How Hector DAO’s bankruptcy case shapes the future of DeFi

The U.S. bankruptcy court recently broke new legal ground by recognizing a decentralized finance corporation – a decentralized autonomous organization – as a debtor for the first time. A DAO is a corporation that is not governed by a central leadership but by smart contracts and code, with decisions made collectively by token holders based on preset rules in a blockchain.

Earlier this year, Hector DAO – a company that managed investments in cryptocurrency assets via smart contracts – ran into severe financial difficulties, resulting in it being placed into receivership in the British Virgin Islands.

On July 15, U.S. Bankruptcy Judge Michael Kaplan recognized BVI bankruptcy – a historic moment as Hector DAO was the first DAO to be recognized as a debtor under U.S. bankruptcy law.

This ruling set an important precedent by recognizing that DAOs, despite their decentralized and autonomous structures, can be treated as debtors in a cross-border insolvency.

With more potential DeFi bankruptcies on the horizon, it is critical to protect consumers and develop legal frameworks for such cases, especially those that do not fit neatly under U.S. bankruptcy law, particularly Chapter 11. Hector DAO's experience highlights the unique challenges presented by decentralized entities and the need for adaptable legal solutions.

The Hector DAO case began when stakeholders, including token holders and developers, became increasingly concerned about the company's ability to meet its financial obligations. Without a central authority, Hector DAO struggled to manage its assets and liabilities, highlighting the unique complexity of DeFi.

The DAO's significant cryptocurrency holdings and its decentralized nature made traditional bankruptcy proceedings extremely difficult. A DAO cannot typically file for bankruptcy in the U.S. because it lacks the formal legal status, such as incorporation, required under U.S. bankruptcy law to be recognized as a debtor eligible for bankruptcy protection. Therefore, a different legal approach was required.

To address the concerns associated with Hector DAO, joint receivers were appointed to manage the assets and a collateral proceeding was initiated in New Jersey under Chapter 15 of the U.S. Bankruptcy Code. Chapter 15 allows U.S. courts to recognize and assist in foreign bankruptcy proceedings and provides a mechanism to coordinate the protection and management of assets across different jurisdictions.

The court's decision underscored the adaptability of U.S. bankruptcy law and demonstrated its ability to adjust to the evolving landscape of decentralized businesses. The implications of this case extend well beyond Hector DAO and signal to the broader DeFi community that U.S. courts are willing and able to adapt existing legal frameworks to account for the complexities of decentralized finance.

The recognition of Hector DAO under Chapter 15 underscores the evolving role of the judiciary in interpreting laws related to new technologies, particularly as regulators face increasing constraints after June 28. Loper Bright Decision of the US Supreme Court. As a result, the courts have become more powerful during this time when it comes to adapting legal frameworks to new technologies.

For decentralized organizations like DAOs that do not fit clearly into traditional legal categories, such legal flexibility is crucial. It also strengthens the role of bankruptcy courts in particular as rule-setters and regulators in the crypto space – a trend that some academics have already noticed.

By recognizing Hector DAO as a debtor under Chapter 15, the court set a precedent for the treatment of DAOs and emphasized the importance of judicial adaptability to ensure that new technologies are not left without redress.

This ruling can serve as a blueprint for other courts grappling with the complexities of decentralized finance, ensuring that the legal system remains responsive and relevant in an age of rapid technological change.

However, it is important to understand the difference between Chapter 11 and Chapter 15 of U.S. law. Chapter 11 is intended for the reorganization of companies with significant creditor involvement and requires a structured approach and specific debtor qualifications. In contrast, Chapter 15 focuses on cross-border bankruptcies and allows for the recognition and coordination of foreign proceedings within the U.S. legal system.

This flexibility is critical for DAOs, as they may not meet the stringent requirements of Chapter 11. Nevertheless, they could seek recognition under Chapter 15 – the part of the law that deals with cross-border bankruptcies – if they are involved in a relevant foreign proceeding and are recognized as a legal entity in that jurisdiction.

Hector DAO's Chapter 15 bankruptcy represents a turning point at the intersection of decentralized finance and traditional legal systems. The U.S. Bankruptcy Court's recognition of Hector DAO as a debtor sets a precedent for how DAOs can navigate financial difficulties within existing legal frameworks.

As decentralized businesses continue to evolve, the impact of this case will likely shape the future of bankruptcy law and the broader DeFi ecosystem, ensuring that the legal system can adapt to the challenges posed by new and innovative technologies.

The case is Hector DAO, No. 3:24-bk-16067, June 17, 2024.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Information about the author

Nizan Geslevich Packin is a professor of law at the Zicklin School of Business at Baruch College with a focus on financial regulation, fintech law, ethics, and privacy.

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