SOS! DAO in Distress!

In previous alerts in this series, we have discussed how transformative DAOs can be for corporate formation and tax status. We have discussed how determining a DAO’s classification—whether a DAO is a legal entity and, if so, what type—is vital before any legal proceeding. And while you’re figuring that out, you might want to ask another fundamental question, specific to bankruptcy: Can a DAO even be a debtor under the Bankruptcy Code and, if so, what are some practical issues that may result? Let’s see.

Remind me: What is a DAO?

A DAO is a decentralized, autonomous organization that is controlled by the organization’s members rather than a centralized authority or corporate entity. A DAO is often not a formal legal entity and there is typically no CEO, management, or board of directors. DAOs usually have a bottom-up governance model built on computer code, and each member who holds a token in the DAO can have a voice in running the DAO. When certain established conditions are met, smart contracts make decisions for the DAO automatically.

What makes an entity eligible for bankruptcy relief in the US?

To be eligible for relief under the United States Bankruptcy Code, you must fall within the definition of a “debtor.” A bankruptcy debtor must be a “person or municipality.” See 11 U.S.C. § 101(13). A “person” is oddly not only a human but is defined to include “[an] individual, partnership, and corporation . . . .” Id. at § 101(41). Some countries and certain states (Vermont, Wyoming, Tennessee, and Colorado) have adopted DAO-specific statutes that may assist bankruptcy courts grappling with whether a DAO is eligible to be considered a debtor under the Bankruptcy Code.

In the Cayman Islands, a DAO can form as a Cayman Foundation, which is considered to be a legal person under the law and can (i) interact and form contracts with third parties; (ii) file and pay taxes; (iii) open bank accounts and make cash transactions; (iv) hold and protect off-chain assets; (v) limit the liabilities of its members; (vi) protect intellectual property; (vii) serve as a vehicle for airdrops and grants; and (viii) act as a parent or holding entity with subsidiaries to carry out functions for a project. In Singapore, some DAOs have sought legal status by retooling existing corporate structures, either by forming as a company limited by shares or a company limited by guarantee. See DAO's Personality Test.

In the U.S., a DAO may be incorporated as an LLC in Wyoming and Tennessee. See Wyo. Stat. Ann. § 17-31-101; Tenn. Code Ann. § 48-250. In Colorado, a DAO is considered a cross between a corporation and an LLC. See Co. Rev. Stat. § 7-25-101. And in Vermont, a DAO can be formed as a type of blockchain-based LLC. See S.B. 269.

Under any of these configurations, a DAO would appear to meet the definition of a “person” or “corporation” under the Bankruptcy Code. For example, if a DAO were to form as a Cayman Foundation and file for bankruptcy in the US, it would appear to be a “corporation” and thus a “person” eligible to remain in bankruptcy, assuming the DAO met all the other eligibility requirements under the United States Bankruptcy Code (e.g., section 109(a), which requires a debtor to reside or have a domicile, a place of business, or property in the United States). But bankruptcy courts have not actively addressed the legal status of DAOs or whether a DAO would qualify as a person or a corporate entity that is otherwise entitled to bankruptcy relief without a specific DAO statute. So a DAO attempting to file for bankruptcy relief where there are no applicable DAO statutes may have a more difficult time demonstrating how it actually qualifies as a “debtor” under the Bankruptcy Code, as a bankruptcy court will have no applicable law to look to when determining the issue.

What are the practical considerations surrounding DAOs in bankruptcy?

While a DAO must first consider whether it is eligible to file for bankruptcy, there are other practical issues that may arise after filing. For example, how can a DAO meaningfully participate in the bankruptcy process if it is truly decentralized? And how would a DAO execute critical day-to-day decisions in a bankruptcy case or seek critical relief from a bankruptcy court? A debtor’s request for relief often requires specific evidentiary support, necessitating live (or video) witness testimony. This historically—and still today—depends on human beings, which does not appear to jibe with the digital and decentralized nature of a DAO. It remains to be seen whether bankruptcy courts will accept alternatives to live witness testimony.

Also, unlike a corporation, where human beings govern things, a DAO’s decisions are ultimately made by computer code. When a bankruptcy trustee is involved (under chapter 7, chapter 11, or subchapter V), there may be practical impediments when a DAO is involved, particularly when it comes to a DAO’s cooperation with the trustee in fulfilling its duties under the Bankruptcy Code. What if a DAO’s members are unwilling to cooperate with the trustee? And who would a trustee even serve for purposes of appearing before a bankruptcy court and answering for a DAO’s failure to cooperate? Even if some members of a DAO can be located, they are often spread across the globe, making enforcing compliance with the Bankruptcy Code a challenge.

In spite of these hurdles, DAOs are gaining traction and popularity. Understanding bankruptcy issues surrounding them is critical. O’Melveny will be closely monitoring the legal issues, including DAOs’ involvement in bankruptcy proceedings. Please contact the authors of this alert or your O’Melveny counsel to see how we can help you navigate this complex and emerging area of practice.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. William K. Pao, an O'Melveny partner licensed to practice law in California, Evan M. Jones, an O’Melveny partner licensed to practice law in California and the District of Columbia, Laura Smith, an O’Melveny counsel licensed to practice law in Texas, and Emma Persson, an O’Melveny associate licensed to practice law in Texas, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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