects the traditional corporate pyramid structure, with top management burdened with fiduciary duties.

These decentralized autonomous organizations, or DAOs, do not have bosses who make decisions for the entire enterprise. DAOs distribute decision-making power broadly – ​​usually to anyone who holds a governance token – and operate collectively. The alt model is growing in popularity: According to a client alert issued last month by Wachtell, Lipton, Rosen & Katz, thousands of DAOs are already in operation, collectively holding billions of dollars in assets.

Here’s a puzzle for DAO participants, though: Who do you sue if things go wrong? In an organization that is decentralized and autonomous by design, does anyone bear responsibility when the business suffers a loss?

Gerstein Harrow, a new law firm specializing in crypto consumer protection, has come up with a creative theory to address these questions. In May, Gerstein Harrow filed a class-action lawsuit in Los Angeles federal court on behalf of crypto investors who allegedly lost more than $50 million when the decentralized finance platform bZx was hacked in November 2021. The class action named two Delaware companies as plaintiffs: Leveragebox LLC, which created open the source code web interface that allows users to access the bZx platform; and bZeroX LLC, which developed the bZx protocol that allows users to trade and lend crypto tokens on margin.

However, at the time of the hack, neither Leveragebox nor bZeroX had control over bZx. The developer of the protocol, bZeroX, transferred it to token holders in August 2021. In other words, bZx was a DAO when the hack happened. How do you blame a security breach on an amorphous collective with no one in charge?

It was there that Gerstein Harrow got creative. The class action claims that the bZx DAO, as well as a successor DAO called Ooki, was a de facto general partnership – and the partnership bears responsibility for the losses of some of its members. In fact, the complaint said, the DAOs have already acknowledged their obligation to respond to the hack. After debate and discussion in the DAO, token holders voted to adopt a compensation plan that provided new tokens to cover some losses and “debt tokens” to cover others. Plaintiffs in the class action claim that the debt tokens will not pay off for years, leaving them with large losses from the hack.

The class action alleges a single count of negligence against all the defendants: the original bZx DAO and its successor Ooki DAO, the developer of the web interface, the protocol developer, two founders who founded the underlying companies and some ancillary actors.

On Monday, most of the defendants (but not the DAOs) moved to dismiss the class action. Defense attorneys at Morrison Cohen and Hahn Loeser & Parks offered some technical arguments, arguing for example that bZeroX, Leveragebox and their founders owe no duty to DAO token holders and therefore, under the economic loss doctrine, cannot be liable for losses from the hack . The proposal also said that the terms of service for the website that provides access to the bZx platform expressly disclaims responsibility for whatever happens on the trading protocol.

But more importantly, in terms of the development of the DAO Act, the proposal asserts that DAOs are not general partnerships. First, according to the motion, there is no indication that all of the individuals who purchased governance tokens considered themselves to be engaged in the common operation of a for-profit business, as opposed to users who simply wanted access to an open source code. crypto platform. There is absolutely no allegation, the motion says, that DAO participants agreed to share losses — which is an element of partnership, according to defense attorneys.

“This radical extension and change of long-standing principles of partnership law should not be resisted,” the letter said.

The biggest problem with the plaintiffs’ DAO partnership theory, the brief says, is that under the “amorphous and often shifting” definition offered in the complaint, the plaintiffs themselves are partners. So if their theory is correct, the letter said, they are just as responsible for the security breach that led to the $55 million hack as any other token holder.

“The plaintiffs’ theory is, to put it politely, far-fetched,” the dismissal motion states. “No court has held that individuals who hold only digital assets somehow operate as a general partnership with all other holders of that asset, and no court has held that all users of an open source software protocol in any way manner operates as a general partnership with all other users of this software.”

The general partnership theory is particularly ill-suited to a class action, the motion states. The same class members who lost money in the hack are also members of the partnership, according to plaintiffs’ theory, and thus liable for class losses. It simply cannot work, the proposal states: Class representatives cannot act on behalf of a class when class allegations include their own wrongdoing.

The plaintiffs’ attorney, Jason Harrow of Gerstein Harrow, told me that the defendants’ argument is a red herring because the name plaintiffs did not have governance symbols, so they were not part of the DAO. (They just used the platform.) And even in cases where DAO participants assert claims against general partners, Harrow said, active members of the collective governing the DAO’s behavior should bear more responsibility than small players on the sidelines.

I should note that Harrow’s class action lawsuit includes citations to three recent legal analyzes that discuss analogies between DAOs and partnerships, so the theory may not be as far-fetched as the defendants suggest.

It is also worth noting that the bZx case involves claims by DAO participants against their own DAOs. While it is not possible for insiders to assert liability claims for which they would be jointly liable, the same may not be true for an outsider with a claim against a DAO for some type of wrongful conduct. DAOs are a relatively new development, so early suits like the bZx case are breaking new ground.

Read more:

Users of ‘specially secure’ crypto network sue over $55m theft

Buying the constitution: The rise of DAOs in legal

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