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Crypto companies can’t avoid legal liability by forming a DAO

US federal regulators just shot down one of crypto investors’ main strategies to avoid legal scrutiny.

On Sept. 22, the CFTC sued the blockchain company bZeroX, its founders, and Ooki DAO, a crypto collective associated with the company, accusing them of illegally selling commodities and futures. bZeroX’s software allows crypto traders to buy and sell cryptocurrencies on margin—meaning, using borrowed money.

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It’s the agency’s first case against a decentralized autonomous organization. DAOs first emerged in 2016, but became more popular during the most recent crypto boom. Under the setup, no one member is responsible for decisions on how to run the organization, which are instead made collectively via vote.

But in its lawsuit, the CFTC treated Ooki DAO no different than bZeroX, which was originally incorporated as a limited liability company. In August 2021, its founders transferred control to a DAO, at first called bZx DAO and later changing its name to Ooki DAO. The government alleges this was a scheme to avoid legal liability.

“Margined, leveraged, or financed digital asset trading offered to retail U.S. customers must occur on properly registered and regulated exchanges in accordance with all applicable laws and regulations,” said CFTC acting director of enforcement Gretchen Lowe in a press release. “These requirements apply equally to entities with more traditional business structures as well as to DAOs.”

The CFTC action is yet another sign from the US government that it won’t allow lawbreakers to hide behind claims of decentralization—or their DAOs—to protect themselves.

You can’t hide behind a DAO

The founders of bZeroX thought that by creating a DAO they were protecting themselves and the company from legal liability. According to the lawsuit, one of the founders said the following on a call with users:

“It’s really exciting. We’re going to be really preparing for the new regulatory environment by ensuring bZx is future-proof. So many people across the industry right now are getting legal notices and lawmakers are trying to decide whether they want DeFi companies to register as virtual asset service providers or not – and really what we’re going to do is take all the steps possible to make sure that when regulators ask us to comply, that we have nothing we can really do because we’ve given it all to the community.”

But they were wrong. “DAOs are not immune from enforcement and may not violate the law with impunity,” the CFTC wrote in its complaint. bZeroX and its founders could not be immediately reached for comment.

Rahsan Boykin, general counsel at the DeFi trading platform Hashflow, said in an interview that the CFTC was right to send this message to the crypto industry. “Everyone knows you can’t trade derivatives in the United States without a license,” Boykin said. “To say that you can do it just because you moved to a DAO is uninformed and dangerous.”

DAOs, which confer membership and voting rights with crypto tokens, see themselves as an emerging business structure in the crypto world, though it’s not a legal method for incorporation. (In Wyoming and Tennessee, however, you can now form a DAO LLC to incorporate and limit individual liability.)

The CFTC’s lawsuit notably implicates all voting token-holders in the Ooki DAO, a warning for anyone involved in or seeking to join a DAO that may be involved in illegal activity. According to data from Dune Analytics, about 1,200 crypto wallets hold Ooki DAO tokens, though one person could have multiple wallets.

One former CFTC lawyer, speaking on condition of anonymity, said that what matters to federal regulators is the illegal activity, not the structure of the organization committing it. “From the CFTC’s perspective, it doesn’t matter if it’s two guys on a corner, two guys under a crypto name, or a thousand people holding tokens in a decentralized organization,” the lawyer said. What’s less clear, the lawyer added, is if any individual token-holders will face charges in this civil matter since none are specifically named.

Allegations of ‘regulation by enforcement’

Not everyone is a fan of the CFTC’s action. Summer Mersinger, a Republican who serves as one of the CFTC’s five commissioners, dissented from the enforcement decision because of the implications for individual DAO token holders. Mersinger called it “arbitrary” and an example of “regulation by enforcement,” untethered to case law. She said it “undermines the public interest by disincentivizing good governance in this new crypto environment.”

Budd White, co-founder of the crypto compliance company Tacen, said the CFTC’s enforcement decision makes sense but “shows a lack of nuance” in the Commission’s understanding of DAOs. “Just look at any of the protections offered to LLCs and other corporations under U.S. regulations today—it’s exceedingly rare to see CEOs or other individual employees of these organizations being held liable for broader misconduct,” White wrote in an email to Quartz. “Shouldn’t DAOs and their members be afforded some of the same protections?”

White said the unique nature of DAOs should be considered as we’re at a “crossroads for setting the regulatory stage for years to come.”

Crypto’s two main regulators

There is a low-grade turf war over crypto developing between the CFTC and the US Securities and Exchange Commission (SEC). While crypto advocates mostly prefer the CFTC as its chief regulator, believing it will be less disruptive and demanding, both agencies seem eager to regulate crypto. What’s likely is that some crypto products will be deemed securities and some will be deemed commodities and many crypto companies will have to comply with one or both of these regulators’ demands.

SEC chairman Gary Gensler recently said that he believes that almost all cryptocurrencies are unregistered securities, though he did concede that bitcoin is likely a commodity. He also indicated that ethereum might now pass the Howey test, a Supreme Court standard for determining what is a security, given its recent changes to how it validates transactions.

Todd Phillips, the director of financial regulation and corporate governance at the Center for American Progress, a left-leaning think tank, said the CFTC decision shows that DeFi is not immune from regulators applying and enforcing the existing financial laws. “If you are facilitating derivatives transactions, whether or not you’re a centralized exchange or a decentralized exchange, you’re still expected to register,” he said. “I imagine the SEC expects the same kind of thing for securities exchanges.”