Lawsuits aimed at recouping UST/Luna losses test uncharted waters

Legal trouble is brewing for Terraform Labs following last week’s collapse of TerraUSD, the native stablecoin of the blockchain that the startup developed. 

Even as Do Kwon and the Terraform Labs (TFL) team attempt to salvage the situation pending the results of a vote on forking the Terra blockchain, angry investors in the stablecoin system, which also includes another non-stablecoin token called Luna, are lawyering up in an attempt to recoup some of their losses.

Do they have a case? And who else besides TFL might become targets of lawsuits? Given the general lack of regulatory clarity around stablecoins, the legal fallout from the TerraUSD (UST) debacle could have far-reaching implications.

Things get muddy

On Wednesday, South Korean media reported that a major law firm, LKB & Partners, is suing Do Kwon and co-founder Daniel Shin on behalf of five investors who claim their damages in the Terra collapse amount to 1.4 billion won (US$1.1 million).

The investors claim they suffered losses in both UST and Luna, the token associated with the stablecoin. Luna was part of a system of market incentives that was supposed to help UST maintain its peg. It was always possible to “burn” a dollar's worth of Luna to “mint” one UST, and it was also always possible to redeem one UST for a dollar’s worth of Luna.

In the event of a de-pegging in either direction, this system was supposed to create arbitrage opportunities that traders could exploit and in turn increase or decrease the amounts of UST in circulation.

The complaints, filed with Seoul Southern District Prosecutors Office, allege fraud and illegal fundraising, according to the Korean news agency Yonhap. The law firm also said that it was receiving inquiries about the suit from other investors as far afield as the US and Italy.

In addition to LKB & Partners' lawsuit, other investors are organizing online and may launch their own suits. A group called Lunascam on the South Korean web portal Naver has gained more than 2,400 members on its page since its launch on May 13, many of whom say they invested heavily in Luna. Pinned messages from the group creators brand both Kwon and Shin “swindlers” and call for other investors to contact them and participate in their plans for legal action.

Many Lunascam members appear to believe that Kwon and Shin were the masterminds behind a “well-planned Ponzi scheme.”

They point to TFL’s Anchor Protocol as a “bait product” because stablecoin farmers could reap 19.5% yields by lending UST to the protocol, and argue that Anchor was deliberately launched in March 2021 following a “sluggish” period for Luna. Anticipation of its release saw Luna prices quadruple from the end of February to its March 17 launch. 

But here it gets a bit muddy. The group also says that TFL’s large bitcoin purchases starting in late February are evidence of the founders “cashing out.” 

According to TFL, this money went to a Singapore-based nonprofit called the Luna Foundation Guard (LFG). Before the de-pegging, the LFG had been building up a reserve of about $3 billion in bitcoin and other cryptocurrencies that was supposed to function as a "release valve" in the case of heavy pressure to sell UST. The LFG then spent that money in a failed attempt to stabilize UST last week. Its reserves now total $87 million.

Trying to brand Terraform Labs’ ecosystem as a Ponzi scheme likely won’t get people very far legally, according to Austin Campbell. He’s familiar with Ponzis: Campbell, who now works as a director of growth at Paxos, previously worked at JP Morgan and was one of the people who looked into the company’s involvement in the Bernie Madoff scandal, for which the bank ultimately had to pay out $2.6 billion to settle charges. “Crypto needs to get much better at throwing this word around,” he says. 

Ponzi schemes work by paying returns to existing investors using the money brought into the scheme by new investors. Usually promising high returns with little or no risk, they can only sustain themselves as long as new investors keep coming in, and they collapse when this slows or if too many people try to cash out. “That was definitely not what was going on here,” says Campbell. “There was a blockchain. It was producing staking returns. They had people building on it. There were actual products.”

Instead, we may end up seeing cases centered around consumer protection and whether TFL represented its products and the risks of investing accurately. 

“The angle that people should be looking at is how TFL marketed this thing,” says Campbell. “Did they imply it had reserves, did they imply it was backed, whether they fully disclosed the risk or whether they were doing the classic promoter thing of talking about all the good things and none of the bad things.”

Legal experts tell The Block this approach would most likely target the founders and Terraform Labs.

If this happens, investigators will document TFL’s advertising, announcements and interviews available online — and then try to ascertain whether what was promoted publicly was in line with what the company was saying behind closed doors.

A prolific tweeter, some of Kwon’s trash-talking may also come back to haunt him. On March 11, for instance, he said they would “keep growing reserves until it becomes mathematically impossible for idiots to claim de-peg risk.” While it doesn’t seem that either Kwon or TFL claimed de-pegging was impossible at this moment, it could be that they didn’t accurately communicate risks of which they were aware.

The extent to which TFL accurately informed the public about the risks of investing in UST will be fought over in court. First, though, TFL needs a new legal team. Its lawyers jumped ship shortly after the collapse and the reason in unclear. TFL has now sought outside legal counsel.

TFL declined a request for comment from The Block. On Saturday, Do Kwon tweeted that he is "happy to engage with any lawsuit or regulatory inquiry to the best of our ability — we have nothing to hide."

Uncharted legal waters

Over the past few years, stablecoins have proved a fertile ground for lawsuits. There’s also been “a marked increase in appetite” lately among litigation funders looking to fund crypto class-actions, says Tom Marshall, an associate at CMS law firm.

“The challenge will be in pulling together a class, who are likely to be geographically spread and with varying appetites to pursue further action,” says Marshall.

Many jurisdictions have stablecoin regulations in the works, but for now these systems still operate in uncharted legal waters. So when things go wrong it’s been left to investors to pursue legal recourse after the fact.

Indeed, amid the UST-related chaos of last week many people may have missed the launch of a class-action suit in California involving a different stablecoin, called GYEN, designed to maintain parity with the Japanese yen. The lawsuit, brought by US-based investors, targets both Japanese internet giant GMO Internet’s GMO-Z.com Trust Company, which created the coin, and Coinbase, which promoted it and allowed trading in it.

In November, GYEN de-pegged and skyrocketed to about 7.5 times higher than the yen. The next day, Coinbase disabled trading for the coin. It's neither clear how many customers were able to capitalize and cash out before the freeze, nor how many suffered losses before Coinbase re-opened trading for the stablecoin. 

“You can’t tell investors that a coin is pegged to a fiat currency when it’s not,” says Elizabeth Kramer, the lawyer acting on behalf of investors in the GYEN case. Kramer says Coinbase and GMO engaged in “plain old deception.”

In court documents, plaintiffs allege that GMO published numerous claims that GYEN was pegged 1:1 with the Japanese yen, including in promotional videos and on their website, and that these claims were also mimicked by Coinbase. Based on this, purchasers might have believed that the value of the token was necessarily equal to the yen.

Additionally, based on a prior destabilizing event last May, plaintiffs argue that both GMO and Coinbase were aware that the peg was “prone to break and that such an event would be likely, if not certain, when GYEN opened for trading on Coinbase.”

Exchanges around the world that listed UST or Luna are likely watching this particular case closely.

What should exchanges that list a stablecoin be required to tell users about the risks? And who all is legally liable when a stablecoin loses its peg? Policymakers around the world have yet to directly address questions like this. The GYEN case and any future lawsuits targeting those involved in the UST debacle will give the courts the chance to weigh in.

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