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Crypto-Savings Lawsuit Puts Principles of DeFi to the Test

The emerging world of decentralized finance offers the holders of cryptocurrency many of the amenities of a modern financial system, under the premise that blockchain technology can cut out the middlemen, replacing flesh-and-blood bankers with autonomous, self-governing computer programs.

The model promises lower costs and greater access. It also begs the question: Who’s responsible when things go wrong?

That is the question being raised by a class-action lawsuit filed in New York federal court against one such novel DeFi service, a cryptocurrency savings application called PoolTogether. The application, described as a “no loss prize game,” incentivizes users to save their cryptocurrencies by offering them the chance to win awards from the interest generated by the collected funds.

The lawsuit, filed by a software engineer named

Joseph Kent,

has challenged the legality of PoolTogether’s operation, saying the scheme is essentially a lottery and prohibited under New York law.

Many are calling decentralized finance, or DeFi, the “Wild West of finance.” This fast-growing industry aims to provide automated banking services for cryptocurrencies to everyone, with no middle men. But DeFi is still in its early stages, which means there are risks. WSJ explains. Photo illustration: Tammy Lian/WSJ

Although Mr. Kent’s lawsuit, supported by two plaintiffs’ law firms, is nominally focused on winning a potentially large pot of financial damages, it also appears to be a deliberate effort to put some of the DeFi community’s core doctrines to the test. A former technology lead for Sen. Elizabeth Warren’s 2020 presidential campaign, Mr. Kent is described in his lawsuit as someone “gravely concerned” at the prospect that cryptocurrency, which consumes voluminous amounts of electricity, could contribute to climate change, besides enabling bad actors to circumvent financial sanctions.

The size of the DeFi market has grown precipitously in the last year, bringing closer attention from the U.S. Securities and Exchange Commission and other regulators. The total value of assets deposited as collateral on DeFi platforms climbed to more than $111 billion in November, up feverishly from about $10 billion at the beginning of 2020, according to DeFi Pulse.

SEC Chairman

Gary Gensler

has questioned whether some DeFi services are actually as decentralized as their creators say, but so far there is little precedent on how U.S. courts might handle those claims.

According to legal experts, Mr. Kent’s lawsuit could be among the first to squarely address the question of who is legally accountable when a DeFi application—known as a “protocol”—is at odds with the law or causes actionable harm to a user.

“It’s an open question how courts and regulators are going to respond to these unique features of DeFi,” said

Carlton Greene,

a lawyer at Crowell & Moring LLP and a former anti-money-laundering regulator.

Filed in late October, Mr. Kent’s suit named PoolTogether Inc., a Delaware corporation, as well as one of the protocol’s founders and a raft of its investors, as defendants. Though the suit is still in early stages, lawyers for PoolTogether Inc. have already made an effort to create distance between the company and the protocol that bears its name.

In a filing last month,

Kevin Broughel,

a lawyer for PoolTogether Inc., said the company merely ran a website that provides how-to information for users to access the PoolTogether protocol. The company, he said, doesn’t own or control the protocol; instead, its operations are governed by its original coding, which can only be changed by a majority vote of holders of its proprietary token, called POOL.

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Mr. Broughel and lawyers for several of the investor defendants declined to comment further on the lawsuit. A lawyer for PoolTogether founder

Leighton Cusack

didn’t respond to requests for comment.

A lawyer for one of the protocol’s investors, Nascent US LLC, said the lawsuit was frivolous. “This apparently ideologically driven lawsuit is a waste of the court’s and everyone else’s time,” the lawyer,

Brian Klein,

said.

Besides PoolTogether’s governance, Mr. Kent’s lawsuit also raises questions on how its protocol fits into existing U.S. regulatory frameworks. The protocol, which is modeled on a U.K. financial product known as premium bonds, straddles two industries that government regulators have long kept a close eye on: financial services and gambling.

Launched in 1956, premium bonds were meant to encourage savings by people “who are not attracted by the rewards of interest, but do respond to the incentives of fortune,” in the words of Harold Macmillan, the U.K.’s Chancellor of the Exchequer at the time. Today, investors can put anywhere between £25 ($34) and £50,000 ($68,010) into the bonds, with more money creating better odds. Unlike a regular lottery, bondholders cannot lose their stake. Instead, prizes are generated from interest on the funds collected.

In the PoolTogether version, the protocol generates interest on cryptocurrency deposits by farming those funds out to third-party lenders. One of the DeFi’s world’s biggest crypto-lenders, Compound Labs Inc., also is named in Mr. Kent’s suit.

In 2014, the U.S. passed a law that allows states to create their own versions of the U.K.’s premium bonds, by authorizing banks and credit unions to create so-called prize-linked savings accounts.

Mr. Kent, who says he deposited $10 worth of cryptocurrency in PoolTogether in October, has argued the protocol doesn’t qualify as any of the institutions permitted under U.S. law to run prize-linked savings accounts. His suit has been filed under a New York state law that allows a person who purchases an illegal lottery ticket to bring a class-action lawsuit on behalf of themselves and other ticket-holders.

Under the state law, defendants in these lawsuits are liable for as much as twice the amount that the entire class paid for their tickets. PoolTogether “gamblers” have made deposits at least $122 million, according to Mr. Kent’s lawsuit.

The PoolTogether defendants have yet to fully respond to Mr. Kent’s claims. But Mr. Broughel, in PoolTogether Inc.’s December filing, said his client would ask the judge to force Mr. Kent to arbitrate the matter, or alternatively dismiss the case as a matter of law. The parties are scheduled to discuss their arguments next month at a hearing in the U.S. District Court for the Eastern District of New York.

In the filing, Mr. Broughel previewed some of his client’s arguments for dismissing the suit. He expressed skepticism of Mr. Kent’s motives, saying his $10 deposit was an apparent effort to create standing for his lawsuit. Mr. Broughel also argued that the PoolTogether protocol isn’t a lottery, and that deposits made by savers don’t qualify as the purchase of lottery tickets.

Mr. Cusack, PoolTogether’s founder, also has defended the protocol against the lawsuit.

“It’s filed by someone who works in politics and the stated motivation is that cryptocurrencies are bad for the environment,” he wrote in November on a PoolTogether message board.

He added: “It’s clearly written by someone who doesn’t understand how protocols operate or even what PoolTogether is.”

Write to Dylan Tokar at dylan.tokar@wsj.com

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