The Legit Ledger Podcast Ep. 6
DAO Liability in Light of the bZx DAO Class Action with Yasamin Parsafar and Christopher Bosch
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Listen to the original podcast released July 26, 2022 here: https://www.sheppard.com/multimedia-412
In this episode, Sheppard Mullin attorneys Yasamin Parsafar and Christopher Bosch discuss Decentralized Autonomous Organization (or DAO) liability considerations in light of Sarcuni et al bZx DAO, a class action lawsuit alleging negligence due to inadequate security measures
resulting in the loss of more than $40 million in funds for token holders.
Guests:
About Yasamin Parsafar
Yasamin Parsafar is a partner with the Intellectual Property Practice Group in Sheppard Mullin’s San Francisco office, where she serves as co-leader of the firm’s Blockchain & Fintech team. Her practice focuses on protecting her clients’ intellectual property rights through counseling, prosecution, enforcement, and litigation. Yasamin leverages her litigation experience to strengthen and protect her clients’ intellectual property, manage risks, and position businesses to succeed in the event of a dispute. She frequently advises and protects brands venturing into Web3 on various issues related to non-fungible tokens, metaverses, games, online marketplaces, and other platforms.
About Christopher Bosch
Christopher Bosch is a Senior Associate with the Governmental Practice Group in Sheppard Mullin’s New York office. Christopher represents banks, broker-dealers, boards of directors, officers, and other professionals in connection with internal investigations and inquiries by government regulators, such as the Securities and Exchange Commission, Commodity Futures Trading Commission, and Department of Justice. He advises firms regarding digital asset regulatory compliance and has represented a blockchain investor in connection with shareholder derivative and class actions alleging securities law violations. Christopher also represents organizations and individuals in connection with a wide variety of corporate litigation.
Transcript:
Yasamin Parsafar:
Hi, everyone. Thanks so much for joining us today on this week's episode of the Legit Ledger. This is Yasamin Parsafar. I am the co-leader of Sheppard Mullin's Blockchain Team and a partner in the Intellectual Property Practice Group. And joining me today, I have Chris Bosch, who's also on our team and a senior associate in the firm's Governmental Practice Group. His practice primarily focuses on financial industry regulation, compliance, and litigation. And today we are going to be discussing the lawsuit Sarcuni v. bZx DAO that was filed in May of 2022 where users of the decentralized finance protocol, which is managed by the bZx DAO and its successors, filed a class action lawsuit alleging negligence due to inadequate security measures that resulted in the draining of over $40 million worth of funds. This case is important because we believe it's going to shed light on how the courts will view DAO liability going forward.
Yasamin Parsafar:
So just real quick, before we jump into it, in high-level terms, a DAO is a decentralized organization which is intended to be a community-driven organization without any centralized leadership. So instead of a centralized leadership, it's governed by token holders who can submit governance proposals and vote on them, and the rules are stored and executed with smart contracts on the blockchain. So this governance model is intended to be fair, democratic, and transparent. And these individual members are making decisions together for everything from technological decisions to financial decisions.
Yasamin Parsafar:
In some cases, a DAO may have a governing council with certain oversight and control, but because they're typically intended to operate without a leadership team and are typically unincorporated, a key legal question has been how and where liability accrues for the operation of a DAO. And there's a big misconception out there that DAOs or people associated with the DAO cannot be sued.
Yasamin Parsafar:
So jumping right into it. Chris, thanks again for joining us today, and can you tell us a little bit about who the plaintiffs in this case are suing, who the defendants are, and the theory on which they seek to hold these people liable?
Chris Bosch:
Absolutely. Thank you, Yasamin, and happy to talk about those points here today. And to just kind of start it off, the plaintiffs in this action are users of the bZx platforms. And what they are asserting here against the defendants is that based on certain misrepresentations by the defendants regarding the operation and security of the platform they were deprived of vast sums of money. And the defendants in this action are various entities and individuals. So just running down that list here, we have the bZx and Ooki DAOs. The Ooki DAO is the successor entity to the bZx DAO. And the plaintiffs in this action are asserting that the bZx and the Ooki DAO are general partnerships. And we'll get into why that's important in a moment.
Chris Bosch:
Other defendants include the individual co-founders of the bZx protocol, certain investors that "participated in the decision-making of the bZx protocol and its successor, the Ooki protocol." And then finally, we have an entity that allegedly controlled the bZx protocol and another entity that operated a trading platform built on the bZx protocol.
Chris Bosch:
So circling back to the point I just made a moment ago about the plaintiffs alleging that the bZx and Ooki DAOs operated as general partnerships. The argument here is that these DAOs are general partnerships among an association of two or more persons to carry on as co-owners of a business for profit. And under the laws of many states, including California, the state in which this case was filed, these are the elements required to form a partnership regardless of whether or not the people involved intended to form a partnership. And this is important because the concept of a DAO is that you don't have any centralized leadership. You don't have a chief executive officer. You don't have a chief financial officer. You don't have a board of directors. You don't have the team steering the ship. The idea is that the leadership and the operation of the enterprise are decentralized amongst the many users.
Chris Bosch:
So if plaintiffs theory bears out here, what they're saying is that sure, there's no partnership agreement governing these DAOs, but there doesn't need to be. Because you have these individuals and these entities operating a business for profit, they have formed a general partnership by law. And why is that important? That's important because once that's determined, that invokes in various jurisdictions various kinds of default rules about how the partnership must operate.
Chris Bosch:
In California, for example, once it's established that there is a general partnership, the partners owe each other certain fiduciary duties. In California, it's a duty of loyalty and a duty of care. The duty of loyalty essentially means that the partner will not act against the interest of the partnership, while the duty of care, under California law at least, is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law.
Chris Bosch:
In terms of liability, general partnerships can be liability nightmares. All the partners are typically considered to be liable jointly and severally for all of the obligations of the partnership unless otherwise agreed to by the individuals involved or provided by law. So essentially, by participating in this entity, it's arguable that whatever liability, whatever liability accrues to these entities, could be all the people involved, all the individuals involved from the co-founders down to the individual token holders, could theoretically be held liable for those obligations.
Chris Bosch:
And that's what the plaintiffs are alleging here. They're alleging that despite the fact that the DAO voted for a remedy for this hack, the individuals involved here are saying that remedy doesn't suffice. It's not going to get the job done because it's going to take so long for us to be compensated. The partnership is jointly and severally liable along with the individual defendants for our damages. So that's why the case theory being advanced by plaintiffs is a really interesting one.
Yasamin Parsafar:
Thanks so much for that, Chris. So I just want to break this down a little for people who might not be as familiar with these issues. So I think what you were saying is that you can form a general partnership under the law without any intention to do so or any legal writing or document that says that you have formed a general partnership and the law is going to look at what the partners are actually agreeing to do, not in terms of operation of the business, not in terms of what structure they're agreeing to form. Is that correct?
Chris Bosch:
Yes, that's right. There does need to be an intention to carry on a business for profit. But aside from that, there doesn't need to be an intention to form a general partnership. And you're right that there doesn't need to be an agreement. And that's an important point because if there can be an agreement that modifies some of what I'm going to call the default rules under a certain state's set of laws. So in the absence of an agreement, you have these default rules that apply as a matter of statute. So they're in the legal framework in the event the people involved in a partnership do not have a governing document. But it's important to note that if there is a general partnership agreement, there is some leeway to modify some of the duties and obligations that would otherwise arise by default.
Chris Bosch:
So that's an important thing to keep in mind here, that if parties seeking to create a DAO are considering this possibility that they can be viewed as a general partnership, perhaps there's a way to integrate a general partnership agreement into the framework of the DAO itself. That's just an idea.
Yasamin Parsafar:
I think that's a really good point. And then the other issue that you raise, which I think is important, is the fact that these laws in terms of the entity as well as the liabilities and obligations attached to that are state specific and can be different depending on various jurisdictions. So another thing I think people need to look at is consider the laws of which states are going to apply to them and govern their organization and the members liabilities and obligations so they have that knowledge going forward in their operations.
Chris Bosch:
I was just going to add that many states have adopted the Uniform Partnership Act, but some states have tweaked it. And what it is, it's a basic framework that has been adopted by many states. But when you get into the intricacies of an individual state's series of statutes, they could theoretically modify some of those provisions, tweak it here and there. So it's important to consider what states you're seeking to operate in and consult a legal professional that can help you figure out exactly what laws you would be subject to.
Yasamin Parsafar:
Great. And then the other point you made, which I think is important, is the concept of, or the doctrine of joint and several liability for the members. So can you explain what that means exactly?
Chris Bosch:
Sure. So joint and several liability means that whatever judgment may ultimately be rendered, that all the parties that comprise this partnership individually can be held liable for the entire sum of the judgment. Or it could be that they bear it together. It depends on how the plaintiff chooses to pursue damages. But the concept is that each individual can be liable for the entire sum of the judgment.
Yasamin Parsafar:
Yeah, I think that's really important here. The other thing that I think this case implicates, this fact pattern which is important for people participating in DAOs to consider is the allegations that were made regarding misinformation. Even though they did not assert claims specifically, misinformation-related claims, they asserted the claims based on negligence, they do make allegations in this case that could potentially give rise to claims based on misinformation given to consumers, such as false advertising under the Lanham Act or violations of Section Five of the FTC's act prohibiting unfair, deceptive acts or practices in or affecting commerce. And there's a lot of analogous state laws involving misinformation.
Yasamin Parsafar:
And particularly here, the plaintiffs are alleging that one of the platforms was represented as being non-custodial and therefore users would maintain control of their own private keys and assets when in reality a single password provided access to all of client funds across a couple of the blockchains on which the platform operated. And they also alleged that the defendants made statements regarding their security measures, having characterizing it as world-class security and not having to worry about ever getting hacked or having the funds stolen when that is precisely what they allege is happening here.
Yasamin Parsafar:
So another important thing for members of a DAO to consider is to look at all your communications to your consumers, review them with an attorney, whether it's marketing, advertising, your white papers, and really consider whether those types of statements could potentially give rise to other claims.
Yasamin Parsafar:
So I think we are close to wrapping it up here. Chris, do you have any final takeaways? I know you gave us a lot already for people to consider, but is there anything else that you want to add?
Chris Bosch:
Sure. Thanks, Yasamin. So just kind of piggybacking on the last point that you made about potential alleged false representations that could be made. When people look at DAOs, the conversation around DAOs in recent years has focused on the question of whether or not the operation of a DAO invokes a security such that the enterprise would be subjected to federal securities laws. And if it were to be subjected to federal securities laws, making misrepresentations in the issuance of securities could in and of themselves be violations of federal securities laws, just to piggyback on your point about potential misrepresentation. So it's very important to be accurate about what the product or the service offers for many reasons.
Chris Bosch:
And this concept of whether or not a DAO invokes a security that is subjected to the federal securities laws. A lot of people think that if you escape the reach of the SEC, if these DAOs truly are decentralized such that they can escape the purview of the SEC, that they're unregulated entities, to your point earlier Yasamin. But what we're saying here in this case is that even if you escape the reach of the SEC, you may find yourself in general partnership land. And in the absence of a partnership agreement, a collection of state general partnership laws govern the conduct of the partners.
Chris Bosch:
Now, some of these default state rules can be modified by an agreement amongst the partners, but in the absence of one, the default rules will govern. And so it's important for individuals seeking to create a DAO or bring in investors or pitch it to potential users that are going to utilize the tokens to participate in the governance of a DAO to consider this question of what could this be classified as? What kind of entity could this be classified as? And what does that mean in terms of the obligations and duties and liabilities of everyone involved?
Chris Bosch:
What you may want to consider is consulting a legal professional that could help explore the possibility of creating some type of limited partnership, perhaps a C or S corporation, or a limited liability company. These are various entities that have pros and cons associated with them, but they offer limited liability provisions for the individuals involved in the enterprise. And if we can figure out a way to work those into the operation of the DAO, that could be a useful approach.
Chris Bosch:
And just in closing, the upshot is that it's very important to reflect upon what the designation of the enterprise means for the individuals participating in the governance of a DAO, from the co-founders all the way down to the users.
Yasamin Parsafar:
Great. Thank you so much, Chris. And thanks everyone again for joining us today. And if you find this information helpful or interesting, please share and subscribe. Thank you.
Resources:
DAO Liability and the bZx Class Action
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This podcast is for informational and educational purposes only. It is not to be construed as legal advice specific to your circumstances. If you need help with any legal matter, be sure to consult with an attorney regarding your specific needs.