Quadriga filed for court protection from its creditors on 31 January 2019, following the unexpected death of its CEO and founder Gerald Cotten, on 9 December 2018. The filing has resulted in speculation that the death may have been a hoax, that significant cryptocurrency or the means to access it have been lost, that Quadriga’s trading may have been inflated, as well as creditor’s claims in excess of CAD 260 million (USD 195 million) and further damage to the fledgling Blockchain industry.

According to Canadian court filings, 0984750 B.C. Ltd was a Canadian company that did business as QuadrigaCX or Quadriga Coin Exchange (Quadriga), operating an online cryptocurrency exchange platform in Canada. Quadriga was founded by Gerald Cotten and launched on Boxing Day in 2013. In November 2018, Quadriga estimated it processed between 60% to 90% of the volume of digital currency exchange transactions in Canada.

Like many exchanges, Quadriga not only allowed users to buy and sell various cryptocurrencies on the QCX Platform, but also to store cryptocurrencies and deposit traditional currency in anticipation of purchase orders. Quadriga experienced difficulty in procuring traditional bank accounts with Canadian banks and was reliant upon the use of third-party payment processors to receive and return traditional currency.

Quadriga then maintained a series of ‘hot’ wallets – cryptocurrency wallets that are connected to the internet to facilitate immediate transactions – and ‘cold’ wallets that were offline and stored physically to avoid hacking.

The crypto boom in 2017 led to a significant increase in trading amid speculation in the bull run on bitcoin, which grew from USD 975 in January 2017 to USD 19,000 by the end of the year, and other cryptocurrencies during that year. Many blockchain businesses achieved significant growth during that period which stretch the operational limits of developing businesses and gave rise to unexpected issues.

The influx of fiat currency to Quadriga (to exchange into cryptocurrency) led to Quadriga having to co-ordinate multiple third-party payment providers and multiple wallets. Amid disputes arising in relation to CAD 28 million (USD 21 million) of fiat currency received from 388 depositors, the Canadian Imperial Bank of Commerce (CIBC) initially froze five accounts linked to Costodian Inc, one of Quadriga’s payment processors, and then successfully applied to the Ontario Superior Court to allow it to pass the funds over to the Accountant of the Superior Court, to then allow the court to identify the proper owners of the money. Given what transpired, these owners may ultimately be the lucky ones.

With other banks also restricting the intake on customer funds for the purpose of purchasing cryptocurrency, it is reported that Quadriga was unable to process all of the fiat currency received, leaving Quadriga unable to process user withdrawals with fiat currency on a timely basis. It is claimed that Cotten used personal money to fund some user withdrawals, but that would only have led to an inevitable commingling of assets.

Then, on 9 December 2018, Cotten died unexpectedly, from complications related to Crohn’s disease, whilst travelling in India. At the time of his death, Cotten was the sole director of Quadriga. In 2015, Quadriga’s parent had been planning to go public but in 2016 all of the directors other than Cotten resigned and the British Columbia Securities Commission issued a cease-trade order. The boom of 2017 was therefore managed primarily by Cotten, who reportedly conducted many of Quadriga’s operations from his home.

Following his death, it took the company almost two months to elect new directors and the employees were not able to access all of Quadriga’s cold wallets. Suffering a significant liquidity crisis, on 31 January 2019, Quadriga applied to the Nova Scotia Supreme Court for a moratorium on proceedings to stop a free-for-all grab for assets to allow it to propose a plan of action to its creditors. On 5 February 2019, the Supreme Court appointed Ernst & Young Inc (Canada) as monitors pursuant to the Canadian Companies’ Creditors Arrangement Act.

Concerns about potential fraud

Prior to the appointment of the monitors, the issues surrounding Quadriga had resulted in an obvious liquidity crisis. However, court filings leading to the appointment of the monitor reveal that traditional currency had also been lost, either temporarily or permanently. It was also reported that the private keys to various of Quadriga’s hot and cold wallets were known only to Cotten, and therefore no longer capable of being accessed. If a wallet’s private keys are lost, they can no longer be accessed and the funds stored on them are essentially lost. The claim that private keys are lost is a plausible (if negligent) explanation for the loss of assets and liquidity issues. However, those Quadriga keys that were not misplaced are leading to wallets with lower balances than they should be.

One of the significant benefits of cryptocurrency is the ability to trace transactions through the public ledger. Whilst the monitors continue in their role, professional and amateur sleuths are poring over the public ledger, tracing transactions involving Quadriga and highlighting evidence that Quadriga was engaging potentially questionable business practices, including back-to-back transactions on other exchanges, rather than accessing wallet storage even when Cotten was alive, to satisfy customer withdrawal requests.

This, together with revelations of apparently inadvertent transfers of significant sums into inaccessible cold wallets has fuelled the conspiracy theories that Cotten’s death was faked as he could no longer continue to maintain his scheme with the sudden collapse of crypto-prices at the end of 2018. That was not helped by the revelation that Cotten updated his will shortly before his death. The monitors have now, as of 1 April 2019, recommended that the bankruptcy transition to proceedings under the Canadian Bankruptcy and Insolvency Act which would allow for a bankruptcy trustee to have investigatory powers, in addition to the ability to sell assets and commence any appropriate legal proceedings.

Could, and how would, this happen in Cayman?

There is not yet an operational crypto-currency exchange in the Cayman Islands. The development of a regulatory sandbox may allow further businesses to develop here, including potential exchanges. However, many of the issues arising with Quadriga are common with custodians and analogies can be found with recent cases such as the liquidation of Caledonian Bank and the provisional liquidations of Abraaj Investment Management Ltd (Abraaj Manager) and Abraaj Holdings (Abraaj Holdings) in the Cayman Islands.

In the Cayman Islands we reserve the term ‘bankruptcy’ for individuals and use ‘insolvency’ for corporate entities, in contrast to Canada and the United States where bankruptcy is used for all of those processes which involve a debtor who cannot, or may not be able to, pay all their creditors.

‘Insolvency’ in Cayman is defined on a pure cash-flow basis – whether a corporate vehicle can pay its creditors as they fall due, rather than the balance sheet basis, which looks at the value of assets on a company’s books versus its liabilities. Accordingly, a company in Cayman with high value assets cannot stave off an insolvency process simply by pointing at accumulated assets but must have adequate measures in place to be able to pay its creditors as and when necessary. If not, then the company may be placed into liquidation by the court, with its estate being administered by neutral, court appointed liquidators.

Ignoring allegations of fraud, which will always inevitably result in losses to creditors, Quadriga’s liquidity issues appear to have been generated by classic failures in corporate governance – focusing too much control on one key man, inadequate back-ups for accessing cold wallets, lack of oversight and management of transactions involving all of the wallets, and insufficient provision in place to access liquidity when issues arose with payment providers. These would have been exacerbated by the extreme volatility of the market in which Quadriga was operating. Adequate contractual arrangements may have enabled the board to stave off pressing demands for payment but invoking a bankruptcy/insolvency process in a situation like Quadriga can ultimately lead to a preservation of greater value for all stakeholders. In a case like Quadriga’s the company may consider that its liquidity issues are not inevitably terminal, and that the business may recover, if given time to restructure its affairs and find those missing cold wallets (for example) – or allow potential fraud and misconduct to be investigated.

In the Cayman Islands, that process would involve the entity, or a ‘friendly’ creditor petitioning the court for an order that the company be wound up and official liquidators be appointed in place of its board. Whilst it may seem perverse that the first step in ‘rescuing itself’ may be to seek its own liquidation, this invokes a collective remedy, designed to prevent the fracturing of a company by creditors taking individual action, which would lead to greater costs in duplicating and defending multiple actions. Given it is a collective remedy, there is a rigid process that must be followed to give creditors due notice and protection and therefore further steps must be taken to get immediate assistance.

In Cayman, that process involves the appointment of liquidators on a provisional basis (provisional liquidators) and the imposition by the Court of a moratorium on creditor action, to allow the company to formulate and present a compromise to its creditors. The appointment of provisional liquidators is a flexible remedy and they can be given powers to work in conjunction with current management to explore and resolve financial issues.

Alternatively, provisional liquidators may be appointed at the request of creditors or shareholders to prevent further dissipation of assets or mismanagement – taking control, or joint sig rights of the private keys at an earlier stage may prevent further deterioration or loss of valuable remaining assets.

When appointed, therefore, provisional liquidators will look to secure and preserve the assets of a company. When looking at Quadriga’s assets, a distinction has to be drawn between those assets which it holds on trust for the users of its exchange, those assets in which property had passed to Quadriga and those assets its holds in its own right. Liquidation does not alter property rights and so to the extent that assets on trust can be identified they must be returned.

The distributed ledger, in theory, provides an ideal audit trail for tracing and verifying trust claims as cryptocurrency should not be capable of being mixed in a way that it loses its identity. This should provide some hope to Quadriga’s customer. In the recent freezes by Binance of funds stolen by hackers from Cryptopia customers were identified and alerted.

However, other common law rules or contractual triggers may lead to property in the currency being lost and to the extent that they have been mixed or misappropriated, the trust claim evaporates into an unsecured creditor claim that relies on the liquidators finding value in realising other assets of the estate.

The liquidation of Caledonian Bank in Cayman involved a substantial Cayman bank that was forced into liquidation as a result of regulatory issues in the United States (for which the SEC was later significantly criticised) with partners of Ernst & Young (also involved in Quadriga) appointed as liquidators. This led to substantial disputes about assets held on trust and the return of those to bank depositors outside of the ordinary context of liquidation. However, the liquidity crisis and inability to immediately locate crypto and traditional currency, suggests that unlike Caledonian, in which the majority of depositors ended up getting repaid most of the monies they were owed, many who think their assets were safely held on trust will be left reliant upon the liquidators to track down or take action to recover missing assets. If assets are returned to the liquidators, they may be traceable by specific customers. But being able to trace a property right into a wallet that is no longer accessible will provide scant comfort for customers and they may then be left with unsecured claims against the estate.

After the ring-fencing and return of trust assets, a situation like Quadriga could be analogous to the liquidation of the Abraaj Manager because in theory its primary value, other than outstanding commissions payable, is represented in its trading platform. Abraaj was a private equity firm operating across six continents with more than USD 13 billion of assets under management until turmoil in 2018 led to the appointment of provisional liquidators. Most of the assets under management were held through a network of investment vehicles, meaning that Abraaj Manager’s true value in the investment management platform through which those vehicles operated, but to which the investments were not tied. Abraaj Manager has been in provisional liquidation since mid-2018, seeking to market the investment management platform without the stigma of a full liquidation process. The QCX Platform, with its accumulated intellectual property and client base could, if purchased by a new company that took pains to correct the issues that led the current disaster, be sold for value that would see some return to those customers who have lost assets. A similar plan is being mooted by Brock Pierce, who claims he wants to rehabilitate Mt. Gox and effect a return to the victims of the Mt. Gox collapse by giving creditors a stake in a new platform. While a liquidator in the Cayman Islands could undergo a form of restructuring to allow for equity in the platform to be returned to creditors, the more usual practice is to auction the platform to a willing bidder and distribute the consideration to the creditors. Equity and rehabilitation (or restructuring as we would call it) provides potential upside return to those who lost out, but a sale and distribution provides an opportunity to close off losses and seek new opportunities.

There is clear utility in cryptocurrency and the markets will continue to develop until they are stabilised either by regulation or commercial market practices. In the absence of regulation, those who continue to invest in and utilise cryptocurrencies would be wise to follow some prudent strategies to ensure those exchanges with the best practices become the trusted players in the market and do not fall victim to another Quadriga or Mt. Gox: Conduct due diligence (initial and ongoing) on the exchange and its backers to ensure that sensible best practices are being used; diversify risk across various exchanges; seek to use non-custodial exchanges which split the exchange and custodian risk; and avoid depositing currency on exchanges for longer than necessary for a trade.

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