Column: Holders of collective crypto tokens must meet user requirements under California law

(Reuters) – (The opinions expressed here are those of the author, a columnist for Reuters.)

It just got a little easier for blockchain protocol users to label crypto collectives responsible for their losses.

In a first-of-its-kind ruling on Monday, U.S. District Judge Larry Burns of San Diego held that the bZx DAO, a decentralized autonomous organization that runs a blockchain protocol, was effectively a general partnership under California law. Under Burns’ reasoning, anyone who was eligible to vote on the DAO’s governance in 2021, when a data hack reportedly cost users $55 million in losses, is liable for security flaws.

Defendants linked to the bZx DAO – a predecessor to the one sued by the US Commodity Futures Commission last year – had argued, among other things, that a decentralized blockchain protocol is fundamentally different from a general business partnership.

The bZx protocol, which allowed users to engage in cryptocurrency margin trading, was controlled by an amorphous group of token holders who had the right to vote on governance issues. These token holders, according to defense attorneys at Morrison Cohen and Hahn Loeser & Parks, never agreed to share profits and losses like old-fashioned business partners. The defense attorney argued that treating these token holders as a partnership would be a “radical extension and alteration of long-standing principles of partnership law.”

Burns disagreed. The judge said the plaintiffs’ lawyers from Gerstein Harrow had made sufficient allegations that the protocol actually allowed token holders to vote to distribute the DAO’s assets, just as a normal business might approve dividend payments.

The San Diego judge was also swayed by the CFTC’s claim in the Ooki DAO case that the two men who created the bZx protocol transferred control to the amorphous, decentralized DAO specifically to evade US regulators. (That strategy clearly backfired.)

Burns cited California state case law that holds that business organizations cannot structure partnerships that seek to benefit from “commercial intercourse” while attempting to escape corresponding liability. In that regard, he said, it was entirely consistent with California precedent — and not a “radical expansion” of partnership law — to hold that bZx DAO could be held liable as a general partnership.

Defense attorney Jason Gottlieb of Morrison Cohen, which represents the bZx protocol founders and two of their predecessor companies, noted in an email that Burns dismissed claims against three of the four defendants. (One dismissal was on jurisdictional grounds. The founders’ predecessor company was dismissed because the plaintiffs failed to show that they had bZx steering marks.)

“We look forward to addressing the merits of plaintiffs’ allegations in due course, after which we are confident that all of the remaining defendants will also be dismissed,” Gottlieb said.

Gerstein Harrow, the plaintiffs’ firm that filed the potential bZx class action, did not respond to my inquiry. I also did not hear back from attorneys for two limited liability companies, Hashed International LLC and AGE Crypto GP LLC, who were named as defendants because they allegedly owned bZx corporate governance tokens. Burns ruled that the plaintiffs’ claims can proceed against those companies.

Burns’ ruling comes three months after US District Judge William Orrick of San Francisco ruled last December in the CFTC’s Ooki DAO case that the collective met California’s definition of an unincorporated association.

However, Orrick’s decision was in the context of a dispute over whether regulators had properly served The DAO with notice of their lawsuit accusing Ooki of illegally operating as an unregistered derivatives exchange. (After Orrick opined that the DAO had been properly served, the CFTC obtained a default judgment against the collective, which still has not appeared in the case.)

Burns is the first judge to rule on whether to dismiss claims against alleged DAO members who argued they cannot be held liable because of the structure of the collective. His ruling can only be interpreted as bad news for any DAO defendants who hoped that decentralized control was a way to avoid liability.

That said, Burns’ ruling leaves many questions unanswered. The judge’s decision suggests that every holder of a bZx governance token at the time of the 2021 hack could be held liable for its users’ losses. But the class action only named a handful of token holders. If bZx users eventually receive a conviction, it is not clear whether or how they can identify and pursue other DAO members.

It is also not clear whether any of the name plaintiffs were holders of governance tokens themselves. When I first wrote about this case last July, I told you about defense arguments that under the general partnership theory, some of the name plaintiffs might be on the hook themselves, and therefore would be prejudiced by asserting class claims.

Burns agreed that the general partnership theory would make anyone who owned bZx governance tokens — potentially including name plaintiffs — liable for users’ losses in the hack. But he pointed to the claim by potential class-action lawyers that the named plaintiffs did not have “meaningful stakes” in the DAO’s governance. At this early stage in the case, Burns said, there is no evidence of an irreconcilable class conflict — but he said the remaining defendants could refile the case if such evidence emerges.

Although private lawsuits, regulatory actions, and even criminal charges have piled up against cryptocurrency issuers and exchanges, lawsuits against DAOs remain rare. The plaintiffs’ firm that brought the bZx case has filed two other DAO cases on behalf of users or investors. Two DAOs face patent infringement claims. It’s not even clear what the CFTC intends to do next in the Ooki DAO case, since the protocol now bars users based in the US

But thousands of DAOs were formed over the past few years. As of last July, they had billions of dollars in assets. To all of them, this week’s ruling in the bZx case should serve as a warning.

Read more:

Crypto plaintiffs’ firms pin hopes on key rulings in government’s Ooki case

Famous venture capital firm is latest critic in regulator’s case against Ooki crypto collective

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

Reporting by Alison Frankel; editing by Leigh Jones

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The opinions expressed are those of the author. They do not reflect the views of Reuters News, which is committed under its fiduciary principles to integrity, independence and freedom from bias.