Lido DAO ruling, significant or not?

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A ruling last week in the class action lawsuit against decentralized finance (DeFi) organization Lido DAO has put stakeholders of DeFi in line to be liable for the misdeeds of the organizations in which they invest, causing much consternation among the digital currency community. However, such reactions may be premature, as it remains to be seen whether any of the named investors in the suit will end up being held liable once the case is heard.

On November 18, Judge Vince Chhabria of the United States District Court for the Northern District of California ruled that institutional investors of a decentralized autonomous organization (DAO), Lido DAO, can potentially be held liable for actions of the decentralized governing body behind the liquid staking protocol on the Ethereum blockchain.

Broadly, a DAO is a group run by rules and smart contracts encoded in blockchain software, with decisions being made collectively by members without, in theory, the need for or presence of a central authority. Such a structure can make it difficult to hold individuals behind the organization to account, which is why the Lido DAO lawsuit sought to draw certain key stakeholders into the firing line.

Judge Chhabria’s ruling produced a swift and worried reaction from investors in DeFi—and crypto bros that enjoy the protection from accountability offered by DAOs—seeing that they may become liable for the actions of decentralized projects with which they are involved.

Miles Jennings, General Counsel and Head of Decentralization at Andreessen Horowitz (a16z) (NASDAQ: ZAHIDX), one of the venture capital (VC) firms named in the suit and now potentially liable for Lido DAO’s actions, epitomized this response:

“Today, a California judge dealt a huge blow to decentralized governance. Under the ruling, any DAO participation (even posting in a forum) could be sufficient to hold DAO members liable for the actions of other members under general partnership laws.”

However, such hyperbolic reactions may not be commensurate with the actual ruling.

The issue at hand

The class action lawsuit in question began when Andrew Samuels, an investor who purchased 132 Lido (LDO) tokens in May 2023 and then sold them at a loss a few weeks later, sued Lido in December of last year for violating U.S. securities regulations.

He alleged that the DAO had failed to register with the Securities and Exchange Commission (SEC) despite issuing securities tokens—a fact that, according to Chhabria’s ruling, is yet to be disputed. 

The controversy arose because Samuels also sued several VC firms, specifically a16z, Dragonfly (NASDAQ: DFLI), Robot Ventures, and Paradigm, alleging that, as members of the Lido DAO general partnership, they were liable for its misconduct.

The investment firms responded by attempting to have the suit dismissed, claiming that their investment did not constitute a partnership under California law and they, therefore, “cannot be held liable… for the alleged conduct of a partnership.”

In his November 18 ruling on the motion to dismiss, Chhabria outlined the key questions under consideration:

“The first question is whether Lido DAO is capable of being sued. The complaint alleges that it was founded by three investors whose whereabouts are either remote or unknown, and who apparently cannot be hauled into court in the United States.” 

On this question, Chhabria ruled that Samuels had “adequately alleged”—note not “adequately proven”—that Lido is a general partnership within the meaning of California law and can therefore be sued.

Specifically, he noted that under California law, “the association of two or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership.”

He also added that DAOs were “a type of organization that seems designed, at least in part, to avoid legal liability for its activities.”

However, the problem remained: If the whereabouts of the founders are remote and unknown, who can be held accountable? Hence, the desire to include in the suit the largest investors in the DAO, which led to the second question Chhabria considered:

“The second question is whether four large institutional investors in Lido—Paradigm Operations, Andreessen Horowitz, Dragonfly Digital Management, and Robot Ventures—are members of the general partnership. If they are, they can be held liable under California law for the activities of the partnership—including for Lido’s failure to register its crypto tokens as securities.” 

On this second question too, Chhabria ruled that Samuels had “adequately alleged” that all the investors, with the exception of Robot Ventures—due to the evidence of its involvement being “much sparser”—could be considered general partners and therefore liable for Lido’s conduct.

Chhabria reasoned that “although the complaint doesn’t contain every detail about the DAO’s operations and interactions with these investment firms, it appears that each of them, with the possible exception of Robot, took an active role in its management or intended to do so.”

Storm in a teacup?

Despite the furor this decision created, Chhabria was keen to point out in his ruling that at this early stage of the case, Samuels only needed to adequately allege, not prove, that a general partnership existed and that he had done so.

In other words, Samuels successfully convinced the Judge that there was a case to be made. This is a long way from convincing him or a jury that misconduct was committed and that the VC firms are liable for that misconduct.

Thus, Judge Chhabria’s decision merely means that the case will proceed. It does not, as some have suggested, set a precedent, dangerous or otherwise—meaning it’s not a ruling that will automatically get applied in the future to similar cases, whose plaintiffs will still have to adequately allege a partnership in order to proceed with a claim/charge.

So, to be clear, Chhabria has not found any of Lido DAO’s VC stakeholders and investors liable. He simply ruled he would not dismiss the lawsuit, and it can, therefore, proceed. 

Those VC firms mentioned could eventually be held liable, depending on the result of the trial, but only if their investment in Lido DAO is found, after all evidence is presented and arguments heard, to have constituted a partnership and if Lido DAO is found to have illegally sold securities tokens—two substantial ‘ifs’ yet to be decided.

Chhabria even acknowledged in his order that during the next phase of the case, when both sides present information to the court, it could become clear that the investment firms are not in a partnership with Lido.

But before crypto-bros return to a state of blissful complacency, just because Monday’s ruling isn’t currently significant doesn’t mean the case couldn’t end up being so.

Hypothetical implications of the case

Participants in DAOs would likely like to believe that they can’t be held liable for how their projects are used, whether because of the organizational structure that distributes the operation and management across a network or because they literally can’t be located if something goes wrong.

Some observers, however, say DAOs are not a unique new form of a legal entity, that they aren’t all that decentralized, and that they have founders or backers who can be held liable. By allowing the case against Lido DAO and its investors to go ahead, Chhabria seemed to sympathize with this stance.

This case “presents several new and important questions about the ability of people in the crypto world to inoculate themselves from liability,” he said.

Therefore, while it’s true that Chhabria’s ruling does not prove significant in isolation, it’s also true that when the case eventually comes to trial, a win on all counts for Samuels would prove significant in the context of the DeFi and digital asset space. 

Investors in DeFi projects and DAOs could potentially be liable for the actions of those organizations and may increasingly be held accountable, mainly if the founders of such entities are anonymous and/or hard to pin down.

This would have a substantial knock-on effect on the market, making investing in DAOs and certain DeFi projects a much riskier proposition, particularly for large institutional investors and VC.

Some may see this as a bad thing with “the insidious overreach of government and the judiciary once again interfering in how and where people want to invest their money,” but it could equally lead to VCs doing more due diligence on potential DeFi and DAO partners. It may also mean that any DeFi project wanting to attract big investors would have to get and keep its activities above board and in compliance.

Perhaps this is what really upset the crypto-bros about Monday’s ruling, contemplating the detrimental impact this form of indirect regulation might have on their questionable business practices, through prospective partners increasingly demanding proof of compliance because they don’t want to find themselves liable for backing dodgy crypto money-making schemes—a single sad tear rolls down our collective cheeks for these long-suffering champions of free market libertarianism.

Whichever side of the fence one sits on, DAOs, fans, and critics alike will have plenty of time to formulate their various responses to the possible outcome of the class action. A case management conference is set for December 6 to set a schedule for the rest of the case, which will likely not be heard until later next year.

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