Samuels v. Lido DAO: A Potential New Frontier for Liability in the Cryptocurrency Space

A recent order handed down by U.S. District Judge Vince Chhabria of the Northern District of California could be a new source of concern for digital asset entrepreneurs and the venture capital firms that invest in and support them. In Samuels v. Lido DAO the court denied the motion to dismiss filed by an entity called Lido DAO ("Lido") and a group of its institutional investors regarding what was alleged to be a sale of unregistered tokens on an exchange. Lido was and is the operator of a successful "Staking as a Service" business conducted through a decentralized autonomous organization, or a "DAO." Founded in 2020, Lido provides a service in which it gathers ETH from individual holders which it then pools and "stakes" to provide validation for transactions on the Ethereum blockchain. It also selects validators and provides an "oracle" to ensure that (i) the validators, (ii) the owners who pooled their ETH, and (iii) Lido itself receive the correct ETH rewards for performing the validation work.[1]

In largely denying defendants' motions to dismiss, the court's order potentially greatly expands the liability venture capital firms based in California might face, particularly in the context of investing in cryptocurrency enterprises, and may raise more questions than it answers for parties involved in such disputes.

Background

Andrew Samuels ("Samuels") bought "LDO" tokens on the Gemini crypto exchange in April and May 2023. He sold the tokens at a loss about a month later. The tokens were originally issued by Lido. Samuels sued Lido and four of its venture capital investors (Paradigm Operations, Andreessen Horowitz, Dragonfly Digital Management, and Robot Ventures, which invested in Lido at various times in 2022 and 2023), alleging that the tokens were unregistered securities and therefore sold to him in violation of Section 12(a)(1) of the Securities Act of 1933 ("the 1933 Act").[2] Samuels did not allege that he had purchased his LDO tokens directly from either Lido or from any of the investor defendants.

The institutional investors and a party—named Dolphin CL, LLC (which claimed to appear "with respect" to Lido)—moved to dismiss.[3] In its order, the court grappled with four questions: (1) whether Lido was capable of being sued by Samuels as a general partnership; (2) if the four venture capital firms constituted members of such a general partnership; (3) whether Lido and its alleged partners could be liable for Samuels' alleged losses; and (4) whether Section 12(a)(1) pertained solely to public offerings and therefore did not apply to Samuels' secondary market transaction.

Discussion

Lido's Capacity To Be Sued

Samuels alleged that Lido was a general partnership under California law and, therefore, as a legal entity could be sued.[4] Dolphin argued that as a DAO, Lido is "just autonomous software that runs without human management." Although the investor defendants "did not have the audacity to argue that Lido is just software," they separately argued that "whatever Lido is, it is not a general partnership."[5]

The court rejected Dolphin's arguments. Judge Chhabria wrote that Lido's alleged actions "are not those of an autonomous software program—they are the actions of an entity run by people."[6] The court pointed to allegations in Samuels's Complaint that Lido makes decisions through votes, has a treasury, and has hired over 70 employees. In response to the investors' argument that Samuels failed to adequately allege that Lido was a general partnership, the court wrote that it is "enough for Samuels to adequately allege that some general partnership exists…. The complaint alleges that some number of people got together and agreed to create and operate an Ethereum staking service because they thought they could make money doing that."[7] The court added that the appropriate time to delve deeper into the "exact contours" of that alleged general partnership would be after reviewing a comprehensive evidentiary record on summary judgment or at trial.[8]

Whether the Investor Defendants Were Sufficiently Involved in Lido's General Partnership To Be Considered Partners

Samuels also alleged that the investor defendants were part of Lido's general partnership. The court agreed, holding that Samuels plausibly alleged that Paradigm, Andreessen Horowitz, and Dragonfly meaningfully participated in Lido's governance and management and, therefore, were a part of Lido's business for profit and, by extension, a part of the general partnership. As to Robot, however, the court held that the Complaint failed to "allege that Robot participated in Lido DAO governance or made any statements about doing so."[9]

Turning to the investor defendants' involvement in Lido, the court reviewed the allegations and emphasized both: (1) the amount of LDO tokens bought by each investor (the more tokens a party has the more voting power it possesses); and (2) statements made by Lido and the investors regarding their particular involvement in the governance of Lido, particularly specific statements about how they might help Lido with their start-up expertise or, more generally, how they typically have helped others with their expertise. To the court, these allegations indicated an intent to be in a general partnership with Lido, despite the absence of typical partnership formalities. The court wrote that while the Complaint didn't "contain every detail about the DAO's operations and interactions with these investment firms," the three investor defendants "took an active role in its management or intended to do so."[10] And it was untroubled by the lack of partnership formalities, noting that those were only "default rules" such that in California, general partnerships can be written, oral, or implied. For the court, Samuels' allegations were enough to "allow the reasonable inference that a Lido DAO general partnership was formed."[11]

Lido and the Investor Defendants' Liability for Samuels' Losses

Regardless of whether they were a part of the general partnership, Paradigm and Andreessen Horowitz argued that they cannot be "derivatively liable for a partnership's violations of Section 12."[12] Section 12 liability is limited to "any person" who "offers or sells a security," whereas Section 11 liability pertains to "every person who was" a "partner in the issuer" of a false registration statement.[13] That distinction and express reference to partners in Section 11 "precludes partnership liability" under Section 12, in Paradigm and Andreessen Horowitz's view.[14]

The court disagreed, reasoning that the 1933 Act "clearly defines person to include a partnership."[15] Further, under California law, "general partners are jointly and severally liable for the obligations of the partnership."[16] While the court acknowledged that a partner cannot be "directly liable for a partnership's violation of Section 12 simply by being a partner," the "partnership can still be a co-obligor, under state law, for the partnership's liability."[17] At the motion to dismiss stage, this appears to be a distinction without a difference.

The court then turned to whether Lido was a "statutory seller" under Section 12(a)(1). Parties can be liable as statutory sellers under Section 12 "where they either pass title or other interest in the security directly to the buyer, or where they 'successfully solicit' someone else to buy a security motivated in part by a desire to serve their own or the security owner's financial interests."[18] The institutional investors argued that they did not solicit Samuels' investment. But the court rejected this view as an overly narrow reading of the statutory seller rules. It referenced several of Samuels' allegations to demonstrate Lido's solicitation including: Lido's efforts in getting LDO on different crypto exchanges; Lido's promotion of these listings and the increase in LDO's price through social media posts; and Lido's encouragement of people to engage in Lido's governance, thereby requiring them to purchase LDO tokens. The court concluded that simply because Samuels did not allege that he directly saw Lido's social media posts does not cause his allegations to fail.[19] And because the institutional investors were allegedly general partners of Lido they were, in effect, bootstrapped into responsibility for the alleged "solicitation" activities in which they did not themselves engage.[20]

The Applicability of Section 12(a)(1) in Non-Public Offerings

Lastly, the court analyzed whether Section 12(a)(1) only applies to public offerings and not to secondary market transactions like Samuels'.[21] Section 5(a)(1) of the Securities Act makes it unlawful to sell an unregistered security, specifically sales made "through the use or medium of any prospectus or otherwise."[22] The defendants argued that the use of the word "prospectus" limits Section 5(a)(1) sales to those made in an initial public offering and that the use of the word "otherwise" simply refers to other communications made in a public offering.

The court rejected that argument. It found that the use of the phrase "prospectus or otherwise" seemed "designed to ensure that the sale of any unregistered security is covered by Section 5(a)(1). "[23] That reasoning is "bolstered" by the fact that Section 4 lists certain exemptions for "transactions by any person other than an issuer, underwriter, or dealer," and "transactions by an issuer not involving any public offering."[24]

Consequences of Samuels

The Samuels Order raises a number of potential concerns for venture capital firms in California as well as for other participants in cryptocurrency token markets. First, the choice of business structure matters a great deal. Lido's corporate structure was a central point of dispute given the decentralized nature of Lido and its non-traditional configuration. In the absence of a recognizable corporate structure and the court's apparent distaste for an organization allegedly set up to "avoid legal liability for its activities," Judge Chhabria liberally applied principles of general partnership to Lido's structure, finding that investors who support the underlying business can become implied partners (sufficient to defeat a motion to dismiss) based solely on allegations of their intention to take an active role in management. Judge Chhabria simply characterizes three out of the four venture capital firms as general partners because they "took an active role in [Lido's] management or intended to do so."[25] Because a defendant cannot disprove its thought processes at the motion to dismiss stage, the court appears to have created a broad test for the survivability of claims against DAOs and those who invest in them. For practical purposes, Judge Chhabria appears to have converted DAOs formed in California into general partnerships, thus rejecting much of the utility of a decentralized entity.[26]

At a minimum, a DAO structure appears to provide negligible, if any, liability protection in California. Once a DAO is held to be a general partnership, those supporting or intending to support its business in any active way (which, after all, is the role of venture capital firm) risk unlimited liability as general partners. Thus, the result in Samuels may weigh in favor of venture capital firms investing only in entities that possess a familiar corporate governance structure or by restricting investments in DAOs to those which have been formed as LLCs under, for example, the laws of Wyoming or Utah. Venture capital firms then would fully know the parameters of the legal liability they may face should the entity they invest in be sued. But because most DAOs are not LLCs, institutional investors in DAOs are at risk.

Second, statutory text matters. In its Section 12(a)(1) analysis, the court relied on Justice Thomas' dissent in Gustafson v. Alloyd Co., Inc., 513 U.S. 561 (1995). In his dissent, Justice Thomas argued that the use of the word "prospectus" in Section 12(a)(2) was broadened by additional statutory language appearing in that section. Judge Chhabria extended that argument to apply to Section 12(a)(1), arguing that the use of the term "prospectus or otherwise" must mean that Section 12(a)(1) applies to private as well as public sales. However, the manner in which the court used the term "otherwise" in this context empties the word "prospectus" of any meaning. The majority in Gustafson made the points that Section 5 of the 1933 Act requires a seller to file a registration statement for "certain defined types of sales (public offerings by an issuer, through an underwriter) … " and that "[t]he primary innovation of the 1933 Act was the creation of federal duties … in connection with public offerings." [27] The district court also sidestepped the fact that Section 4 of the 1933 Act exempts sales of securities from registration requirements if the transaction at issue is undertaken by "any person other than an issuer, underwriter or dealer…." Because Samuels purchased his securities on the secondary market, he plainly did not purchase them from an issuer, underwriter or dealer.[28] Taken together, this language is likely to cause difficulties for a line of reasoning based on a 29-year-old dissent.

Third, procedural posture matters. Judge Chhabria consistently referenced the procedural posture of the case to justify his conclusions. Because the allegations need only be sufficiently pled on a motion to dismiss, Judge Chabbria did not delve further into plaintiff's allegations or defendants' arguments because they are able to be more fully developed during discovery or at trial. However, that is cold (or no) comfort for most class action defendants. It reinforces the unfortunate reality that the success of many class actions is predicated on the plaintiff prevailing at the motion to dismiss stage.[29] Settlement often becomes far more likely when a motion to dismiss is denied and results in a large payout to the plaintiff simply because defendants wish to avoid the burdensome exercise and costs associated with discovery. The current posture should signal to a judge what is at stake rather than the minimal threshold needed to be met as a means to avoid, for now, a deeper analysis of the allegations.

Lastly, the regulatory regime—or the lack thereof—matters. As the Samuels Order illustrates, in the absence of legislation, investors in California, including venture capital firms, are susceptible to broad liability exposure in connection with their efforts to support innovation in cryptocurrency.[30] To be fair, because of the absence of rulemaking, judges are largely left to opine on unfamiliar governance structures and circumstances that they are ill-equipped to navigate without much-needed guidance. The issues of what kind of crypto activity amounts to an "investment contract" and what activities amount to an "offer or sale" are still hotly contested in the courts and in Congress. Until those issues are clarified, however, a pure DAO structure does not appear likely to be an attractive vehicle for venture capital investment and active support.

The new Congress and the incoming Administration have promised to advance both legislation and rulemaking that will address these issues. Until that framework is in place, however, parties engaging and investing in cryptocurrency should exercise caution so as to insulate themselves from becoming the next unwitting class action defendant.