Serving process on a decentralized autonomous organization through its help chatbot?
Introduction to Decentralized Autonomous Organizations
Web3.0 and the rise of decentralized technologies such as blockchain, cryptocurrencies, and non-fungible tokens raise new and complicated legal issues. As discussed in more detail in our prior post on decentralized governance, smart contracts on a blockchain network like Ethereum, use a decentralized autonomous organization (“DAO”) form of governance. This is an emerging legal structure where there is no central governing body and the members share a common goal to act in the best interests of the entity. The DAO token holders participate in management and decision-making of an entity, by collectively casting votes. All votes and activity through the DAO are posted on a blockchain which provides public transparency of its users’ actions. Unlike a traditional legal entity that acts through a central authority, in a DAO the collective participants act as the governing body. This article discusses some emerging DAO legal and tax issues and highlights a recent court order that permitted serving a DAO with a summons.
Emerging Questions on Legal and Tax Status of DAOs
There are emerging and novel legal questions about how a DAO may be subject to regulatory or legal action. DAOs lack legal status in most of the United States, and, as a result, may be considered, by default, as a general partnership, with each member potentially having unlimited liability for its actions. DAOs unlike their traditional legal entity counterparts are only recognized as legal entities in three states: Vermont, Wyoming, and Tennessee. Each of these states allows the DAO to register as a type of LLC.
The lack of legal status in most of the United States is a significant liability risk to the DAO’s participants. Additionally, because it lacks legal status it is unclear if a DAO may enter into a contract or conduct traditional business activities. It is also unclear on what basis and how a DAO should be taxed. Should the IRS treat this emerging legal entity, by default, as a partnership? If so, how would Schedule K-1’s be issued since one of inherent features of a DAO is token holders anonymity? Absent a centralized structure, how would each participant receive aggregate information regarding the DAO’s activities (and their share thereof to be reported on a tax return)? Finally, there are basic litigation issues under Federal Rules of Civil Procedure such as how can a party serve the DAO with a summons, discovery, notices, or motions?
Service of Process on a Decentralized Autonomous Organization: CFTC v. Ooki DAO, C.A. No. 3:22-cv-5416
A federal district court has answered one of these foundational legal questions: a DAO can be served with a summons. On October 3, 2022, the United States District Court for the Northern District of California entered an order (the “Order”) granting the United States Commodities Futures Trading Commission’s (“CFTC”) motion to serve members of the “Ooki” DAO (formerly d/b/a/ bZx DAO) with a summons through online communications. Specifically, the court granted the CFTC’s motion for alternative service on Ooki DAO and ruled that the CFTC effectively served Ooki on September 22, 2022, when the CFTC provided a copy of the summons and complaint through Ooki’s DAO help chat box as well as contemporaneous notice by posting the summons on Ooki’s online forum. The CFTC sued Ooki on September 22, 2022, alleging that the DAO, through its decentralized blockchain-based software protocol, illegally offered leveraged and margined retail commodity transactions in digital assets, engaged in activities that only registered futures commission merchants can perform, and violated the Bank Secrecy Act.
The CFTC’s lawsuit and the Order approving alternative service on the DAO through online communications undermines the idea that DAOs are not subject to regulation or legal liability. The CTFC’s complaint seeks to impose legal liability on each Ooki DAO token holder that voted as part of the Ooki DAO’s governance process. Note that the CTFC did not pursue a potentially broader group of actors which could have been defined as any recipient of a token as it would be very difficult to prove that receipt of a token (which may happen for any number of reasons) was tantamount to participating in illegal activity. The CFTC also did not make a distinction between token holders that specifically voted to engage in alleged illegal activities and those who did not. The CFTC’s target in the lawsuit is any token holder that voted as part of the governance process. The legal theory is likely that the exercise of the right to vote is an indication that the token holder participated in the governance of the DAO and if that governance resulted in illegal activity, that token holder should be held individually liable for their role in the collective DAO governance decision. That is a broad standard that can have significant consequences to the DAO and its members if it were applied outside of the regulatory context and instead in traditional litigation.
Ooki DAO has until October 13, 2022, to respond to the complaint otherwise the CFTC may win a default judgment against the token holders that voted as part of the Ooki DAO governance process. If this happens, another novel legal issue that will emerge will be how will the government enforce the judgment on the DAO? If it can determine the identities of the token holders would it seek to enforce the judgment on only U.S. token holders since they have assets in the United States that could be available to satisfy any judgment or would it pursue all token holders regardless of whether they were U.S. persons?
The DeFi Education Fund (“DEF”), a Washington, D.C.-based lobbying group that is focused on decentralized finance, and LeXpunK, a collective of lawyers and developers that are active in the crypto space have filed motions with the court for permission to file Amicus Curiae briefs regarding the CFTC’s motion for alternative service. DEF’s motion can be found here and LeXpunK’s motion can be found here. Both amicus curiae briefs argue that the CFTC’s service of process was inadequate and violates due process. As of the date of this writing, no counsel has entered a notice of appearance on behalf of Ooki DAO.
Implications to Decentralized Autonomous Organizations and Other Decentralized Technologies
The Ooki DAO case may have significant implications for all DAOs. While decentralization may provide many technological benefits it comes with significant risk as it may introduce unlimited legal liability for any token holders that participate in the DAO governance process. This may be a headwind to the proliferation of Web3, DAOs, and other technologies that rely on decentralization. Additionally, the outcome of the Ooki case may spur additional state legislation to recognize DAOs as a subset of an LLC to limit the potential liability of token holders that participate in a DAO’s governance.
It is important to note that a different federal district court outside of the Northern District of California may be confronted with a similar fact pattern for a different decentralized organization or DAO and may rule differently than the United States District Court for the Northern District of California (as it would not be bound by the Order). The legal and tax implications of DAOs are rapidly developing areas of the law. As this technology becomes mainstream Courts will inevitably have to address many tax and legal issues of first impression. One thing is certain, in the United States District Court for the Northern District of California members of a DAO can be served a summons through online communications by posting a copy of the summons and complaint in the help chat box and by posting it on the DAO’s online forum.
Cryptocurrency, Digital Asset, and Blockchain Attorneys
Do you have DAO, Cryptocurrency, Digital Asset, or Blockchain Issues or questions? Freeman Law is an innovative thought leader in the DAO, cryptocurrency, digital asset, and blockchain space. DAO, blockchain, and virtual currency activities take place in a rapidly evolving regulatory landscape. Freeman Law is dedicated to staying at the forefront as these emerging technologies continue to revolutionize social and economic activities. Contact us to schedule a consultation or call (214) 984-3000 to discuss your DAO, cryptocurrency and blockchain technology concerns.
Freeman Law International Tax Symposium
Readers may be interested in the Freeman Law International Tax Symposium scheduled to take place virtually on October 20 and 21, 2022. Attendees will qualify for CLE, CPE, and CE and the slate of presenters includes well-recognized speakers and panelists, such as the IRS Commissioner, a prior Chief Counsel of the IRS, a former Acting Assistant Attorney General of the U.S. Department of Justice Tax Division, and many others in government and private practice.