Thoughts re: Lido DAO

Yesterday’s order re motions to dismiss the Lido DAO class action suit has been making headlines. If you have not heard, or read about, the latest development in the Lido DAO case (N.D. Cal), the Order is here.

tl;dr

Order denying VC Investors’ (a16z, Dragonfly and Paradigm) motion to dismiss complaint brought by a class of LDO holders against Lido DAO as a general partnership and the three VCs above and Robot Ventures. Of note, the court held:

• the unwrapped DAO is capable of being sued as a general partnership.
• the general partnership claim was sufficiently pled, even though there are no allegations or facts to suggest there was any sharing of DAO profits and losses among token holders. “[U]nder California law, profit sharing is “evidence of a partnership, rather than a required element of the definition of a partnership.”
• Even though the lead plaintiff did not purchase LDO from the DAO, the allegations claiming the DAO was a statutory seller pursuant to Section 12 of the ‘33 Act were sufficiently pled, despite the fact the court acknowledged the DAO passed no title to LDO, and there was no allegation the DAO directly solicited plaintiff’s purchase. Rather, the solicitation was based on the allegation that the DAO “was comprehensively involved in the creation and issuance of LDO.”
• Even though the VC Investors did not violate any securities laws, the claim seeking to hold them jointly and severally responsible for the DAO’s alleged violations of securities laws was sufficiently pled.

Observations and actionable tactics

General misunderstanding surrounding DAO “wrapping” and offshore foundations.

Based on inbound questions about the implications of this order, and from what I’m seeing on CT/ X, there is some confusion re: how wrapping works in the decentralized network context. Perhaps the two most fundamental areas of confusion are:

• You do not wrap a protocol. There seems to be a lot of hand wringing over how one incorporates or organizes a set of code. You don’t. Wrapping focuses on human-organized and executed activities. Where humans come together in an organized way to take concerted action on behalf of the project ecosystem, then you have a wrap opportunity. A few examples include:
  • Software/IP development
  • Token issuance
  • Treasury management
  • Grant management (if independent from treasury)
  • Protocol governance
  • Promotional/ecosystem ambassador activity
  • Secondary market liquidity management (market-making, exchange relations, etc)
  • UI management
• You do not use an ownerless foundation to wrap governance. Perhaps the most significant impact of the Lido order may be the growing industry realization that the most commonly used TGE meta structure (BVI tokenco wholly owned by a Cayman ownerless foundation company) presents general partnership risk where governance token holders reside in California, or any other jurisdiction applying the same partnership standard. As I mentioned in an earlier article, Ownerless foundations do not extend limited liability protections to token holders. Historically, use of ownerless foundations have been an exercise in risk balancing- where governance does not have any ability to effect outcomes resulting in the sharing of profits or losses among token holders, then unwrapped governance was potentially viewed as at lowered risk of being deemed a general partnership. The Lido order makes clear, however, that profit/loss sharing is not a requirement in certain jurisdictions. What remains unclear is (assuming profit sharing restrictions are in place) what additional mitigants would be required to sufficiently reduce partnership risk.The suitability of an entity for wrapping purposes depends on the wrapping opportunity. For example, you would most commonly use a Delaware C corporation to wrap devco operations, but you would not use that entity to issue a token. For protocol governance, the wrapper must be: (i) a member-based organization: (ii) that is non-profit in nature; (iii) that statutorily affords limited liability to its members; and (iv) provides sufficient legal flexibility to accommodate the permissionless nature of member admissions and departures.The two entities best suited to wrapping governance, in my personal opinion, are the Swiss association, for projects seeking to exclude US residents, and the WY DUNA for projects with US holders.

Mandatory wrapping of governance.

Based on the partnership theory set forth in the Lido order, DAOs will represent juicy targets for plaintiffs’ class action firms. Why? Because there are plenty of failed, or failing, projects and, if VCs can be held to account to individual holders, then there will almost always be deep pockets to incent these lawsuits.

Given this, I would advise investors to consider requiring wrapped governance. Perhaps not in every case, but the mandate needs to be on the table, and seriously considered where warranted. Until we get crypto market structure legislative relief in the US, I would advise project/issuer clients to expect this requirement in financing negotiations.

Advanced structuring to mitigate statutory seller exposure

One issue I have not seen discussed much is the statutory seller issue. It potentially creates DAO exposure for token sales in which the DAO has no involvement. The standard was applied with very broad gloss that would capture virtually all projects that do not pay particular attention to asset and liability management.

An example of a meta structure that would potentially foreclose the statutory seller issue would be to isolate governance in an association or DUNA while issuance, development, market making, marketing occur in other entities. Avoid shared treasury assets and functions. In practice this looks like a Swiss governance association agreeing to fund a certain activity and voting to move treasury assets to another ecosystem participant for execution; as opposed to the governance body simply issuing binding instructions to a foundation board or other entity.

Alter ego and the maintenance of organizational formalities.

As complexity in meta structuring grows, alter ego becomes a greater risk. The topic probably deserves its own post, but suffice it to say that where governance intersects with other ecosystem actors, all wrapped entities should be operating in accordance with the required organizational formalities of each. This includes ensuring the meta structure does not create or perpetuate unreasonable economic inter-dependency/thinly capitalized actors within the ecosystem.