David Z. Morris is CoinDesk's Chief Insights Columnist. He holds Bitcoin, Ethereum, and small amounts of other crypto assets.

After a series of apparent collapses, defaults and liquidity crises across protocols like Terra and crypto-affiliated lending platforms and hedge funds, we’re seeing the first signs of what is likely to be a wave of legal action from users and investors who lost money.

But those cases will require navigating some tricky questions. Because lending protocols in particular have been studiously vague in describing the exact nature of their services, it's not clear what sort of responsibilities these companies have when it comes to depositor's funds.

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“The jury is still out on that,” according to Marcelo Diaz-Cortes, a securities litigation lawyer with the Miami-based firm LKLSG. Diaz-Cortes contrasts currently distressed crypto projects with straightforward fraud cases he’s helped litigate, such as Argyle Coin, a supposedly diamond-backed token that was in reality a Ponzi scheme. “It was a straight fraud – it didn’t really exist.”

That wasn’t the case with the most dramatic collapse of recent weeks, the unwinding of the TerraUSD “algorithmic stablecoin” in May. That token’s design was so deeply flawed that its demise was easy for experts to predict – but its mechanism was described transparently and, it seems, mostly accurately.

“It wasn’t a secret as to how the thing functioned,” Diaz-Cortes said. “If that was the way it really worked, [judging it fraudulent] would be a tough sell for a court, for a jury.”

That doesn’t mean there’s no case. In standard securities cases, fraud can still be found “when someone at the company or promoting it had a little extra knowledge and didn’t disclose it,” according to Diaz-Cortes.

A court might, for instance, examine statements from Do Kwon or Terraform Labs about transitioning UST to a backed model, or rumors that the token was secretly bailed out by third parties when it previously lost its peg in May of 2021. Either could imply that, despite public statements, the team knew its creation didn’t actually work as advertised.

Another good sign for anyone pursuing relief directly from Terra’s creators is that they appear to now be under investigation in Korea, one of the group’s centers of operation. While such investigations are usually kept under wraps until they conclude, they can still provide firepower for plaintiffs.

“It’s certainly something we put in our complaints,” Diaz-Cortes said. “Look, the government’s sniffing, the government filed an action. … At hearings, we’ll point to it as circumstantial evidence of something fishy going on.”

Some wiped-out Lunatics have instead focused legal firepower on the exchanges, with one class-action suit targeting Binance.US, an exchange that sold the UST token and described it, according to the complaint, as “safe.” Diaz-Cortes believes such suits against exchanges could have legs if an exchange or other promoter was “not completely forthright about the potential [risk] exposure.”

The same group of plaintiffs, which includes pseudonymous Terra victim and researcher Fatman, has said it will also file suit against Terraform Labs, the entity that created a litany of apps – like the lending protocol Anchor – that used the LUNA and UST tokens. That possibility highlights one of the key underlying points in the Terra case: Despite leaning on the rhetoric of “decentralization,” Terra was tightly controlled by a small inner group. That could in and of itself become further grounds for claims of misrepresentation and fraud.

Is Celsius a bank?

The “lending platform” Celsius could be accused of similarly exaggerated claims – while it tied itself rhetorically to DeFi, or decentralized finance, it is an entirely centralized entity that merely acted as an intermediary to DeFi. That also makes it a ripe target for lawsuits after it froze withdrawals – potentially a prelude to default.

One early, if flaccid, signal came from YouTube influencer BitBoy, who last week announced his intent to file a class action against Celsius after it froze his funds. Just days later, BitBoy withdrew the proposal after remembering that he had been paid to promote Celsius, as he was for years paid directly to promote scams. This is the epitome of the extremely useful expression “hoisted by his own petard.” Truly a shame.

Regardless, more competent actors are sure to draw a bead on Celsius. The problem is that it and similar “lending platforms” have avoided clear classification and regulation. Depositors seeking high yields often used these platforms as crypto banks, despite the lack of regulation and consumer protections.

In fact, recent regulatory actions taken against interest-bearing accounts at lending platform BlockFi characterize the offerings as unregistered securities. BlockFi itself isn’t facing quite the same financial problems as Celsius, so it might not wind up a target of private lawsuits. But if a court thinks Celsius or a similar platform were also actually selling securities rather than banking services, it could be harmful for depositors because buying a security doesn’t imply any right to redeem it for a specific price.

Another legal question is what Celsius actually did with depositors’ money to earn the yield it passed onto them. As CoinDesk reported this month, the platform began pursuing increasingly risky strategies starting in early 2021, including sending client funds to volatile DeFi “yield farms,” later including Luna’s Anchor protocol.

Though Celsius apparently withdrew funds from Anchor before the Terra collapse, the general investment strategy could face scrutiny in court.

Under conventional banking law, there’s no duty to disclose the loans or other strategies used to generate yield on customer deposits.

“[Banks] don’t owe customers special duties of care. They just owe those deposits back when you ask for it,” Diaz-Cortes said. “You’re not able to bring in issues as to, ‘you shouldn’t have done this with the money.’”

He added that “it’s just a black and white thing” whether banks can meet their obligations and “not necessarily fraud” if they’ve re-hypothecated funds.

But that’s only true up to a certain point. “The question will be whether they did something reckless, fraudulent and irresponsible” with client funds, Diaz-Cortes said. “It’s going to come down to what they knew and what was happening behind the curtain.”

Alternatively, plaintiffs might argue that Celsius wasn’t a bank at all but rather a broker investing on their behalf.

“In terms of these crypto deposit accounts, they’re a little bit of both [bank and brokerage],” Diaz-Cortes said. “You’re not just putting $10 in and expecting $10 back. You’re leaving it there [to earn] interest.”

That could lower the bar for what counts as fraud, according to Diaz-Cortes. “With brokerage accounts, sometimes you do get those claims that this was advertised as a safe investment, and you breached the duty.”

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David Z. Morris is CoinDesk's Chief Insights Columnist. He holds Bitcoin, Ethereum, and small amounts of other crypto assets.

David Z. Morris is CoinDesk's Chief Insights Columnist. He holds Bitcoin, Ethereum, and small amounts of other crypto assets.