Can DAOs Be Sued? Insights From Lido’s Recent Case

According to a recent decision from the US District Court for the Northern District of California, decentralized autonomous organizations, or DAOs, may not provide the liability protection the industry once thought. In a seminal case, a Federal Court in California ruled that, despite the governing body being a DAO, several prominent investment firms may in fact be managing Lido’s operations and may be liable for its wrongdoings – i.e., Lido DAO may not be decentralized or autonomous.

The following opinion editorial was written by Alex Forehand and Michael Handelsman for Kelman.Law.

Court Ruling Challenges DAO Liability Shield

Lido failed to dismiss the allegations at the earliest stage, raising questions as to the liability of DAO participants and putting DAO governors in the crosshairs. This is unsurprising, however, as the Court takes all the facts pleaded by the plaintiff as true in a motion to dismiss. Under that assumption, the Court was forced to reject Lido’s argument that it is a non-legal entity. The Court found the Plaintiff met its minimal pleading burden to survive the motion to dismiss, and that the governing body behind the staking protocol may be considered a general partnership under California state law despite the DAO’s supposed decentralized nature.

In its decision on the Lido defendant’s motion, the Court addressed three novel questions surrounding liability in the digital age: first, whether Lido DAO is capable of being sued; second, whether Lido DAO could be considered a general partnership; and third, whether four large institutional investors—Andreessen Horowitz, Paradigm Operations, Dragonfly Digital Management, and Robot Ventures—may be considered general partners and held liable under California law for the activities of Lido.

Can Lido DAO Be Sued?

As to whether Lido DAO is capable of being sued, the Court had no problem that the Plaintiff met its burden. Pointing to the decision-making process determined by tokenholder votes, the Court found that “Lido’s alleged actions are not those of an autonomous software program, they are the actions of an entity run by people.” While this argument may win in the end, it was not sufficient to grant the DAO’s motion to dismiss.

Is Lido DAO a General Partnership?

This determination led to the second question of whether Lido DAO can be treated as a general partnership for purposes of liability in the case. Under the lenient motion to dismiss standard, the Court held that “[t]he complaint alleges that Lido DAO’s founders formed it to run an Ethereum staking service that keeps a percentage of the staking rewards and that they plan to ultimately distribute this revenue to themselves and other tokenholders—in other words, to carry on, as coowners, a business for profit.”

Denying the argument that the DAO lacked all the traditional requirements of a general partnership, the Court leaned on Lido’s structure of allowing governance based on tradable tokens to determine there was a “reasonable inference that the Lido founders (and possibly other early investors) agreed to displace California’s default partnership rules governing partners’ entrance into and exit from the partnership.”

The Court refrained from defining what exactly is required to be considered a general partner, and acknowledged that as the case proceeds, “it may become clear that the Lido DAO general partnership is narrower (for instance, including only the founders) or broader (for instance, including everyone who has voted on a governance proposal or who holds any LDO).”

Again, while the Defendants’ argument was not persuasive enough to grant the DAO’s motion to dismiss, this argument is sure to come up at summary judgment, or at the trial itself.

Are Certain Large Institutional Investors Partners?

Despite avoiding a full delineation of the bounds of the partnership, the Court was nonetheless forced to answer the third and final unprecedented question of whether certain large institutional investors in the DAO—namely, Paradigm Operations, Andreessen Horowitz, Dragonfly Digital Management, and Robot Ventures—might qualify as partners subject to liability.

According to the decision, of the one billion LDO tokens generated, 36% went into Lido’s treasury and the remaining 64% was given to the founders and early investors. In the years following Lido’s launch, Paradigm bought 10% of the supply (100 million LDO), Andreessen Horowitz purchased $70 million, and Dragonfly increased its position after an initial $25 million purchase. The decision also notes “30 million LDO were sold, in another transaction, to purchasers including Robot Ventures (an investment vehicle for its two cofounders), although the specifics of that transaction are uncertain.”

The court found that all but Robot may be held liable as general partners. When it came to participation, the Court focused on Paradigm, Andreessen Horowitz, and Dragonfly’s role in governance, and their plans to leverage their network to help develop the Lido protocol. As to Robot, however, the Court noted there was “[in]sufficient allegations to infer that Robot meaningfully participated in Lido DAO governance,” though the decision did acknowledge Robot’s developmental contributions and position as a “key ‘strategic partner.’” Thus, the Court’s concern appears to be with control rather than contribution.

However, the Court went on to reject Robot and Dragonfly’s argument that their lack of “ultimate control” prevented them from being partners. Instead, the Court cited California case law that only requires each party have the “right of joint participation in the management and control of the business” (emphasis added).

The eventual outcome of this case may have significant implications for those participating in DAOs. Not only may they be responsible for the actions of the protocol and find themselves subject to suit merely for voting on a proposal, but those a court ultimately deems general partners are jointly and severally liable for the entire judgment against the partnership. As the General Counsel and Head of Decentralization for Andreessen Horowitz crypto explained: the ruling “dealt a huge blow to decentralized governance.”

Conclusion

While a final ruling is needed before we have a better picture of what factors make one a general partner in a California DAO, this decision does not suggest a bright future for DAO participants. Eroding the advantages of what was once thought to be a promising new business organization, Judge Vince Chhabria chided how the case “present[ed] several new and important questions about the ability of people in the crypto world to inoculate themselves from liability by creating novel legal arrangements to profit from exotic financial instruments.” In a cutting-edge industry, imposing personal liability on DAO participants could have a chilling effect on the new business organization, stifling its ability to continue pushing boundaries.

Whether you are an investor, entrepreneur, or business involved in cryptocurrency, our team is here to provide the legal counsel needed to maneuver this complex landscape. If you believe we can be of assistance, schedule a consultation here.

This article originally appeared at Kelman.law.

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