Decentralised Autonomous Organisations and their treatment by courts

Decentralised Autonomous Organisations (DAOs) and their treatment by courts

In the ruling of the Court of First Instance (CFI) in Mantra Dao Inc and Another v. John Patrick Mullin and Others [2024] HKCFI 2099, the CFI made an order for disclosure of financial information in a dispute concerning the true management, ownership and control of a Decentralised Autonomous Organisation (DAO). The ruling serves as an indication of the Hong Kong courts' forward-thinking approach to interlocutory relief in crypto-asset disputes, particularly where they involve a DAO structure. The need for forward thinking is illustrated by the recent appointment of receivers in relation to Hector DAO, a separate matter but which demonstrates both the risks and remedies available to stakeholders in DAO structures.

What is a DAO?

A DAO is a governance structure, based on blockchain technology, whereby decision-making is implemented via token-based voting by members and not by any centralised governing body as would be typical in a company or other organisation. Individuals are members of a DAO by virtue of holding a crypto asset such as digital or non-fungible tokens and which come attached with voting rights in the DAO. Decision-making is carried out autonomously through smart contracts, which automatically execute once pre-programmed conditions are met on the blockchain, e.g. a requisite number of votes are reached. DAOs are often formed with a common purpose, such as investing in start-ups or purchasing cryptocurrencies. For example, Constitution DAO was created by a collective of cryptocurrency owners with the aim of pooling funds to make a bid on a rare original of the U.S. Constitution at a public auction.¹

Given a DAO is a mere governance structure, its existence will typically be represented by a limited company or other legal entity to anchor it in the real world and facilitate its operation, albeit with a novel governance framework.

Mantra DAO

In Mantra DAO, a dispute arose between the 1^st Plaintiff, being the legal entity held out as representing the DAO, and the 2^nd Plaintiff, being a Malaysian-incorporated company claimed to be involved in the conception and set-up of the DAO, and the 1^st and 2^nd Defendants, being former employees of the 2^nd Plaintiff, the 3^rd and 4^th Defendants, being individuals elected as members of the DAO Council, and the 5^th and 6^th Defendants, being companies involved in the operation of the DAO. The parties were in dispute regarding the true ownership, management and control of the MANTRA DAO project (Mantra DAO). Mantra DAO was created for the purpose of carrying out various decentralised finance activities.

The Plaintiffs alleged that day-to-day management of Mantra DAO had been delegated to the Defendants who had, since around January 2021, failed to report to them on the management of Mantra DAO and had misappropriated cryptocurrencies from Mantra DAO's accounts. The Defendants claimed that Mantra DAO was not owned by the Plaintiffs but instead was governed as a DAO, through the ownership of tokens and execution of smart contracts to carry out decisions as voted for by token holders. All transfers of Mantra DAO's assets were for legitimate purposes, as intended under the relevant white paper which set out the objectives of Mantra DAO.

The Plaintiffs sought an interim order from the CFI compelling the Defendants to preserve and disclose Mantra DAO's books and records in their possession dating back to January 2021. The Plaintiffs argued that such relief was necessary to allow them to monitor Mantra DAO's operation and development pending trial and, if necessary, to take additional measures to protect their interests.

The decision of the CFI

In considering whether to grant the disclosure order sought by the Plaintiffs, Hon Lok J held that the court must consider the balance of convenience and the possible effects of the granting or non-granting of such an interlocutory order.

Lok J made the order sought by the Plaintiffs and, in support of doing so, held that, inter alia:

• damages were an inadequate remedy for the Plaintiffs if the application were refused, given the fast-moving nature of the cryptocurrency industry and the difficulties in tracing transactions, which are often anonymised. It was important for the Plaintiffs to have an up-to-date picture of the financial operation of Mantra DAO in order to substantiate and quantify their claims;
• the 1^st to 4^th Defendants, as the "Councillors" of the DAO, had a duty to keep a proper account of the cryptocurrency trading business under Mantra DAO. Considering this duty, an order for disclosure would not cause any additional or significant hardship or burden on the Defendants;
• the Defendants' concern raised at the hearing that confidential business secrets might be wrongfully disclosed to the Plaintiffs could be addressed by properly worded non-disclosure undertakings by the Plaintiffs' legal and financial advisers;
• there had been no undue delay by the Plaintiffs in commencing proceedings or lodging the disclosure application; and
• the disclosure order sought by the Plaintiffs was not a novel kind of interlocutory relief and could be properly understood as an order in aid of the preservation of disputed assets. The Defendants' argument that the disclosure order was in substance an order for account under O43 of the Rules of the High Court Cap. 4A, which is a remedy that should not be granted at the interlocutory stage, was accordingly rejected.

Commentary

The decision above was interim in nature and no substantive decision has been reached on the underlying dispute between the parties. In fact, Lok J expressly sidestepped the substantive dispute by admitting:

"At this stage, it suffices for me to say that cryptocurrency trading is a new, novel and innovative business. The Hong Kong courts, and indeed many other courts in different jurisdictions, have little experience in dealing with such kind of disputes. The courts may not be familiar with the modus operandi and the structures for the operation of such kind of business. The legal effects of the Governance Agreement, the White Paper, the Management Agreement and the Employment Agreements have to be fully investigated at the trial. Given the allegations by both camps, the court is not in a position to form a preliminary view about the overall merit of the claim."

However, the decision does demonstrate the willingness of the court to grant interim relief even in situations it does not yet fully understand, such as where a DAO is involved. Suffice to say, the precise legal status of a DAO remains uncertain and is not the subject of any specific legislative framework in Hong Kong.² The real test will come if and when the matter goes to trial.

Hector DAO

Formed in October 2021, Hector DAO was a group of crypto-asset holders using a network of smart contracts on the blockchain that were programmed to facilitate financial transactions with crypto assets (the Hector Network). One became a Hector DAO participant by acquiring a crypto-asset token (known as HEC) carrying voting rights in the DAO. HEC could be acquired by transferring other types of crypto asset to a digital wallet address associated with the DAO (the Treasury Wallet) in exchange for issues of HEC, or by purchasing it from existing HEC token holders on the secondary market.

Over time, an informal project management team formed within Hector DAO, consisting of individuals who provided services to Hector DAO and implemented proposals approved by HEC token holders. Beginning in early 2022, a small group of individuals took on overall responsibility for management of Hector DAO and the Hector Network (the Core Five).

In May 2022, the Core Five formed a BVI-incorporated company, Hector Enterprise Inc., for the purpose of acting as an intermediary for off-blockchain transactions for Hector DAO, such as contracting with service providers or executing investment contracts. Hector Enterprise Inc. became the medium through which all cost-incurring activities of Hector DAO were routed.

Over 2022 and 2023, Hector DAO came under significant financial distress, suffering losses in its Treasury Wallet due to crypto-market volatility and the significant collapse of prominent crypto assets. As a result, the HEC token holders voted to liquidate the Hector Network and redeem the HEC token against the assets held by or on behalf of Hector DAO (the Treasury Assets), and a liquidation committee was formed (the Liquidation Committee).

A development team then began to program a distribution smart contract and user interface application to distribute the remaining Treasury Assets in accordance with the liquidation proposal. On 15 January 2024, a group of hackers exploited a vulnerability in the distribution smart contract, resulting in the theft of assets worth US$2.7 million (the January 2024 Hack).

As a result of security concerns arising from the January 2024 Hack, the Liquidation Committee was unable to distribute the remaining Treasury Assets to HEC token holders. They accordingly sought the appointment of receivers to perform this function.

On 16 February 2024, Hector Enterprise Inc. filed a court application in the BVI to appoint members of Interpath (the Receivers) as joint and several receivers over the assets and undertakings of Hector DAO. On 9 April 2024, the BVI courts issued a final receivership order appointing the Receivers on a full and final basis. Under the terms of the order, the Receivers were granted extensive powers over the Treasury Assets and the operations of Hector DAO, including the authority to take and retain possession and control of the Treasury Wallet and all books and records relating to Hector DAO, investigate antecedent transactions affecting Hector DAO and enter into transactions on behalf of Hector DAO.

The Receivers subsequently sought recognition of the BVI receivership of Hector DAO as a foreign proceeding in the United States and, on 16 July 2024, the Receivers succeeded in obtaining a Chapter 15 recognition order from the United States Bankruptcy Court in the District of New Jersey.³

The future

The legal proceedings concerning both Mantra DAO and Hector DAO are an early indication of the potential for misappropriation and tracing claims arising out of DAOs, whether as a result of cybersecurity vulnerabilities or disputes concerning the management and governance of the DAO. Both cases also serve as an illustration of the tendency, whether by informal or contractual arrangement, for management and operation of the DAO to be delegated to a few key stakeholders, notwithstanding the decentralised nature of voting by token holders. The management decisions of these few stakeholders may then lead to and/or become the subject of future litigation. Both cases also indicate that DAO proceedings will typically involve the limited company or other legal entity held out as representing the DAO.

The CFI's ruling in Mantra Dao demonstrates that the Hong Kong courts are willing to apply established principles on interlocutory relief in aid of asset preservation and tracing to the nascent arena of crypto-asset disputes. The courts' forward-looking approach in this arena was previously signalled in Nico Constantijn Antonius Samara v. Stive Jean Paul Dan [2022] HKCFI 1254, where the CFI granted a proprietary injunction over bitcoins misappropriated by a fraudulent agent. This forward-looking approach to interlocutory relief will be of interest both to commercial litigants and to insolvency practitioners dealing with crypto assets.

Given Hector DAO itself is not a legal entity and has no legal personality or existence, it is logical that the Receivers would be appointed over the Treasury Assets and business of Hector DAO (as opposed to being appointed over Hector DAO as though it were a legal entity). The receivership order describes the Treasury Assets as all those held by or on behalf of Hector DAO, and Hector DAO itself is described as a respondent. Without the benefit of a published judgment by the BVI court, it is unclear how the court overcame the fundamental question of how Hector DAO, without any legal personality or standing, could be named as a defendant and therefore how the assets held by or on its behalf should be defined. It therefore remains to be seen how the courts will deal with DAOs.

Both the Mantra DAO and Hector DAO cases leave unanswered the true legal nature of a DAO. It may be useful to conceptualise a DAO as a mere framework for the operation of a business and therefore part and parcel of that business. The question then raised by this is who owns and has rights in the business. A DAO is intended to operate by virtue of its tokenised governance structure. However, if a DAO is owned by a company, the shareholders of that company must, at law, have certain fundamental rights over the company's business and any DAO it owns. It may be an argument that the assets contained in the DAO are held on trust for the relevant token holders. One can already foresee a situation where the powers and duties of the trustee clash with the powers and duties of those managing the legal entity and the relevant shareholders in that legal entity.

One further complication arises from white papers that have traditionally been prepared to set out and govern the goals, objectives and operation of DAOs. Whether white papers have any binding effect is a question that has yet to be answered. Construing white papers as binding may answer the question of what legal effect a DAO has on its assets and stakeholders. However, the fact that white papers are not generally written to be legally binding may, yet again, give rise to disputes over matters and situations which are unanticipated or not provided for. The answer may be for robust and legally binding governance documents such as shareholders' (token holders') agreements to go hand in hand with white papers. Alternatively, white papers may need to be drafted as though they are shareholders' agreements to effectively bind stakeholders to a DAO in the event of any dispute, such as in both Mantra DAO and Hector DAO, and may give much-needed clarity to the outcome of such disputes.

1. Constitution DAO has since been wound down after making a losing bid for the original Constitution at Sotheby's.
2. Following the Mantra DAO ruling, a member of the Legislative Council has called for Hong Kong to establish a legal framework for DAOs to further develop the local Web3 ecosystem.
3. The authors in drafting this section have referred to the Declaration of James Drury of Interpath In Support of (I) Verified Petition For Recognition Of Foreign Proceeding And (II) Motion In Support of Verified Petition For Recognition Of Foreign Proceeding And For Related Relief filed on 16 June 2024 in the United States Bankruptcy Court, District of New Jersey.

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