SAMUEL HIRSCH—Cryptocurrency has multiple uses for investors. First, cryptocurrency is a form of currency used to purchase goods and services or store value, similar to traditional currency. The popular tokens in this realm include Bitcoin and Ethereum.
Another use of cryptocurrency has grown more popular recently. Investors purchase crypto tokens to acquire voting rights in a profit-seeking organization. Each token has a predetermined unit of voting power that the token holder can exercise. These types of tokens gave rise to a type of decentralized finance, or “DeFI,” allowing token holders to engage in votes on business matters in a more untraditional manner than standard business structures. One method of DeFi that has risen in popularity is a decentralized autonomous organization, or “DAO.”
A DAO is an informal organization of token holders, who seek profit, and have the right to propose and vote on business opportunities within that DAO. Each token holder gets a predefined share of voting power in that DAO. The key to a DAO is the lack of central authority and the bottom-up management approach. But what is the specific business structure adopted by the DAO?
Profit-seekers traditionally organize under business structures such as Partnerships and LLCs, where the regulatory framework is well-established. Those entities can have a negotiated agreement outlining the relationships of all the stakeholders, and some of those entities even provide limited liability for the entity’s obligations.
Under California law, when two or more persons associate to conduct a business as co-owners for profit, they form a partnership, whether or not the persons intended to form the partnership. Generally, when two or more individuals go into business together and do not form an entity to act on behalf of, the default rule is that they are treated as a general partnership, even if they did not intend to create a general partnership. Under general partnership laws, each partner can be held jointly and severally liable for obligations of the partnership, with no limit on each general partner’s liability.
So, the question remains: what type of business structure is adopted by the DAO? A recent California court case suggests that a DAO is a general partnership by default. Therefore, there is a possibility that all token holders are held jointly and severally liable for obligations of the DAO, with no limit on that liability.
In Sarcuni v. bZx DAO, the plaintiffs alleged that the defendant token holders of the bZx DAO were partners in a general partnership. The plaintiffs sought redress after collectively losing $1.7 million in crypto assets due to a successful phishing attack on a developer of the DAO. The plaintiffs proved that the DAO (1) is an association of two or more persons that are (2) carrying on as co-owners of (3) a business for profit. The court was persuaded by the plaintiffs’ arguments and found that a general partnership existed amongst the token holders of the bZx DAO. Consequently, the plaintiff sought to hold each defendant token holder jointly and severally liable for the negligence of the DAO and allocate the cost of repaying the $1.7 million amongst the defendants.
The implications of this case are troubling for future investors of DAOs, who may be unaware that they could be subjected to significant liabilities for such a minor investment in a DAO. For example, there has been a recent rise in the popularity of a DAO known as Wall Street Memes. Wall Street Memes is a DAO that offers a marketplace for creators and purchasers of meme content. At one point, a person could have purchased a token in the Wall Street Memes platform for a mere $.03. The fact that an investor in such a DAO could be exposed to limitless liability solely because they purchased a $.03 stake in the DAO is troubling.
Investors in DAOs need to ensure they understand the risks associated with them before exposing themselves to substantial liability. Some states have begun to acknowledge and formalize rules for DAOs, such as in Tennessee. As states enact regulation for this new form of entity, investors must become familiar with their applicable state laws and adjust accordingly.
