Crypto collective token holders must face users' claims under California law

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

It just got a little bit easier for blockchain protocol users to tag crypto collectives with responsibility for their losses.

In a first-of-its-kind decision on Monday, U.S. District Judge Larry Burns of San Diego held that bZx DAO, a decentralized autonomous organization operating a blockchain protocol, was, in effect, a general partnership under California law. Under Burns’ reasoning, anyone who was eligible to vote on the DAO’s governance in 2021, when a computer hack allegedly cost users $55 million in losses, faces liability for security failures.

Defendants associated with the bZx DAO — a predecessor to the that was sued by the U.S. Commodity Futures Commission last year — had argued, among other points, 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 were entitled to vote on governance issues. Those token holders, according to defense lawyers at Morrison Cohen and Hahn Loeser & Parks, never agreed to share profits and losses like old-fashioned business partners. Defense counsel argued that to treat these token holders as a partnership would be a “radical expansion and alteration of long-standing principles of partnership law.”

Burns disagreed. The judge said plaintiffs lawyers from Gerstein Harrow had offered adequate allegations that the protocol, in fact, did allow token holders to vote to distribute the DAO’s assets, just as an ordinary business can authorize dividend payments.

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

Burns cited California state case law holding that business organizations cannot structure partnerships that attempt to take advantage of “commercial intercourse” while trying 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 the bZx DAO can be held liable as a general partnership.

Defense lawyer Jason Gottlieb of Morrison Cohen, who represents the bZx protocol’s founders and two of their predecessor companies, noted in an email statement that Burns dismissed claims against three of the four defendants. (One dismissal was on jurisdictional grounds. The founders' predecessor companies were dismissed because plaintiffs failed to show they held bZx governance tokens.)

“We look forward to addressing the merits of plaintiff's allegations in due course, after which we’re confident that all of the remaining defendants will be dismissed as well,” Gottlieb said.

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

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

Orrick’s decision, however, 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 held that the DAO had been properly served, the CFTC obtained a default judgment against the collective, which has still not entered an appearance in the case.)

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

That said, Burns’ ruling leaves a lot of 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 users’ losses. But the class action only named a handful of token holders. If bZx users eventually obtain a judgment, it’s not clear whether or how they could identify and pursue other DAO members.

It’s also not clear whether any of the name plaintiffs were themselves governance token holders. 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 themselves be on the hook and would therefore be conflicted out of asserting classwide claims.

Burns agreed that the general partnership theory would leave anyone who owned bZx governance tokens – potentially including name plaintiffs — liable for users’ losses in the hack. But he pointed to the assertion by prospective class counsel that the named plaintiffs did not hold “meaningful stakes” in the DAO’s governance. At this early stage in the case, Burns said, there’s no proof of an irreconcilable conflict within the class – but he said the remaining defendants can revisit the issue if such evidence emerges.

Even as private litigation, regulatory actions and even criminal accusations 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 are facing patent infringement claims. It’s not even clear what the CFTC intends to do next in its Ooki DAO case, since the protocol now bars users based in the U.S.

But thousands of DAOs were formed in the last several years. As of last July, they held billions of dollars in assets. For 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 ruling in government’s Ooki case

Famed 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, say bZx defendants

Reporting By Alison Frankel; editing by Leigh Jones

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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 World’s Most Valuable Coin.