Wachtell Lipton Discusses Legal Considerations for Decentralized Autonomous Organizations

We recently wrote about the emergence of a new breed of business organizations — decentralized autonomous organizations (DAOs) — to contend that the governance design for these blockchain-based organizations should heed some of the hard-fought lessons that have helped to form the pillars of modern corporate governance.  It is also important to confront certain features of DAO governance that present distinct challenges for counterparties seeking to invest or engage in commercial transactions with DAOs.  A few recent DAO controversies highlight the need for greater clarity in the legal status of DAOs, more robust governance, and a reckoning with the distinct legal and commercial risks that may accompany transacting with a DAO.

Potential investor liability: A recent putative class action filed against one DAO raises the specter of potential liability for DAO investors, potentially even for mere purchasers of DAO governance tokens.  In this case, after a theft of cryptoassets from a blockchain protocol controlled by the bZx DAO, the users whose assets were stolen sued various parties that included the DAO itself for failing to maintain adequate security measures.  The suit alleges, among other things, that because the DAO was not established as a legally recognized entity, it should be treated as a general partnership, such that each DAO member — potentially including every holder of a bZx DAO governance token — should be jointly and severally liable for the DAO’s alleged negligence.

This unusual general partnership theory is not a central aspect of the lawsuit and has not yet been addressed by the court.  Nevertheless, the theory bears close attention as investors who participate actively in a DAO’s governance may face greater risk of unlimited liability as constructive general partners.  Consequently, DAO organizers should consider forming traditional business entities (so-called “legal wrappers”) for DAO activities where liability concerns are heightened.  Prospective DAO investors, for their part, should be mindful of the risk of investing in organizations that lack a traditional legal entity’s liability shield and consider self-help measures, such as forming limited liability entities to hold DAO tokens.

Breach of commercial agreements: A recent dispute between Merit Circle DAO and one of its earliest investors highlights the uncertainties facing counterparties that enter into commercial arrangements with a DAO.  Here, a seed investor entered into an investment contract with a legal entity affiliated with Merit Circle DAO that entitled the investor to a large allocation of the DAO’s governance tokens.  After the tokens grew substantially in value, an individual member of the DAO community proposed that the investment be unwound on the basis that the investor had not been sufficiently active in supporting the DAO.  Management of the DAO’s affiliated legal entity (that had entered into the investment contract with the investor) objected to the proposal, noting that the investor had fulfilled its contractual obligations and that negative community sentiment cannot justify a breach.  The DAO nonetheless approved the proposal by majority vote.  The parties eventually reached a negotiated resolution that avoided litigation.

This dispute highlights important considerations for DAOs and their counterparties when entering into agreements.  Clear and intentional breaches that may be unusual in a typical commercial environment could arise more frequently in settings where a DAO’s members, through express governance rights or community pressure, could cause the contracting entity to breach an agreement.  The prospect of such conduct could hinder DAOs’ ability to enter into commercial agreements on desirable terms.  Counterparties should be prepared to litigate to enforce contracts with DAO-affiliated entities, although pursuing contractual remedies may be complicated by open questions about the legal status of DAOs, the pseudonymity of their participants, and jurisdictional issues.  Careful drafting is essential to ensure clarity as to the remedies for a breach and to delineate what effect, if any, a vote by DAO members can have on contractual obligations.

Altering the functionality of a blockchain protocol: Another recent proposal approved by a DAO underscores the risk that a majority vote could disparately treat users of DAO-controlled blockchain protocols — potentially including the expropriation of assets.  The largest user of the Solend DAO’s decentralized finance (DeFi) protocol had deposited into the protocol a significant amount of cryptoassets as collateral to borrow stablecoins.  Under the mechanics of the protocol, if the market value of the deposited cryptoassets fell such that the loan became under-collateralized, the protocol would automatically liquidate the deposited cryptoassets.  The proposal — made by the Solend code development team — requested emergency power to take over the user’s account and complete an over-the-counter liquidation in the face of perceived risk of the loan position unwinding in a disorderly manner.  The DAO overwhelmingly approved the proposal, although later voted to reverse the decision in the face of criticism.  And this situation was not a unique occurrence.  As another example, the development team behind Bancor (another DeFi protocol) also recently determined — unilaterally — to modify an important feature of its protocol and then sought ratification of this action by Bancor DAO after the fact.  The ability of a centralized body to modify a blockchain protocol calls into question the degree of some DAOs’ actual decentralization in certain circumstances.

Counterparties should evaluate the extent to which a DAO (or its development team) can alter the functionality of the protocol to modify an idiosyncratic commercial arrangement and potentially damage the counterparty’s economic position.  Counterparties should also assess the DAO’s governance framework — for instance, whether the development team has actual or effective voting control.  Up-front risk assessment is prudent when transacting directly with DAO-affiliated blockchain protocols, as there will typically be no written agreement between the user and the protocol other than the source code itself.  As a result, aggrieved users may be left with no clear legally responsible counterparty, and instead bear only nuanced, untested arguments regarding implied agreements or theories such as unjust enrichment or conversion.

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Setting aside the merits of the parties’ respective positions in the controversies above, we believe these situations underscore the need for greater clarity regarding the legal status of DAOs and their members, the urgency of developing and enhancing DAO governance best practices, and the importance of a DAO’s counterparties to carefully consider the legal and commercial risks that may be attendant to transactions with this novel form of business organization.

This post comes to us from Wachtell, Lipton, Rosen & Katz. It is based on the firm’s memorandum, “Recent Developments Highlight Fundamental Legal Considerations for DAOs,” dated July 8, 2022.

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