How can insiders sue an amorphous crypto collective? They can’t, say bZx defenders

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Motion to dismiss class action

(Reuters) – The nascent blockchain industry has spawned a new kind of business organization that overtly rejects the traditional corporate pyramid structure, with top leadership laden with fiduciary duties.

These decentralized autonomous organizations, or DAOs, dont have bosses who make decisions for the entire enterprise. DAOs distribute decision-making power widely typically, to anyone who holds a governance token and operates collectively. That alt-model is increasingly popular: According to a client alert issued last month by Wachtell, Lipton, Rosen & Katz, thousands of DAOs are already in operation, collectively holding billions of dollars in assets.

Here’s a puzzle, though, for DAO participants: Who do you sue if things go wrong? In an organization that is, by design, decentralized and autonomous, does anyone bear responsibility when the enterprise is harmed?

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Gerstein Harrow, a new law firm that bills itself as specializing in crypto consumer protection, has come up with a creative theory to address those questions. In May, Gerstein Harrow filed a class action in Los Angeles federal court on behalf of crypto investors who allegedly lost more than $50 million when the decentralized finance platform bZx was hacked in November 2021. The class action named two Delaware companies as defendants: Leveragebox LLC , which created the open-source web interface that allows users to access the bZx platform; and bZeroX LLC, which developed the bZx protocol that allows users to trade and lend crypto tokens on margin.

But by the time of the hack, neither Leveragebox nor bZeroX was in control of bZx. The developer of the protocol, bZeroX, turned it over to token holders in August 2021. bZx, in other words was a DAO when the hack occurred. How do you lay blame for a security breach on an amorphous collective with no one in charge?

That’s where Gerstein Harrow got creative. The class action alleges that the bZx DAO, as well as a successor DAO called Ooki, were a de facto general partnership and the partnership bears responsibility for the losses of some of its members. Indeed, the complaint said, the DAOs have already recognized their obligation to respond to the hack. After debate and discussion within the DAO, tokenholders voted to adopt a compensation plan that granted new tokens to cover some losses and debt tokens to cover others. Complaints in the class action assert that the debt tokens wont really pay out for years and years, leaving them with heavy losses from the hack.

The class action asserts a single count of negligence against all of the defendants: the original bZx DAO and the successor Ooki DAO, the web interface developer, the protocol developer, two entrepreneurs who founded the underlying companies and some ancillary players.

On Monday, most of the defendants (but not the DAOs) moved to dismiss the class action. Defense lawyers at Morrison Cohen and Hahn Loeser & Parks offered some technical arguments, asserting, for instance, that bZeroX, Leveragebox and their founders have no duty to DAO tokenholders and therefore, under economic loss doctrine, cannot be liable for losses from the hack. The motion also said that the terms of use for the website that allows access to the bZx platform expressly disclaims liability for whatever happens on the trading protocol.

But more importantly, when it comes to the development of DAO law, the motion contends that DAOs are not general partnerships. For one thing, according to the motion, theres no indication that all of the people who bought governance tokens considered themselves to be engaged in the joint operation of a profit-directed business, as opposed to users who simply wanted to access an open-source cryptoplatform. There is certainly no allegation, the motion said, that DAO participants agreed to share losses which is an element of partnership, according to defense lawyers.

This radical expansion and alteration of long-standing principles of partnership law should not be countenanced, the brief said.

The biggest problem with plaintiffs DAO partnership theory, the brief said, is that under the amorphous and oft-changing” definition offered in the complaint, the plaintiffs themselves are partners. So if their theory is correct, the brief said, they are just as responsible for the security breach that led to the $55 million hack as every other tokenholder.

Plaintiffs theory is, to put it politely, far-fetched, the dismissal motion said. No court has held that individuals who merely hold digital assets are somehow operating as a general partnership with all other holders of that asset, and no court has held that all users of an open-source software protocol are somehow operating as a general partnership with all other users of that software.

The general partnership theory is particularly ill-suited for a class action, the motion said. The same class members who lost money in the hack are also members of the partnership, under plaintiffs theory, and thus liable for class losses. That simply cant work, the motion said: Class representatives cannot act on behalf of a class when class allegations include their own wrongdoing.

Plaintiffs’ lawyer Jason Harrow of Gerstein Harrow told me defendants’ argument is a red herring because the name plaintiffs did not hold governance tokens so were not part of the DAO. (They just used the platform.) And even in cases in which DAO participants assert claims against general partners, Harrow said, active members of the collective who direct the DAO’s conduct should bear more liability than small players on the sidelines.

I should note that Harrow’s class action complaint includes citations to three recent legal analyzes discussing analogies between DAOs and partnerships, so the theory is perhaps not as far-fetched as defendants suggest.

Its also worth noting that the bZx case involves claims by DAO participants against their own DAOs. Even if its not feasible for insiders to assert liability claims for which they would be jointly responsible, the same might not be true of an outsider with claims against a DAO for some kind of wrongful conduct. DAOs are a relatively new development, so early suits like the bZx case are breaking untrodden ground.

Read more:

Users of ‘especially secure’ crypto network sue over $55 million theft

Buying the Constitution: The rise of DAOs in legal

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Alison Frankel

Thomson Reuters

Alison Frankel has covered high-stakes commercial litigation as a columnist for Reuters since 2011. A Dartmouth college graduate, she has worked as a journalist in New York covering the legal industry and the law for more than three decades. Before joining Reuters, she was a writer and editor at The American Lawyer. Frankel is the author of Double Eagle: The Epic Story of the Worlds Most Valuable Coin.

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