The US Bankruptcy Court recently broke new legal ground by recognizing a decentralized finance entity—a decentralized autonomous organization—as a debtor for the first time. A DAO is an entity governed by smart contracts and code rather than centralized leadership, where decision-making is collectively made by token holders based on pre-set rules on a blockchain.
Earlier this year, Hector DAO—an entity that managed crypto-asset investments through smart contracts—faced severe financial difficulties, leading to its placement under joint receivership in the British Virgin Islands.
On July 15, US Bankruptcy Judge Michael Kaplan granted recognition to the BVI receivership—a historic moment as Hector DAO became the first DAO recognized as a debtor under US bankruptcy law.
This ruling set a significant precedent by acknowledging that DAOs, despite their decentralized and autonomous structures, could be treated as debtors in a cross-border insolvency context.
As more potential DeFi failures loom on the horizon, it’s crucial to protect consumers and develop legal frameworks to address such cases, especially those that don’t fit neatly under the US Bankruptcy Code, particularly Chapter 11. Hector DAO’s experience underscores the unique challenges decentralized entities pose and the need for adaptable legal solutions.
Hector DAO’s case began as stakeholders, including token holders and developers, grew concerned about its ability to meet financial obligations. Without a central authority, Hector DAO struggled to manage its assets and liabilities, highlighting DeFi’s unique complexities.
The DAO’s substantial cryptocurrency holdings and decentralized nature made traditional bankruptcy proceedings extremely challenging. A DAO typically can’t file for bankruptcy proceedings in the US, as it lacks a formal legal entity status, such as incorporation, that’s required under the US Bankruptcy Code to be recognized as a debtor eligible for bankruptcy protection. Therefore, it necessitated a different legal approach.
Addressing the concerns associated with Hector DAO, joint receivers were appointed to manage its assets, and ancillary proceedings were initiated under Chapter 15 of the US Bankruptcy Code in New Jersey. Chapter 15 allows US courts to recognize and assist foreign insolvency proceedings, providing a mechanism to coordinate the protection and management of assets across jurisdictions.
The court’s decision highlighted the adaptability of US bankruptcy law, demonstrating its capacity to accommodate the evolving landscape of decentralized entities. The implications of this case extend far beyond Hector DAO, signaling to the broader DeFi community that US courts are willing and able to adapt existing legal frameworks to address the complexities of decentralized finance.
Hector DAO’s Chapter 15 recognition underscores the judiciary’s evolving role in interpreting laws related to novel technologies, particularly as regulatory agencies face increasing constraints following the June 28 Loper Bright US Supreme Court decision. As a result, courts in this era have become more powerful venues for adapting legal frameworks to accommodate emerging technologies.
For decentralized entities like DAOs, which don’t fit neatly into traditional legal categories, such judicial flexibility is crucial. It also strengthens the role of bankruptcy courts, in particular, as rule-makers and regulators in the crypto space—a trend that some scholars have already noted.
By recognizing Hector DAO as a debtor under Chapter 15, the court set a legal precedent for treatment of DAOs, and emphasized the importance of judicial adaptability in ensuring that new technologies aren’t left without legal recourse.
This ruling may serve as a blueprint for other courts dealing with the complexities of decentralized finance, ensuring that the legal system remains responsive and relevant in an era of rapid technological change.
However, it is important to understand the distinction between Chapter 11 and Chapter 15 of the US code. Chapter 11 is designed for reorganization of businesses with significant creditor involvement, requiring a structured approach and specific debtor qualifications. In contrast, Chapter 15 focuses on cross-border insolvency, allowing for recognition and coordination of foreign proceedings within the US legal system.
This flexibility is crucial for DAOs, which may not meet the stringent requirements of Chapter 11. Still, they could seek recognition under Chapter 15—the cross-border insolvency part of the code—if they are involved in a qualifying foreign proceeding and are recognized as a legal entity in that jurisdiction.
Hector DAO’s Chapter 15 bankruptcy case represents a pivotal moment in the intersection of decentralized finance and traditional legal systems. The US Bankruptcy Court’s recognition of Hector DAO as a debtor sets a precedent for how DAOs can navigate financial distress within existing legal frameworks.
As decentralized entities continue to evolve, the implications of this case will likely shape the future of bankruptcy law and the broader DeFi ecosystem, ensuring the legal system can adapt to challenges of new and innovative technologies.
The case is Hector DAO, No. 3:24-bk-16067, 6/17/2024.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Nizan Geslevich Packin is professor of law at Baruch College Zicklin School of Business, with focus on financial regulation, fintech law, ethics, and privacy.
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