Signage is seen outside of the US Commodity Futures Trading Commission (CFTC) in Washington, D.C., U.S., August 30, 2020. REUTERS/Andrew Kelly
(Reuters) – The U.S. Commodities Futures Trading Commission has devised a theory to prevent the decentralized, amorphous crypto collectives known as DAOs from capitalizing on their diffuse structure to evade liability.
Not everyone on the commission is a fan, to put it mildly.
The CFTC posited on Thursday, in a $250,000 settlement with the architects of a DAO that allegedly operated as an unregistered derivatives exchange, that DAOs are unincorporated, for-profit associations whose members, under longstanding contracts precedent, are personally liable for DAO debts.
Commissioner Summer Mersinger does not agree. In a stinging dissent, Mersinger accused the CFTC of improperly relying on inapplicable precedent from private cases to exercise the government’s sanction power. Mersinger, a Republican who was appointed to the CFTC by President Joe Biden, said the agency should have engaged in formal rulemaking on DAO liability rather than engaging in “blatant ‘regulation by enforcement’” that could, perversely, discourage DAOs’ regulatory compliance.
“The commission’s approach in these actions will have public policy implications that extend far beyond this particular settlement and lawsuit,” Mersinger said. “Yet the commission has made this consequential decision with no public notice or input whatsoever. It is regulation by enforcement, plain and simple.”
The CFTC did not respond to my query about Mersinger’s criticism, which has been echoed by the Blockchain Association, a crypto industry trade group.
The DAO at the center of the controversy is Ooki, which controls a blockchain protocol that allows users to take long or short positions on cryptocurrency valuations. The CFTC argued in its San Francisco federal court complaint that the Ooki DAO violated the Commodity Exchange Act by operating as an unregistered futures commission merchant and by failing to implement anti-money laundering and know-your-customer systems. The government contends that every Ooki token holder who has participated in DAO governance votes is liable for the DAO’s conduct.
The CFTC’s simultaneously filed settlement agreement with the developers of the protocol, Tom Bean and Kyle Kistner, explains the commission’s theory in more detail. According to the government, Bean and Kistner first designed the protocol for bZeroX LLC, their limited liability company. In 2021, bZeroX transferred control of the protocol to a DAO, originally called bZx, then renamed Ooki.
The transfer, according to the CFTC, was specifically intended to insulate the protocol from regulation. Thursday’s filings quoted comments by one of the founders during a call with bZeroX users: “It’s really exciting,” the unidentified founder allegedly said. “We’re going to be really preparing for the new regulatory environment by ensuring bZx is future-proof.” The idea, according to the CFTC filings, was that bZx could fend off regulators by claiming that control of the protocol belonged to the amorphous community of token-holders.
The CFTC’s theory is that all of the Ooki DAO community members who exercised control can be held liable because the DAO meets the legal definition of an unincorporated association, and members of such associations are personally responsible for the groups’ obligations.
In the settlement with Bean and Kistner, the commission cited three cases to back that assertion. In 1994’s Karl Rove & Company v. Thornburgh, the 5th U.S. Circuit Court of Appeals ruled that U.S. Senate candidate Dick Thornburgh was liable, as a member of an unincorporated association, for his campaign’s obligations to Rove’s marketing firm. The New Hampshire Supreme Court ruled in a 1984 case that an individual member of a taxpayer’s association could be held liable for the fees of a lawyer who represented the group. And the Maine Supreme Court held in 1973 that members of a New Year’s Eve dance committee were liable to a slip-and-fall plaintiff.
Under that precedent, the CFTC said, Bean and Kistner are personally responsible for the Ooki DAO’s debts.
I emailed Bean, Kistner and a spokesperson for bZx but did not hear back. Under the settlement, they did not admit or deny the CFTC’s allegations. Defense counsel in the CFTC case, Jason Gottlieb and Daniel Isaacs of Morrison Cohen, declined to comment.
CFTC commissioner Mersinger said in her dissent that the CFTC should not have relied on three private cases to justify a government enforcement action. “I am skeptical of any federal or state governmental agency wielding its power to sanction in this manner, based on a legal theory from state common law contract and tort cases between private parties,” she wrote.
Moreover, Mersinger asserted, by defining DAO membership through token holders’ use of their voting power, the CFTC will discourage DAO members from using that power lest they trigger liability. That’s a policy mistake, Mersinger said, that will hinder good governance and regulatory compliance within DAOs.
Mersinger acknowledged that the Commodity Exchange Act doesn’t give the CFTC specific authority over the Ooki DAO. But rather than advance a novel theory of liability in an enforcement action, she said, the commission could have relied on an aiding-and-abetting claim against Bean and Kistner while engaging in formal rulemaking — including public comment — to develop an equitable policy for DAO liability.
Ooki’s counsel has not yet made an appearance, and the DAO did not respond to my query via its chatbot. But I’m sure we will see Mersinger’s arguments resurface if Ooki files a motion to dismiss the CFTC suit.
You can see why regulators are worried about crypto developers trying to use DAOs to shirk liability. As I reported in July, in a story about a class action by Ooki DAO insiders who lost millions when the bZx protocol was hacked, thousands of DAOs are in operation, holding billions of dollars of assets. (Plaintiffs in the class action contend that the Ooki DAO is a general partnership and thus liable for partners’ losses.)
The CFTC appears to have made a policy determination that litigation is the best way to define DAO exposure, just as the U.S. Securities and Exchange Commission has relied on litigation to challenge crypto tokens as unregistered securities. I expect the Ooki case will show whether that was a good decision.
Read more:
how can insiders sue an amorphous crypto collective? they can't, say bzx defendants
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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.
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