alerts & publications
DAOs and Bankruptcy5월 24, 2022
They are all the rage: People are forming decentralized autonomous organizations (DAOs) as vehicles to purchase or bid on a wide range of assets—NFL teams, golf courses, fossil-fuel companies, even a copy of the U.S. Constitution. In our previous client alerts about DAOs, we looked at what DAOs are, their tax considerations, and regulatory questions. In this, the latest edition, we are looking at DAOs and bankruptcy.
As we’ve explained in our earlier alerts, a DAO is a decentralized, autonomous investment or financial organization that is controlled by the organization’s members rather than by a central corporate entity. DAOs typically share several features: a “bottom-up” governance model built on computer code, with each member having a voice in the project’s future and how funds are spent; the issuing of tokens to raise money for the DAO or to establish a governance protocol for the DAO (e.g., a token entitles a member to a vote); and smart contracts that make decisions for the DAO automatically based on a computer code or consensus mechanism. DAOs are rarely formal legal entities, unlike a corporation or limited liability company, and there is typically no CEO, board of directors, or other management.
The Section 363 Sale Process
What is a Section 363 sale? Section 363 of the U.S. Bankruptcy Code is the primary mechanism by which a debtor-in-possession or a trustee of a bankrupt entity may sell estate assets to a prospective purchaser. A “363 sale” is a court-supervised process, which affords a purchaser certain rights and protections that may not be afforded to a buyer in an out-of-court sale. Sales of assets under Section 363(f) are “free and clear” of claims, liens, encumbrances, and other interests. Purchasers who are found by a court to have acted in “good faith” may also be protected against the purchase being unwound on appeal.
A 363 sale is typically quicker and more transparent than sales outside of bankruptcy. The debtor-in-possession or the trustee often proposes a condensed timeline for a 363 sale as outlined by specific “bid procedures” and a corresponding asset purchase agreement (APA), which has to be approved by the bankruptcy court.
The bid procedures provide the roadmap for how the sale will be conducted, and they give the debtor-in-possession the flexibility to get the highest or best bid for the benefit of the creditors. Such procedures may also offer protections to a “stalking horse bidder”—an initial, committed bidder for the debtor’s assets (if one has been designated by the debtor-in-possession)—and to establish a floor for subsequent bidding. Such protections may include a break-up fee (typically from 1% to 4% of the purchase price) and an expense reimbursement provision (usually capped). The stalking horse bidder also has the benefit of being “first,” and can negotiate the terms of the APA, which will serve as the form for subsequent bidders. These protections compensate the stalking horse bidder for incurring the upfront time and expense of vetting the transaction while others could outbid the stalking horse.
There are drawbacks to some parties in the 363 process. One is the “as-is, where-is” nature of the sale of assets, which means that a debtor-in-possession or a trustee is usually in no position to provide representations or warranties about the assets it purports to sell—nor will there typically be any surviving entity to stand behind any representations. But the quick and as-is nature of the process is often counterbalanced with the “free and clear” benefits of the bankruptcy court’s order approving the sale. Another drawback is that the transparent nature of Section 363 sales creates a greater risk that a prospective purchaser may be outbid. While competition presumably benefits the debtor and the estate (drawing up the price for a higher distribution to creditors), it does not help a purchaser who hopes to buy on the cheap. Last, an out-of-court sale (as opposed to the 363 process) may avoid any negative effects of a bankruptcy filing on the debtor’s business operations.
Can DAOs Bid in a 363 Sale Process?
The 363 sale process raises a number of questions and some interesting issues for DAOs. Are DAOs particularly well-suited to the 363 sale process because of how fast they can raise funds? How should the DAO be structured to participate in a live auction? Who, ultimately, will be the decision-maker for the DAO? How would a DAO consummate a 363 sale (who would have authority to execute the APA)?
On the one hand, a DAO might be an efficient and rational player in a 363 process. The smart contracts implementing the DAO’s purpose can quickly—autonomously and automatically—respond at decision-making points. That certainly could be an advantage in an auction, where the consideration is simply cash (like bidding for a copy of the Constitution). But bids for a business are not always simple and predictable; they are not always apples-to-apples. Can smart contracts be written to contemplate oranges too? Can they account for assumption of certain contracts, treatment of employees, specific performance as a remedy? In those cases when the coding cannot contemplate the twists and turns of a sale, it is yet to be seen whether the voting rights that DAO members receive upon purchasing tokens will be sufficient to guide a DAO through a quickly moving 363 sale. This has been addressed in non-bankruptcy circumstances by a DAO designating limited decision-making authority to certain individuals.
The decentralized nature of a DAO may jibe with the disclosure and transparency of a 363 sale. A DAO could work well for buyers seeking anonymity, and, with a DAO, financial wherewithal can be easily established (as was the case for ConstitutionDAO). Also, a DAO’s smart contracts are visible, verifiable, and publicly auditable.
So, can a DAO become a successful purchaser with all the protections and benefits in a court-supervised process under Section 363? Section 363(m) of the Bankruptcy Code protects from reversal or modification on appeal a sale or lease of property “to an entity that purchased or leased such property in good faith.” First, a DAO is not an “entity,” though this point may be addressed by a DAO’s use of, among other options, a Cayman Foundation—a popular structure that operates as a hybrid between a company and a trust. The good faith finding also looks at the integrity of the buyer’s conduct. The anonymity of a DAO’s members may present a hurdle to establishing the record necessary for such a finding. And anonymity may mean that the DAO cannot attest that the sale is not being made to an insider, and this could subject the sale to greater scrutiny. The ability to enter the DAO’s smart contract into evidence and the decentralized nature of the DAO’s decision-making may be helpful factors in these analyses.
Assuming that the DAO is the successful bidder of a 363 sale, since the DAO is typically not a separate legal entity, the DAO token-holders should also consider the implications of having partial direct ownership of the purchased assets. It may be possible for the DAO’s smart contracts to address these post-sale closing ownership rights.
DAOs present unique challenges in navigating the Section 363 sale process. Understanding the underlying legal nature of DAOs is critical to any analysis, and O’Melveny will be closely monitoring the legal issues surrounding DAOs, including their involvement in federal bankruptcy cases. Please contact the attorneys listed on this Client Alert or your O’Melveny counsel to see how we can help you navigate this complex and emerging area of practice.
Each client alert in this series includes some crypto-lingo at the end to help you navigate the cryptoverse. Here are some terms:
Vaporware—A provocative idea that will probably never happen.
Cryptosis—A condition with one symptom: The afflicted has been bitten by the crypto bug, and will not stop talking about crypto.
KYC—“Know Your Customer” is a form of identity verification required by many crypto exchanges since regulatory agencies imposed it in 2017. The SEC’s Rule 17a-3(17) requires that exchanges make a good-faith effort to obtain personal information and create a record for each account.
Moon—If the price of a cryptocurrency coin is soaring, it is said to be mooning.
 See 11 U.S.C. § 363(b), (c).
 See 11 U.S.C. § 363(f).
 See 11 U.S.C. § 363(m).
 This issue also seems relevant should a DAO become financially distressed and need to seek protection under the Bankruptcy Code. A future client alert will explore this issue further.
 See, e.g., 11 U.S.C. § 363(m) (good faith purchaser must be an “entity”); see also Barnes v. 309 Rte 100 Dover LLC, 2020 U.S. Dist. LEXIS 209188, at *21 (D. Vt. Nov. 6, 2020) (affirming, in relevant part, that a Member Group comprised of individuals and entities were good-faith purchasers under Section 363(m) of the Bankruptcy Code).
 See, e.g., C & J Clark Am. Inc. v. Carol Ruth Inc. (In re Wingspread Corp.), 92 B.R. 87 (Bankr. S.D.N.Y. 1988) (sales to fiduciaries in Chapter 11 cases are not per se prohibited but are subject to heightened scrutiny because they are rife with possibility of abuse).
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Peter Friedman, an O’Melveny partner licensed to practice law in the District of Columbia, Matthew Hinker, an O’Melveny partner licensed to practice law in Delaware and New York, William K. Pao, an O’Melveny partner licensed to practice law in California, Scott Sugino, an O’Melveny partner licensed to practice law in California, Jennifer Taylor, an O’Melveny partner licensed to practice law in California, Laura Smith, an O’Melveny counsel licensed to practice law in Texas, and Emma Persson, an O’Melveny associate licensed to practice law in Texas, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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