DeFi & Financial Services

On 24 November 2023, the Investment Association published a report on behalf of the wider Technology Working Group to the UK Government’s Asset Management Taskforce (the “Working Group”) on a “Blueprint” for the implementation of a fund tokenisation regime in the UK (the “Tokenisation Report”).

The Financial Conduct Authority (“FCA”) which, along with HM Treasury is an observer to the Technology Working Group, also provided input on the Tokenisation Report and launched a new fund tokenisation page on its website.

The industry focus on fund tokenisation is mainly aimed at authorised funds in the UK, rather than the unauthorised funds that are typically used within the traditional institutional-investor-focussed private equity space, but the information contained herein will nonetheless be of interest to the wider market and it will be interesting to see how things develop for the industry as a whole.

As discussed in Part I of this series, NFT-based lending is pioneering a new avenue of investment and activity on the blockchain that will enable new and innovative use cases. In this Part II, we will discuss the implications for Lenders.

I. Issues for Lenders:

These on-chain loans secured by digital assets present a question for lenders: how do lenders get comfortable extending secured financing to borrowers where the secured asset is digital, like an NFT? In traditional financing, lenders and borrowers negotiate a security agreement, which governs the rights a lender will have in a transaction. Per the Uniform Commercial Code (the “UCC”), which regulates interests in personal property as collateral for debt, a security interest in tangible collateral can be perfected against third parties by possession of the collateral or by filing a financing statement. At the same time, a security interest in many kinds of intangible collateral can be perfected against third parties only by filing a financing statement. Sometimes, best practice calls for possession and filing (when both types of perfection are permitted under the UCC).

Mechanically, when the lender and borrower agree to terms on a peer-to-peer marketplace like Blur (as discussed in Part I of this series), the NFT is placed into a vault – a smart contract with specific storage and security features – with a lien on it; at this point, the principal is transferred to the borrower. As discussed below, the UCC, as currently adopted in most states, does not account for perfection of a security interest in digital assets by any method other than the filing of a financing statement, so a vault & lien combination is insufficient to perfect a security interest in the NFT collateral against third parties; however, the 2022 UCC Amendments provide certain clarity for perfecting a security interest in digital assets against third parties.

In general, the UCC is periodically updated to incorporate emerging technologies and trends. Among other updates, the 2022 UCC Amendments address digital assets and distributed ledger technologies, affording transactors in goods and services updated default rules under the UCC. As such, lenders should be aware of the varying new measures to ensure their loans are adequately secured and perfected against the borrower and any third party, including customers and other creditors of the borrower. Hence, the lender would be first in line to realize on the collateral in a fight with other creditors of the borrower.

Despite the protracted crypto bear market, innovators in non-fungible tokens (“NFTs”) are hard at work. Gone are the days when NFTs were merely profile pictures (“PFPs”) displayed on a pseudonymous social media account or shown for their prestige online or in real life to confused friends and colleagues. As discussed in our two-part series explaining Ordinals and their implications for NFT owners and creators, this year NFTs have expanded beyond the Ethereum blockchain, where NFTs initially grew to prominence as a result of the blockchain’s ability to execute smart contracts, to the original blockchain, Bitcoin.

Beyond Ordinals, gaming-related innovations, new ERC standards, and other innovations, the industry continues to push forward to new frontiers, such as NFT-based lending.

This is Part I of a two-part article on NFT-based lending (Click here for Part II). In this part, we will discuss recent innovations in NFT-based lending, explaining various mechanics and functions. In Part II, we will dive into the legal issues for lenders involving secured transactions under the UCC, Pre- and Post- Article 9 and 12 Amendments.

Last month, the Commodity Futures Trading Commission (CFTC) announced settled charges against three decentralized finance (DeFi) protocols for various registration and related violations under the Commodity Exchange Act (CEA) during the relevant period of investigation.  As a result, each entity paid a civil monetary penalty and agreed to cease violations of the CEA.  According to a statement by Commissioner Kristin N. Johnson, these latest settlements are the first time the CFTC charged a DeFi operator (e.g., Opyn, Inc. and Deridex, Inc.) with failing to register as a swap execution facility (SEF) or designated contract market (DCM). Moreover, these latest enforcements against DeFi entities arrive soon after the CFTC’s successful enforcement and default judgment against Ooki DAO, which the CFTC alleged was operating a decentralized blockchain-based software protocol that functioned in a manner similar to a trading platform and was violating the CEA (prior coverage of the Ooki DAO enforcement can be found here).

Unlike traditional corporate entities with a typical hierarchical structure, a decentralized autonomous organization (“DAO”) – a management structure that uses blockchain technology – functions as a leaderless entity. Without a formal corporate structure, DAOs instead operate by distributing governance rights among persons who hold a specific governance token. Consequently, federal and state courts have been grappling with how to consider a DAO under existing laws that were traditionally interpreted against long-standing corporate entities.

As discussed in a prior post, DAOs allow individuals to organize and coordinate at arms-length, and rely on code (a “protocol”) to govern and execute functions traditionally determined by governing documents, like operating agreements and articles of formation, and undertaken by executives. A DAO’s protocol is committed to a public ledger on a blockchain, which guarantees accessibility and transparency. Each member is granted governance rights – the ability to propose and approve initiatives, called proposals – through a governance token. In light of their unique makeup, DAOs lack centralized leadership and a typical top-down management structure.

Accordingly, parties have debated whether a DAO should be recognized as a general partnership under state corporation laws (i.e., N.Y. P’ship Law §10: “an association of two or more persons to carry on as co-owners a business for profit….”) or, in the case of the Commodity Futures Trading Commission’s (“CFTC”) Ooki DAO enforcement, whether a DAO could be deemed an “unincorporated association” under the Commodity Exchange Act (“CEA”). Following the filing of the CFTC’s enforcement action, it is not surprising that the structure of the Ooki DAO, and the CFTC’s enforcement action against the DAO itself, has garnered a lot of media attention and industry reaction, and has raised novel legal issues.

Several questions have arisen in recent years regarding the potential liability of DAO members:

  • While DAOs are emerging as a viable structure in the DeFi space, does their non-traditional makeup necessarily shield them from real world liability?
  • Does a DAO’s structure render its activities “enforcement proof” or, at the very least, difficult to effect traditional service of process upon?
  • Can a DAO be an “unincorporated association” under federal or state law?
  • Who should be liable for the decisions made by a DAO?
  • Because token holders participate in the DAO’s governance, can they be deemed personally liable for its actions (akin to the general partners in a general partnership), even if each governance token holder is essentially unknown to the other DAO members, who likely reside in multiple jurisdictions?

As discussed in Part I of this series, state DAO LLC laws have been enacted in the last several years and have become one option for decentralized autonomous organizations (or DAOs) to create a so-called “legal wrapper” or real-world corporate entity to shield individual members from liability.

In Part II we will look at some of the standout features of the United States’ DAO laws.[1]

DAOs as LLCs, or LLDs. As discussed below, the Wyoming (SF0038, codified at W.S. §17‑31‑101 through §17‑31‑116; Wyoming Governor Mark Gordon signed an amendment to the DAO Supplement into law (SF0068) (the DAO Supplement and its 2022 amendments) (collectively, the “WY Law”)  and Tennessee (HB2645/SB2854, to be codified at Tenn. Code Ann. §48-250-101 through 48-250-115) (the “TN Law”), DAO LLC laws opt for the “wrapper” approach by “wrapping” DAOs within an LLC. Utah, however, goes further. Under the “Utah Decentralized Autonomous Organizations Act” (HB 357) (codified at Utah Code Ann. §48-5-101 – 406) (the “Utah Law”), rather than being wrapped by an LLC, limited liability decentralized autonomous organizations (or “LLDs”) are the legal entity formed under the Utah Law. (Utah Code Ann. §48-5-104). Under the Utah Law, LLD members enjoy limited liability and are only liable for the on-chain contributions that the member has committed to the DAO. (Utah Code Ann. §48-5-202). Further, members cannot be held personally liable for any excess liability after the DAO assets have been exhausted. (Utah Code Ann. §48-5-202(1)(b)). Utah further covers situations when a DAO refuses to comply with an enforceable judgment or order against the DAO by stating that members who voted against using the DAO’s treasury to satisfy a judgment may be liable for any monetary payments in the judgment or order “in proportion to the member’s share of governance rights in the [DAO].” (Utah Code Ann. §48-5-202(d)(2)).  The Utah Law, in another effort to foreclose certain theories of liability, also explicitly states that a developer, member, participant or legal representative of a DAO may not be imputed to have fiduciary duties toward each other or third parties solely on account on their role, absent certain express actions or statements. (Utah Code Ann. §48-5-307).  These questions have been more salient for DAO members, given the ongoing CFTC enforcement against the Ooki DAO and the recent California district court ruling that various governance token holders in a DAO could be deemed to be members of a “general partnership” under California law and thus potentially joint and severally liable in the suit.

Little-known legal trivia: In 1977 Wyoming was the first state to pioneer the LLC, which is now a commonly applied legal innovation.  Fast forward more than forty years…in July 2021, Wyoming again tried to be at the vanguard of new corporate formations and passed legislation that recognized decentralized autonomous organizations, or DAOs, as legally distinct business entities, with protections for token holders similar to those offered to corporation stockholders or limited liability company members. Wyoming may have jumped off the blocks first, but Tennessee and Utah are not far behind. Recently, on March 1, 2023, the Utah Legislature passed HB 357 (codified at Utah Code Ann. §48-5-101-406), the “Utah Decentralized Autonomous Organizations Act” (the “Utah Law”).

This article is Part I of a two-part article on developments in state DAO LLC laws. In this part, we will briefly outline the basics of a DAO and the latest state enactments in the area, as well as explain why real-world corporate formations may be attractive for some DAO members. In Part II, we will do a deep dive into the more notable aspects of the new crop of state DAO LLC laws and offer some final thoughts.

In what appears to be an issue of first impression, a California district court ruled that various defendants allegedly holding governance tokens to the bZx DAO (or “Decentralized Autonomous Organization”), a protocol for tokenized margin trading and lending, could be deemed to be members of a “general partnership” under California law under the facts outlined in Plaintiffs’ complaint, and thus potentially joint and severally liable for negligence related to a phishing attack that resulted in the loss of users’ cryptocurrency. (Sarcuni v. bZx DAO, No. 22-618 (S.D. Cal. Mar. 27, 2023)). The ruling is significant given that this is purportedly the first court to substantively consider the legal status of a DAO under state law (albeit in a ruling on a motion to dismiss); interestingly, in a prior settlement the defendant bZeroX, LLC and its founders reached with the Commodity Futures Trading Commission (CFTC) in 2022 over claims that bZeroX and its founders unlawfully offered leveraged and margined retail commodity transactions in digital assets, the order expressly considered the bZx DAO (and its successor Ooki DAO, which is co-defendant in the instant action) as an “unincorporated association” under federal law. (In re bZeroX, LLC, CFTC No. 22-31 (Sept. 22, 2022)).

A DAO is a decentralized autonomous organization where token holders can vote on governance decisions of the DAO. DAOs don’t typically operate within a formal corporate structure, opting instead to distribute governance rights among persons who hold a specific governance token. The entire raison d’être of a DAO is to take advantage of web3 technologies and operate without a traditional corporate formation to make decisions without a central authority or usual top-down management structure. While DAOs are emerging as a viable structure in DeFi space, this ruling shows that their non-traditional makeup may not necessarily be a shield from real world liability.  Plaintiffs’ theory that the DAO members are part of a general partnership means that anyone holding governance tokens at the relevant time would be jointly and severally liable for the torts of the DAO.  To be sure, even though existing structures do not fit the novel web3 organizational primitive that is a DAO, nothing prevented the bZx DAO (or its successor Ooki DAO), from creating a so-called “legal wrapper” or real-world corporate entity to shield individual members from liability and limit potential creditors to monetary recovery from the DAO’s treasury only.