First enforcement action against a DAO dismisses belief that the DAO structure is regulation-proof
By John Bassilios and Georgia Francis
The first enforcement action has been brought against a decentralised autonomous organisation. The Commodity Futures Trading Commission filed a complaint against Ooki DAO (previously, bZeroX LLC). In this article, we examine the enforcement action, responses to the CFTC’s approach and the implications for DAOs.
A DAO is structured such that there is no central authority and instead decision-making related to management and governance issues are voted on by tokenholders. We provided an full explanation of DAOs and their structure in an update earlier this year.
bZeroX, LLC and the Ooki DAO
bZeroX, LLC is a limited liability company that creates financial software and financial products including tokenised margin loans and tokenised margin positions. After operating from June 2019 to August 2021, bZeroX, LLC transferred control of its protocol from a limited liability company structure to a DAO structure (the Ooki DAO).
The enforcement action
The CFTC filed:
- a settlement order against bZeroX, LLC and its two founders for US$250,000; and
- an enforcement action in a US district court against Ooki DAO (bZeroX, LLC’s successor)
because it considered that:
- the relevant protocol allowed for any person with an Ethereum wallet to contribute margin to open leveraged positions whose value was determined by the price difference between two digital assets from the time the position was established to the time it was closed;
- Ethereum is one of a few cryptocurrencies that is considered a ‘commodity’ under the Commodity Exchange Act;
- commodities that are not ‘actually delivered’ within 28 days, are considered to be ‘retail commodity transactions,’ and are regulated in the same way as derivatives (as opposed to physical commodity transactions);
- the Ooki DAO by offering, executing, confirming, soliciting and accepting orders for retail commodity transactions on its protocol, where such transactions were not conducted on a registered derivatives exchange, breached the Commodity Exchange Act for failure to register as a Designated contract market (DCM);
- the Ooki DAO, by soliciting and accepting orders for a retail commodity transaction and accepting money or property to margin those transactions on its protocol, was found to have breached the Commodity Exchange Act for failure to register as a futures commissionmerchant (FCM);
- the Ooki DAO, given the activities it was involved in, should have but failed to comply with Bank Secrecy Act requirements concerning the adoption of a Customer Identification Program (KYC/AML procedures).
In bringing this enforcement action against the Ooki DAO, the CFTC must overcome a handful of fundamental issues related to jurisdiction and culpability.
A key threshold issue was whether the CFTC had actual authority over Ooki DAO, given that one of the main features of a DAO is the absence of a central authority. The CFTC considered that it could exercise jurisdiction as the Ooki DAO had sufficient nexus to the United States as it offered trading on its protocol to persons located in the United States.
Another key issue for the CFTC was determining culpability where the decentralised nature of the DAO meant there was no governance framework or persons operating the protocol (which is facilitated by way of smart contract technology). On this issue, the CFTC determined that any tokenholder who voluntarily votes to affect the outcome of governance issues is considered to be a ‘member’ of the DAO for liability purposes. However, the CTFC considered that because governance participation is not mandatory, that passive tokenholders, who do not cast votes, will not be considered ‘members’ for the purposes of apportioning liability.
Interestingly, CFTC Commissioner Summer Mersinger dissented with the enforcement action as she considered CFTC was relying on an ‘inapplicable State law legal theory’ which did not contemplate developments in the financial space such as a DAO, and that this enforcement action demonstrated ‘regulation by enforcement’.
Criticism of the CFTC’s approach
Recently, a group of lawyers and developers that filed an amicus brief in the enforcement action against Ooki DAO argued that should the CTFC be required to take action under the Commodity Exchange Act, it should be against any person it believes violated the Commodity Exchange Act and not the DAO itself. The group contended that while the CFTC can bring this type of enforcement action under the Commodity Exchange Act against a ‘person’ or ‘association’, a DAO is neither and to treat it as such would mean the CTFC was effectively amending statutory definitions.
On 30 November 2022, the CFTC, Ookie DAO and the amicus parties will attend Court to present arguments and have the outcome of the enforcement action determined.
In the event the CFTC succeeds, the key takeaways for DAOs – specifically, for DAOs that offer their protocol in the US or active tokenholders in DAOs that are offered in the US – include the following.
- The CFTC will consider there is a sufficient nexus and assert its jurisdiction, where US retail customers are involved in and/or are offered services on a DAO protocol. This means that DAOs with an appropriate nexus to the United States are subject to the CFTC’s authority.
- Regardless of the governance structure, the CFTC will look to the nature of the digital asset transactions facilitated by the DAO, rather than the form of the DAO itself, to determine whether any commodity or derivatives laws are being violated. Therefore, digital asset market participants (whether conducted via a DAO or more traditional corporate structures) should understand the implications of retail commodity transactions, which are regulated in the same manner as derivatives by the CFTC.
- DAO tokenholders who are active in voting on governance issues, will be considered by the CFTC as a member of the DAO for the purposes of determining liability, so those who do choose to participate in voting on the governance affairs of a DAO must be aware of this risk.
Australia’s position on DAOs
The nature of a DAO does not allow it to fit cleanly within existing company structures under Australian law, meaning that bespoke laws (similar to the rules for corporate collective investment vehicles) would need to be introduced if a DAO was to be structured as a company.
Based on existing Australian laws, there is an argument that a DAO could satisfy the definition of a ‘partnership’, which is defined as the relation which subsists between persons carrying on a business in common with a view of profit and includes an incorporated limited partnership within the meaning of Part 5 of the Partnership Act 1958 (Vic). Where a DAO is treated as a partnership or association, we note that section 115 of the Corporations Act 2001 (Cth) will apply, which places restrictions on the number of members an unincorporated partnership or association may have.
The Australian Law Reform Commission (ALRC) has been tasked with a Review of the Legislative Framework for Corporations and Financial Service. The possible regulatory design choices for DAOs posed by the ALRC include:
- a DAO that operated in a purely decentralised, unwrapped form, which is treated as an unincorporated association or otherwise; or
- a ‘wrapped’ or hybrid arrangement under which a DAO operates through a company or corporate form, tailored to the operation and activities of DAOs.
We have recently written about the regulation of DAOs in Australia in our article ‘ALRC comments on regulation of crypto assets and DAOs’.
What does this mean?
Many hold the view that the decentralised nature of a DAO means that it is outside the reach of regulators and lawmakers. However, the CFTC is attempting to set a precedent that the founders and the voting tokenholders of a DAO can be held to account for the DAO’s actions. It would follow that DAOs in the US would not be considered ‘regulation proof’ as once thought.
While it is uncertain whether the CTFC will succeed, this is an example of where applying existing legal principles to regulate crypto-asset activity becomes problematic.
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