Decentralized Autonomous Organizations (“DAOs”)

DAOs are organizations operate on a blockchain and are managed by token holders often used for Fintech activities. The identities of token holders are recorded on the blockchain and their rights are executed by self-executing computer code (smart contracts). In contrast, for traditional organizations like companies limited by shares, the identities of shareholders are recorded in a central registry. The shareholders’ rights are exercised through the management of the company, as well as the enforcement of company legislation and the articles of association.

In Hong Kong, the laws in relation to DAOs, including their ownership and control, are yet to be developed. However, the recent case of Mantra DAO Inc. and Another v John Patrick Mullin and Others [2024] HKCFI 2099 highlights the critical need for financial transparency in the management of cryptocurrency platforms and underscores that new legal entities such as DAOs are not beyond the power of the courts to protect the legitimate interests of stakeholders.

Mantra DAO Inc. & Another v John Patrick Mullin & Others [2024] HKCFI 2099

Background

The case concerns a dispute regarding the control and ownership of a DAO platform project (the “Project”) and the alleged misappropriation by former employees that run the Project (the “Defendants”).

The Plaintiffs established the Project and entrusted its daily management to certain Defendants. The Plaintiff’s allegations against the Defendants included (1) failure to report operations of the Project to the Plaintiffs, (2) unauthorized assumption of ownership over the Project, and (3) misappropriation of the underlying cryptocurrency assets.

Contrarily, the Defendants argued that, given the decentralized nature of a DAO, the Project was not meant to be exclusively owned by any single entity, including the Plaintiffs. Instead, the Project was governed by a specific governance agreement outlined in the Project’s whitepaper, which established a distinct governance framework that the decision making power over the assets of the Project lied within the token holders through the exercise of voting rights.

After the unsuccessful application for various interim measures against the Defendants, the Plaintiffs narrowed their requests to a court order requiring the Defendants to disclose financial records and documents in relation to the Project’s financial activities (the “Accounts Disclosure Order”).

Court’s findings

The Court ordered the Defendants to provide the Project’s financial spreadsheets along with supporting documents for each entry, subject to non-disclosure agreements in the balance of convenience, after considering the following:

·           The Court noted that the cryptocurrency sector is rapidly evolving, with decisions often made to gain a competitive edge. Thus, it is crucial for the Plaintiffs to receive regular updates on the Project’s financial operations. Without such information, the Plaintiffs would struggle to assess their losses or contest the Defendants’ decisions, especially given the challenges in tracking anonymous cryptocurrency transactions.

·           The Accounts Disclosure Order would not interfere with the Project’s cryptocurrency trading activities. The Defendants are expected to maintain accurate records for the project, and they also have a responsibility to report to the relevant token holders regarding the Project’s funds. Therefore, the order should not impose any undue burden on the Defendants.

·           Adequate measures from the Plaintiffs’ legal and financial advisors could mitigate the Defendants’ concerns about potential leaks of trade secrets.

Implications on DAOs: Legal risks and compliance

Traditional organizations adopt a centralized governance ownership structures, which are subject to regulations by well-established laws and tools such as company registration and licencing regimes. However, in fact, DAOs lack full decentralization, and the purported decentralization may be misused for evading current regulatory obligations. When a DAO is broken down into its constituent parts, many of its activities may constitute regulated activities for which extensive frameworks are already in place to protect consumers and investors, maintain financial stability, and mitigate financial risks.

Moreover, DAOs are susceptible to manipulation by a few selected stakeholders. Coupled with limited disclosure requirements in the broader crypto-asset market, DAOs could serve as a marketing ploy or a tool to obscure decisions made by dominant governance token holders under the guise of community involvement. In extreme scenarios, malicious entities can acquire adequate DAO governance tokens to sway voting outcomes to the detriment of minority token holders. As the number of governance tokens held by founders, developers or venture capital investors is rarely disclosed or understood by financial authorities, and the true economic motives behind the owners of governance tokens remain unclear, this presents a potential risk for retail investors who might fall prey to scams or deceitful practices, leading to significant financial harm.

This court ruling serves as a reminder of the need to keep books and records for operators of decentralized cryptocurrency projects, including DAOs. Even though the ownership and governance of these projects are still subject to legal uncertainty, they should be ready to communicate this information to stakeholders. In the context of cryptocurrencies, where blockchain transactions are frequently anonymous and nearly hard to reverse, this duty is especially important for maintaining good governance and safeguarding stakeholders’ interests.