Decentralised Finance (DeFi): Litigation risk and safeguards

The growth of decentralised finance (DeFi) has resulted in the rapid development of both regulatory and judicial oversight. As regulators and courts grapple with issues ranging from the definition of “property” to questions of control and governance, including how to determine relevant laws and courts, we are seeing an increase in requests for advice on exposure to civil disputes risk from a range of industry participants, including financial institutions, investors and software engineers.

This article sets out areas of disputes risk which companies and individuals in the DeFi space should be aware of.

Jurisdiction and governing law

Determining the appropriate court and governing law in the context of DeFi disputes (previously considered here) when it is unclear where certain parties or assets are located, and where smart contracts can be silent on this issue or provide for offshore jurisdictions raises a variety of difficult issues.

Among these issues, determining the location of a crypto asset is arguably the most critical. It affects taking security over an asset, buying or selling an asset, proprietary remedies in respect of an asset and which courts will take jurisdiction over a dispute involving that asset.

Law reform bodies in the UK and Europe have started projects to address these issues. UNIDROIT adopted Principles on Digital Assets and Private Law in May 2023 and, in the UK, in February 2024, the Law Commission launched a call for evidence as part of its project on digital assets in private international law. The Law Commission will consider critical topics such as:

• the country where parties should litigate their dispute.
• the appropriate governing law?
• how ensuing judgments may be enforced in foreign jurisdictions.

Following the introduction of the Property (Digital Assets etc) Bill into Parliament by the new government, which addresses the overall property status of digital assets, it is likely that these questions will be a central focus of the Law Commission as it and other bodies engage with key stakeholders to build consensus on these questions.

Leaving jurisdictional issues to one side, as with any dispute the precise approach that a claimant party might take will be informed by the specific context. However, we have seen the following types of claim.

Contractual claims

A complex web of relationships arises in the context of many DeFi arrangements and this provides different bases for contractual claims, notwithstanding the often opaque structures that sit behind DeFi arrangements.

Identifying contracts (and, in some instances, their scope) in this context is itself a challenge – it may be that the terms and conditions of use of a DeFi platform, or the parameters for introducing a code, are construed to be a contract. Our team have previously considered the uncertainty inherent in many DeFi arrangements, and the fact that it may not immediately be clear what the contractual arrangement is and whether agreements made pursuant to DeFi protocols satisfy the formal requirements required to be considered as binding legal contracts.

Considerations of whether execution formalities have been complied with, whether a party has capacity, and circumstances where multiple parties are involved all give rise to legal uncertainty in this context. This remains an issue for prospective claimants and defendants alike.

Smart contracts raise particular issues regarding formalities, execution and interpretation. For instance, if a smart contract is entered into automatically by a computer it may be difficult to establish who are the parties to the contract and where it was concluded. If the contract does not operate as expected, it may be uncertain as to whether underlying code forms part of the contract and how it should be interpreted. Our three-stage guide to Smart legal contracts under English law discusses how the courts may approach these issues.

Claims in contract that may be made in this context could range from disagreements concerning incentive structures associated with a DeFi platform or the validity of smart contracts, to alleged underperformance of a platform and associated claims regarding breaches of warranties or representations.

In circumstances where there are gaps, or where it is not immediately clear that a contractual arrangement exists, prospective claimants may consider other avenues for making a claim, such as potentially making a claim in tort.

Tortious claims

Tortious claims are being formulated in a variety of different ways including (for example):

• Notwithstanding the decentralised governance structures, prospective claimants may assert that software developers or other participants in a DeFi arrangement owe a duty of care to consumers or other participants. This issue arose in Tulip Trading Limited (A Seychelles Company) v Bitcoin Association For BSV & Ors [2023] EWCA Civ 83 which concerned the determination of whether there was a real prospect of success to Tulip Trading’s claim that bitcoin developers owed fiduciary duties to users and that, insofar as Tulip Trading was concerned, the bitcoin developers had breached that duty. The Court of Appeal found that there was a real prospect of success – our team’s article on this case is available here.
• Increasingly, we are seeing threats of action being taken in the context of statements made by crypto providers or other DeFi entities, and their affiliates in the public domain. These can relate to, for example, statements relating to that party’s role or authority over a platform, statements regarding the rationale for making changes to underlying code, or other comments intended to influence the users of a relevant platform.

Unjust enrichment

Where assets have been wrongfully transferred (for example, by mistake), claimants have brought unjust enrichment claims against intermediaries and recipients (including the exchanges with whom the recipients held the receiving wallets). While the claimant was unsuccessful, the recent case of D'Aloia v Persons Unknown Category A & Ors [2024] EWHC 2342 (Ch) has provided significant guidance on multiple issues that unjust enrichment claims in respect of digital assets are likely to encounter, and adds to a growing body of case law and commentary that such a claim is, in principle, available at English law. In particular, it may prompt exchanges to examine their ongoing anti-fraud procedures and regulatory compliance. Our team’s article on D’Aloia is available here.

Follow-on claims resulting from regulatory compliance and enforcement

As the regulatory landscape continues to develop in the UK (for example, see here for our team’s article on the financial promotions regime for cryptoassets), entities are put in a difficult position of simultaneously needing to comply with new laws which impose restrictions on their operations, while also adhering to commercial agreements. While those new regulations are as yet untested by the courts, there is scope for disgruntled counterparties to bring claims asserting that a party is going beyond what the law requires (or conversely, not meeting its regulatory requirements) or otherwise bringing claims against it for failing to perform its obligations.

Similarly, in the event that a DeFi arrangement becomes subject to enforcement action, for example, because of sanctions or AML issues, this may give rise to a host of civil disputes including concerning the diminished value of assets or inability to access those assets.

Managing the risks

To mitigate the risk of claims, consider:

1. Developing policies and procedures concerning public-facing statements and the use of disclaimers, where appropriate.
2. Monitoring and developing mechanisms for managing rapid regulatory change.
3. Where relevant, reviewing contractual terms to determine if there is (for example) appropriate provision for rapid regulatory change.
4. Analysing the governance and voting structure (if applicable) of the relevant platform – this will have a bearing on questions on whether a platform can be considered truly “de-centralised”.

It is, however, critical to be aware of the double-edged sword effect that the introduction of certain strategies may have. For example, introducing policies and procedures may work to reduce risks of claims of (for example) negligent misstatement, but increase the risk that a prospective claimant may assert that there is indeed a centralised governance structure (thus potentially increasing the risk that the existence of certain duties may be alleged). Balancing these risks will require a holistic assessment of a given entity, having regard to the specific factors relevant to it and its operational model.