What’s All the Fuss About? Bankrupt Crypto Organizations

It has been a while since our last installment of our “What’s All the Fuss About?” feature. That’s because it is rare that a article about commercial law creates such a stir that it prompts one to wonder what all the fuss is about. Today’s installment features an article by three authors, two of whom collaborated on a prior article reviewed in this forum. If you review the past columns in this series, you will detect pattern. Articles that address new technology, especially crypto or AI, find a lot of readers, or at least a lot of downloaders. For the rest, I offer this tl;dr.

Every once in a while, I get a hankering to understand quantum theory. I tried A Brief History of Time, but once Stephen Hawkings started asking me to imagine four-dimensional space, my brain broke. Maybe if he dumbed it down a bit, I’d be okay. I tried A Briefer History of Time. Same problem. A friend, Ken Ford, wrote a book for the “general reader” called 101 Quantum Questions.  Thanks Ken, now there’s another thing I will never understand: sub-atomic particles with characteristics like “spin” but no mass.

I have given up on understanding quantum physics. But will anybody write about blockchain-based business entities in a way I can understand?

Thank goodness, Kara Bruce (left), Christopher K. Odinet (below right), and Andrea Tosato (bottom left) (the Authors) have made understanding crypto organizations possible, even for people like me tethered to the brick-and mortar world. They know that readers will come to their Bankrupt Crypto Organizations for the crypto. They should stay for the Authors’ exploration of the challenges of conventional bankruptcy to the ethos of the decentralized autonomous organizations (DAOs) about which they write and for their description of a possible path towards building bankruptcy frameworks based on distributed ledger technology (DLT), which would be more consistent with that ethos.

DAOs leverage blockchain networks, smart contracts, and digital assets to create new forms of collective action and resource management. Some DAOs have recently gone bankrupt, but interacting with our current bankruptcy regime inserts a centralizing authority into a “crypto anarchist” ecosystem. The Authors explore the tensions between the theoretical underpinnings of DAOs, which are based on autonomy, egalitarianism, and decentralization, and the “centralized requirements of court-supervised insolvency proceedings.” While the Authors propose an alternative based in private ordering, BrokeDAO, they acknowledge that some of the limitations on what can thereby accomplished are insurmountable.

Part I of the paper describes the birth of DAOs out of a heady brew of cypherpunks, crypto-anarchy, and cryptoeconomics. These movements coalesce around a shared opposition to government regulation and a belief that autonomous organizations could self-regulate through a system of digital protocols.  Today, there are over 20,000 DAOs, with 3.2 million participants and assets in excess of $20 billion. DAOs are as diverse in their internal structures and governance mechanisms as they are in purpose. What unifies them is their commitment to individual autonomy and decentralized collective governance through technologies designed to incentivize some decisions while disciplining others.

The Authors next identify four key features of DAOs that are relevant in the context of insolvency. First, DAOs can adopt any corporate form, but many choose to ignore legal formalities. They do so at their peril, as the failure to incorporate can subject entities to default rules that treat them as partnerships, with two dramatic consequences. Any partner can bind the entity as to ordinary business matters, and the partners enjoy no shield from personal liability. Some states have granted statutory recognition to make it easier for DAOs to enjoy the advantages of LLCs, but many DAO founders prefer to operate outside of such structures. Principled anarchy. They don’t want officers or directors; they don’t want disclosures.

Second, with respect to the management structure of DAOs, the Authors create a 2x2 matrix, dividing entities along axes of automation and decentralization. DAOs that maintain a centralized management structure do not raise special challenges in the context of bankruptcy, and the Authors hesitate to even consider them DAOs, as they fail to conform to the techno-anarchy that informs the ideal structure for these entities. The real challenges in bankruptcy arise when the DAOs operate in a decentralized manner.

Third, the assets of a DAO are mostly tokens, including cryptocurrencies, stablecoins, NFTs, and governance tokens. A court faces unique challenges in determining who has a property interest in those tokens, as between the DAO and its members, and the governing law may be hard to identify. In particular, the redeemability of stablecoins and the determination of rights in tokenized assets present daunting difficulties. Finally, there is the ever-present danger of hacks, bugs, and software glitches, all of which can both precipitate a bankruptcy and complicate it.

Finally, because of the broad way in which the bankruptcy code defines creditors, token holders in a DAO might qualify as creditors rather than equity holders. DAOs do not very often rely on traditional financial institutions for loans. Nonetheless, they may have other creditors, including service providers, other DAOs or blockchain-based business entities, governmental entities to which they may owe taxes, fees, or penalties, as well as tort or crime victims to which the DAO may owe compensatory damages or restitution.

Bankruptcy is an attractive option for distressed DAOs because of all the benefits that bankruptcy provides to debtors, including the possibility of reorganization. The Authors identify three drivers of DAO bankruptcy: the volatility of decentralized financing can lead to a “bank run”; litigation threats; and involuntary bankruptcy forced by tokenholders or other creditors.

While Bankruptcy is attractive to the entity, it also undercuts some of the ideals or principles that made DAOs an attractive form for participants. In order to avail themselves of bankruptcy proceedings, DAO’s must first establish domicile or property within the United States and that they are “persons” subject to the Bankruptcy Code. The Authors think DAOs should be able to do so. Some DAOs may be ineligible for bankruptcy protections if they qualify as regulated financial institutions. The Authors think it unlikely that most DAOs will have much trouble establishing that they exist outside of regulatory schemes.

However, DAOs and bankruptcy proceedings are a bit of an odd couple. The key features of bankruptcy include centralized control by a human agent. These elements are antithetical to the principles that guide DAOs. Bankruptcy proceedings are also transparent in ways that run contrary to the high value DAO participants place on privacy. Moreover, bankruptcy proceedings require fillings and appearances by a representative of the entity, forcing DAOs to adopt aspects of the centralization that they reject.

The Authors use the first bankruptcy of Hector DAO to illustrate the problems. Everything that could go wrong did go wrong with HectorDAO, including security breaches and a collapse in cryptocurrencies that led its assets to decline in value from $100 million to just over $9 million. A tokenholder brought suit, and the entity sought receivership. The receivers commenced bankruptcy proceedings. Doing so was possible because HectorDAO had centralized leadership, which facilitated swift decision-making. A more ideologically rigorous DAO might lack such structures, and by design, it might be incapable of availing itself of bankruptcy, especially because participants would not welcome the disclosures that are necessary to such a proceeding.

However, as DAOs grow more complex and sophisticated, they tend towards more centralized organization, rendering bankruptcy a more attractive option should they become distressed. Cost-benefits analsyis prevails. DAOs will abandon their philosophical commitments if bankruptcy proceedings maximize recovery. But some DAOs won’t have a choice about whether they enter bankruptcy proceedings. Their creditors or tokenholders, who could be treated as creditors, might force the entity into involuntary bankruptcy.

Okay, the ride has been wild enough already, but in the final section, the Authors imagine a bankruptcy system suited to the needs of DAOs. Building on DAOs that already provide alternative dispute resolution, the Authors sketch the characteristics of a bankruptcy apparatus that would mirror the anonymized, decentralized, non-hierarchical structure of DAOs. DAO-based alternative dispute resolution services already exist. They replicate the structures of DAOs and are organized in a manner consistent with the values that attract people to DAOs.

The Authors walk through various iterations of such an imagined DLT-based bankruptcy entity, dubbed BrokeDAO. The entity could oversee liquidation of the assets of a distressed DAO, manage dispute resolution, ferret out waste and mismanagement, and assist DAOs in finding human-mediated professional services that can help maximize the value of assets. In its most advanced iteration, BrokeDAO could help DAOs that function as something more than investment vehicles reorganize so that people who have come to depend on the DAO’s functions can continue to benefit. Its automatic responsiveness could achieve efficiencies that would improve on existing insolvency frameworks.

And yet, the Authors are aware of the limits and vulnerabilities of their BrokeDAO framework. Lacking the coercive power of a bankruptcy court, private mechanisms depend on voluntary cooperation and coordination. Private ordering might replicate the effects of centralized control through a system of incentives and penalties that encourage collective action and discourage conduct that aids one creditor at the expense of the entire web of stakeholders. BrokeDAO can exercise leverage over tokenholders, but it will have to create some enticement to get outside creditors or vendors to give up their standard legal claims in exchange for some tokenized stake. Its ability to do so will be most limited with respect to tort claimants and regulatory bodies like the SEC. In the end, the Authors conclude, BrokeDAO may have a limited shelf life, in that it is workable only so long as the DLT community remains closed. The BrokeDAO model will only work if it provides an alternative to traditional bankruptcy that creditors find superior.

As someone who tries to avoid thinking about such things, my assessment is that the Authors have persuaded me that their topic is important. It is also big and terrifying. I understand just enough about the ideology that underpins DAOs to know that I don’t share it, and I worry about people so driven by selfishness and mistrust of human agents that they think it necessary to set up powerful economic entities, free from human agency. The very lack of belief in principled conduct should suggest that these entities will be subject to sophisticated hacks by people who act aggressively on their lack of principle. Ultimately, the costs of securing the system might exceed its benefits.

Whether or not I like it, DAOs are everywhere, and their growth is likely unrelenting. The legal culture has to be flexible enough to accommodate them and also to make them want to accommodate it. If we cannot work out some sort of modus vivendi between law and crypto organizations, there will be a lot of financial carnage, and not very much accountability.

If you missed our previous columns in the series and still don't know what the fuss was about, here's what you missed:

• Generative Interpretation byYonathan Arbel and David Hoffman
• Lawyering in the Age of AI, by Jonathan Choi, Amy Monahan, and Dan Schwarcz
• Debt Tokens, by Diane Lourdes Dick, Chris Odinet, and Andrea Tosato
• Governing AI Agents by Noam Kolt
• The Great Scrape by Daniel Solove and Woodrow Hartzog