CFTC Sues a DAO, Raising Legal Questions for DeFi Founders and Users

The regulatory crackdown on crypto continues.

The Commodity Futures Trading Commission on Thursday announced settled charges against the founders of bZeroX, the company behind the bZx protocol. The CFTC fined bZx founders Tom Bean and Kyle Kistner $250,000 for allegedly “illegally offering leveraged and margined retail commodity transactions in digital assets,” as well as failing to adopt customer identification requirements known as KYC.

But in a novel move, the CFTC also filed a lawsuit against an associated DAO. The CFTC alleges that the Ooki DAO, which Bean and Kistner purportedly founded as a way to decentralize control of the bZx protocol, likewise violated the same laws. Though Bean and Kistner settled charges against themselves and bZeroX, while neither admitting nor denying the charges, the CFTC is seeking penalties against the DAO, including disgorgement, fines, and potential trading and registration bans.

“The order finds the DAO was an unincorporated association of which Bean and Kistner were actively participating members and liable for the Ooki DAO’s violations of the [Commodity Exchange Act] and CFTC regulations,” the Commission stated in a press release.

A DAO is an organizational structure where control is spread out rather than hierarchical. DAOs use smart contracts on a blockchain, with participants using governance tokens to vote on proposals.

In an unprecedented action, the CFTC reasoned that Bean and Kistner are liable for the DAO’s allegedly illegal behavior because they held Ooki tokens and voted on governance proposals related to how the DAO operated. In a dissenting statement, CFTC Commissioner Summer Mersinger called the action “blatant regulation by enforcement” and said it fails to “rely on the legal authority” of the Commission’s mandate.

“I cannot agree with the Commission’s approach of determining liability for DAO token holders based on their participation in governance voting for a number of reasons,” Mersinger wrote.

The way in which the CFTC defined the Ooki DAO as an unincorporated association and determined the bZx founders’ liability could have far-reaching implications in the world of DeFi and DAOs—the latter of which becoming an increasingly popular way to quickly organize large groups of people toward a singular goal, including fundraising for a common cause, while decentralizing decision-making for the group.

The enforcement action is already having a chilling effect on certain DAOs, according to Delphi Labs General Counsel Gabriel Shapiro. “Already seeing DAO delegates talking about quitting their roles,” he tweeted earlier today. “If you are a DeFi founder threatened by regulatory action, please consider that you might have options beyond settlement,” he cautioned.

In an emailed statement to Decrypt, the DeFi Education Fund called the lawsuit against Ooki DAO an “unprecedented action [that] seeks to create novel policy in response to novel issues, all via an enforcement action.” Jake Chervinsky, head of policy for crypto lobbying group Blockchain Association, echoed the sentiment, tweeting yesterday: “The CFTC’s bZx enforcement action may be the most egregious example of regulation by enforcement in the history of crypto.”

There is already growing worry within the crypto industry that the CFTC’s approach in its action against bZx and its founders could be applied broadly to other DAOs and their members.

“I think the real challenge is what the CFTC will determine if this is part of their approach to going after the individual governance token holders,” Prime Trust Vice President of Regulatory Affairs Jeremy Sheridan told Decrypt in an interview. “Because of the novel nature of this approach, this will be precedent-setting and damaging for the rest of the industry, and that’s the concern.”

Sheridan said we may be seeing an unfortunate consequence of escalation, and the CFTC, seeing how the SEC has become involved with regulating cryptocurrency, may be attempting to flex its regulatory muscle to gain greater authority.

“That is the challenge, and the unfortunate consequence of not having sound efficient, concrete regulatory structures in place that give lines of areas of responsibility, lines of engagement that everyone in the industry is really clamoring for,” Sheridan said.

Other legal experts, however, aren’t so sure. Stephen Palley, legal partner at Brown Rudnick, isn’t surprised by the way in which the CFTC defined Ooki DAO as an unincorporated association, but told Decrypt that the action nevertheless raises important questions.

”The more interesting questions,” Palley said, “are whether or not the underlying protocol itself actually fits within the scope of the [Commodity Exchange Act] or whether the [Commodity Exchange Act] is fit for purposes with respect to a decentralized protocol.”

If nothing else, the CFTC has made it clear that merely organizing as a “DAO” does not exempt participants from abiding by existing regulations.

“Being a DAO in the U.S. is a dangerous business,” Snapshot Ecosystem Lead Nathan van der Heyden told Decrypt. “Simply distributing a token and holding a few votes doesn’t absolve founders who are breaking the law from any legal responsibility,” he said.