DeFi exploits: who is liable when a smart contract is hacked, and can you recover your funds?

In November 2024, a DeFi lending protocol called Radiant Capital was exploited for $58 million. The attacker found a vulnerability in the protocol's smart contract that allowed them to borrow funds without sufficient collateral. Within four minutes, $58 million was drained from the protocol. The users who had deposited their cryptocurrency into Radiant's lending pools lost their funds. There was no bank to call, no insurance to claim, and no regulator to complain to. The funds were gone — moved through cross-chain bridges to the attacker's wallets before anyone could react.

This scenario has played out dozens of times in the DeFi space. In 2022 alone, over $3 billion was stolen from DeFi protocols through exploits, hacks, and rug pulls. Major incidents include the Wormhole bridge hack ($326 million), the Nomad bridge hack ($190 million), the Beanstalk Farms exploit ($182 million), and the Wintermute hack ($160 million). In each case, users who had deposited their cryptocurrency into the protocol lost their funds, and the question arose: who is liable, and can the funds be recovered?

As a crypto compliance counsel, I have worked with victims of DeFi exploits — both individual users and institutional investors — to explore legal avenues for recovery. The legal landscape is nascent and complex. In this article, I explain the legal theories of liability in DeFi exploits, the practical challenges of pursuing claims, and the real cases that are shaping this emerging area of law.

The DeFi landscape: why traditional legal concepts struggle

Decentralized Finance (DeFi) refers to financial protocols built on blockchain technology — typically Ethereum — that operate without a central intermediary. Lending protocols (Aave, Compound), decentralized exchanges (Uniswap, Curve), and yield aggregators (Yearn, Beefy) allow users to deposit cryptocurrency and earn returns, trade tokens, or borrow against their holdings. The protocols are governed by smart contracts — self-executing code that automatically enforces the protocol's rules.

The appeal of DeFi is that it is permissionless and transparent — anyone can use it, and all transactions are visible on the blockchain. The risk is that it is also unregulated and uninsured. When a traditional bank is robbed, the depositors' funds are insured by the government (FDIC in the US, EDIS in the EU). When a DeFi protocol is exploited, there is no insurance — the funds are simply gone.

Traditional legal concepts struggle with DeFi for several reasons:

• No identifiable defendant: Many DeFi protocols are governed by DAOs (Decentralized Autonomous Organizations) — groups of token holders who vote on protocol changes. The DAO has no legal personality, no registered address, and no identifiable officers. Who do you sue?
• Jurisdictional uncertainty: DeFi protocols operate on the blockchain, which exists in no specific jurisdiction. The developers may be anonymous and located anywhere in the world. The smart contracts are deployed on Ethereum, which is not a jurisdiction. Where do you file the lawsuit?
• Terms of service: Most DeFi protocols have terms of service that disclaim all liability. Users must agree to these terms (or at least acknowledge them) before using the protocol. The disclaimers typically state that the user assumes all risk of loss, including the risk of smart contract bugs.
• Anonymity: The attacker who exploits the protocol is typically anonymous. Even if you can identify the attacker's wallet address, you cannot easily connect it to a real person. And even if you can identify the person, they may be in a jurisdiction that does not cooperate with your legal system.

Theories of liability in DeFi exploits

Despite these challenges, several legal theories have been advanced for recovering losses from DeFi exploits:

1. Negligence against the developer

The most straightforward theory is negligence: the developer who wrote the smart contract had a duty to write secure code, breached that duty by writing buggy code, and the breach caused the user's loss. This theory is appealing because it targets an identifiable defendant (the developer) and relies on well-established legal principles.

The challenge is proving the duty of care. In traditional software development, the duty of care is established by the contractual relationship between the developer and the user. In DeFi, there is typically no direct contractual relationship — the developer writes the code, deploys it on the blockchain, and users interact with it autonomously. The developer may argue that they have no relationship with the users and therefore no duty of care.

However, in cases where the developer actively promoted the protocol, solicited user deposits, and represented that the code was secure (particularly if the code was audited), a court may find that a duty of care exists. The key question is whether the developer's actions created a reasonable reliance on the security of the protocol.

2. Negligent misrepresentation against the auditor

Most major DeFi protocols commission security audits from firms like CertiK, Trail of Bits, ConsenSys Diligence, or OpenZeppelin. The audit report typically identifies vulnerabilities and rates the protocol's security. Users rely on these audit reports when deciding whether to deposit funds.

If an auditor failed to identify a vulnerability that was later exploited, users may have a claim for negligent misrepresentation. The theory is that the auditor represented the protocol as secure (by issuing a clean or positive audit report), the representation was false (because a vulnerability existed), and users relied on the representation to their detriment.

The challenge is that audit reports typically include disclaimers. The standard disclaimer states that the audit is not a guarantee of security, that the audit covers only the code reviewed at a specific point in time, and that the auditor is not liable for any losses. Courts have not yet definitively ruled on whether these disclaimers are enforceable in the context of DeFi audits.

However, if the auditor missed an obvious vulnerability — one that a competent auditor should have identified — a court may find that the disclaimer does not protect the auditor from liability for gross negligence. This theory is particularly promising because auditors are typically identifiable entities with known addresses and insurance.

3. Products liability (defective product)

A more novel theory is to treat the smart contract as a product and apply products liability law. Under this theory, the smart contract is a defective product (because it contains a vulnerability), and the developer (as the manufacturer) is strictly liable for injuries caused by the defect.

This theory has not been tested in court, and there are significant challenges. Products liability law traditionally applies to physical goods, not software. Courts have been reluctant to extend products liability to software, and it is unclear whether a smart contract qualifies as a product. However, some legal scholars have argued that the autonomous nature of smart contracts (they execute without human intervention) makes them more analogous to products than to services.

4. Unjust enrichment against the attacker

If the attacker can be identified (which is rare but not impossible), the users can file a claim for unjust enrichment — the theory that the attacker was unjustly enriched at the users' expense. This claim is relatively straightforward to prove (the attacker took the users' funds without legal basis), but the challenge is identifying the attacker and obtaining jurisdiction over them.

In several cases, attackers have been identified through on-chain analysis, IP addresses (obtained through Norwich Pharmacal orders served on ISPs), or KYC records from exchanges where the attacker cashed out. Once identified, civil claims and criminal charges can be pursued.

5. Breach of contract against the protocol DAO

Some DeFi protocols have established legal entities (typically foundations in Switzerland, Singapore, or the Cayman Islands) that govern the protocol. If the protocol's terms of service constitute a contract between the protocol and the users, a breach of that contract (e.g., failure to maintain adequate security) could give rise to a breach of contract claim.

The challenge is that the terms of service typically disclaim all liability. However, some jurisdictions (including Switzerland and the EU) have consumer protection laws that may render certain disclaimers unenforceable, particularly if the user is a consumer rather than a professional investor.

Tracing and recovering exploited funds

Parallel to legal claims against developers and auditors, there is the option of tracing and recovering the exploited funds directly. This is the same methodology used in crypto fraud recovery — see our crypto scam recovery guide — but with some DeFi-specific considerations:

• Flash loan attacks: Many DeFi exploits use flash loans — loans that are borrowed and repaid within a single transaction. The attacker borrows a large amount, exploits the vulnerability, and repays the loan, all in one transaction. This means the exploit is a single transaction on the blockchain, making it easier to identify but also meaning the attacker's wallet is only briefly exposed.
• Cross-chain movement: After the exploit, the attacker typically moves the funds through cross-chain bridges to obscure the trail. See our chainhopping article for the tracing methodology.
• Mixer usage: Some attackers use mixers (Tornado Cash on Ethereum, or Bitcoin mixers) to break the tracing trail. After the OFAC sanctioning of Tornado Cash in 2022, many DeFi attackers have switched to alternative mixing methods or chainhopping instead.
• White hat negotiations: In some cases, the protocol team negotiates with the attacker to return the funds, offering a bounty (typically 10% of the exploited amount) in exchange for the return of the remaining 90%. This has been successful in several cases (e.g., the Poly Network hack, where the attacker returned $610 million after negotiations).

The tracing and recovery process for DeFi exploits is similar to other crypto recovery cases: identify the attacker's wallet, trace the funds through bridges and mixers, and file freeze requests at exchanges where the funds are headed. The main difference is that DeFi exploits often involve larger amounts, which means law enforcement is more likely to be interested and the resources available for tracing are greater.

Case study: the Ronin Bridge hack

In March 2022, the Ronin Bridge — a sidechain bridge for the Axie Infinity game — was hacked for $625 million. The attacker exploited a vulnerability in the bridge's validator set, allowing them to authorize fraudulent withdrawals. The attack was attributed to the Lazarus Group, a North Korean state-sponsored hacking organization.

The US Treasury Department sanctioned the Ethereum address associated with the hack, making it illegal for any US person to transact with the address. This was the first time OFAC sanctioned a specific Ethereum address. Chainalysis and TRM Labs traced the funds through multiple wallets and bridges, identifying approximately $30 million that was cashed out on the Bitget exchange.

In April 2022, the FBI seized approximately $30 million in cryptocurrency from the Lazarus Group's wallets — the first seizure of North Korean crypto theft. The funds were returned to the Axie Infinity developers (Sky Mavis), who used them to compensate affected users. This case illustrates that recovery is possible when law enforcement has the resources and the political will to act, particularly when the attack is attributed to a sanctioned nation-state.

However, the vast majority of the $625 million was never recovered. The Lazarus Group moved the funds through Tornado Cash (before it was sanctioned) and then through chainhops to various blockchains, eventually cashing out through OTC brokers in China and Russia. The recovered $30 million represents less than 5% of the total loss.

The role of DeFi insurance

Several DeFi insurance protocols have emerged to address the risk of smart contract exploits. Nexus Mutual, InsurAce, and Bridge Mutual allow users to purchase coverage against smart contract failures. If the covered protocol is exploited, the insurance pays out to the policyholders.

The coverage is typically limited to specific protocols and specific types of exploits. The insurance payout is determined by a claims assessment process, which involves the insurance protocol's community voting on whether the claim is valid. The process can take weeks, and the payout may be less than the full loss (insurance protocols typically have limited capital pools).

If you are a DeFi user, purchasing insurance from a reputable DeFi insurance protocol is one of the most effective risk mitigation strategies. However, the insurance market is still young, and the insurance protocols themselves carry risk (if the insurance protocol is exploited, the policyholders may not receive their payout). Diversification — both across protocols and across insurance providers — is essential.

Regulatory developments affecting DeFi liability

The regulatory landscape for DeFi is evolving rapidly. Several developments are likely to affect liability for DeFi exploits:

• EU MiCA regulation: The Markets in Crypto-Assets regulation, fully effective in 2024, includes provisions that may apply to DeFi protocols. While MiCA primarily targets centralized crypto service providers, its broad definitions could encompass some DeFi protocols — particularly those that have a identifiable operator or governance entity.
• US SEC enforcement: The SEC has increasingly targeted DeFi protocols, arguing that many protocol tokens are unregistered securities. While this is primarily a regulatory enforcement issue, it has implications for liability — if a protocol is found to have issued unregistered securities, the operators may face civil liability to users.
• CFTC enforcement: The Commodity Futures Trading Commission has asserted jurisdiction over DeFi protocols that offer derivatives or leveraged trading. The CFTC has brought enforcement actions against Ooki DAO and other DeFi protocols, establishing that DAOs can be held liable for regulatory violations.
• UK Financial Services and Markets Act: The UK's FSMA, as amended in 2023, brings cryptoassets into the regulatory perimeter. While DeFi is not specifically addressed, the broad definitions may apply to some DeFi activities.

The trend is clear: DeFi is moving from an unregulated space to a regulated one. As regulation increases, the legal avenues for recovery from DeFi exploits will expand. But regulation also means that DeFi protocols will need to implement compliance measures, which may increase costs and reduce the appeal of DeFi relative to traditional finance.

The DAO liability question: can a DAO be sued?

One of the most novel legal questions in DeFi is whether a DAO (Decentralized Autonomous Organization) can be held liable for losses caused by a protocol it governs. DAOs are collective governance structures where token holders vote on protocol changes, parameter adjustments, and treasury management. The question is whether the DAO itself — as distinct from the developers or the foundation — can be a defendant in a lawsuit.

In the US, the CFTC's enforcement action against Ooki DAO in 2023 established an important precedent. The CFTC held that a DAO can be held liable for regulatory violations, even though the DAO has no legal personality, no registered address, and no identifiable officers. The court agreed, finding that a DAO is an "unincorporated association" and can be sued under applicable law. The token holders who participated in governance votes were held to be members of the association and potentially liable.

This precedent has significant implications. If a DAO can be held liable for regulatory violations, it can potentially be held liable for civil claims (negligence, breach of contract) as well. The practical challenge is enforcement — a DAO has no assets to seize (the treasury is controlled by smart contracts, and the token holders are anonymous). But the Ooki case suggests that courts are willing to pierce the DAO veil and hold individual token holders liable, at least in cases of active governance participation.

Some DAOs have responded to this risk by establishing legal wrappers — typically Swiss foundations, Cayman Islands LLCs, or Marshall Islands DAO LLCs — that provide a legal entity to interface with the traditional legal system. The legal wrapper holds the DAO's treasury and enters into contracts on the DAO's behalf. If the protocol is exploited, users can sue the legal wrapper, which has identifiable directors and registered assets. However, the legal wrapper typically disclaims liability for smart contract failures, and the enforceability of these disclaimers varies by jurisdiction.

Case study: the Wormhole bridge hack and recovery efforts

In February 2022, the Wormhole bridge — one of the largest cross-chain bridges connecting Ethereum, Solana, and other blockchains — was hacked for $326 million. The attacker exploited a vulnerability in the bridge's signature verification, allowing them to mint wrapped assets without backing and withdraw real assets from the bridge.

Wormhole was operated by Certus One, a subsidiary of Jump Trading. Unlike many DeFi protocols, Wormhole had a clear corporate structure — the operator was a identifiable legal entity. This gave users a potential defendant for legal claims. However, Wormhole's terms of service disclaimed all liability for losses, and no lawsuit was filed.

Instead, Jump Trading (the parent company) chose to recapitalize the bridge — they injected $326 million of their own funds to make affected users whole. This was a business decision: Jump Trading's reputation in the crypto space depended on Wormhole's reliability, and allowing users to take the loss would have damaged the company's credibility. This case illustrates that even when legal recovery is uncertain, the threat of reputational damage can incentivize protocol operators to compensate users voluntarily.

On the tracing side, the attacker's wallet was identified immediately, and Chainalysis traced the funds. However, the attacker (who remains unidentified) did not attempt to cash out through regulated exchanges. Instead, the funds were held in the attacker's wallet for over a year, during which time the value of the stolen assets fluctuated significantly. As of 2025, the majority of the stolen funds remain in the attacker's wallet, unrecovered. This case demonstrates that even with immediate identification and tracing, recovery is not guaranteed if the attacker does not attempt to cash out through traceable channels.

Practical advice for DeFi users

If you use DeFi protocols, here are practical steps to reduce your risk and improve your chances of recovery if an exploit occurs:

• Check for audits: Only use protocols that have been audited by reputable firms. Check the audit report — not just the fact that an audit exists. Look for the severity of identified vulnerabilities and whether they were fixed.
• Diversify: Do not deposit all your crypto in a single protocol. Spread your deposits across multiple protocols to limit your exposure to a single exploit.
• Purchase insurance: If available, purchase insurance from a DeFi insurance protocol. The cost is typically 2-5% of the deposited amount per year, which is a reasonable price for protection against total loss.
• Document your deposits: Keep records of your deposits — the protocol, the amount, the date, and the transaction hash. If the protocol is exploited, these records are essential for filing claims.
• Act quickly if exploited: If a protocol you use is exploited, contact us immediately. We can begin tracing the exploited funds and file freeze requests at exchanges before the attacker cashes out. Time is critical.
• Join class actions: Several law firms are pursuing class actions against DeFi protocols and their auditors. If you are affected by an exploit, joining a class action can be a cost-effective way to pursue recovery.

The bottom line

DeFi exploits are a significant risk for anyone using decentralized financial protocols. The legal avenues for recovery are limited but growing — negligence claims against developers, negligent misrepresentation claims against auditors, and tracing/recovery of the exploited funds are all viable under certain circumstances. The regulatory landscape is evolving, and as DeFi becomes more regulated, the legal protections for users will likely improve.

If you have lost funds in a DeFi exploit, contact us. We can assess your legal options, trace the exploited funds, and coordinate with law enforcement and forensic firms to maximize your chances of recovery.