Quadriga bankruptcy: C$190 million may have turned into digital dust

In 2018, Quadriga Fintech Solutions Corp. (“Quadriga”), through its wholly-owned subsidiaries, was one of Canada’s largest online cryptocurrency exchanges. Quadriga survived the first boom and bust cycle of cryptocurrencies when the value of Bitcoin skyrocketed to C$25,000 and fell back down to C$4,200 all within one year, but it did not survive the death of its co-founder and CEO, Gerald Cotten. 

After graduating from university in November 2013, Cotten, together with Michael Patryn, co-founded Quadriga, an online exchange that allowed users to store, buy and sell various cryptocurrencies, upon depositing cash or cryptocurrency with the exchange. Quadriga made money by charging its users a fee for each transaction on the platform. In 2014, only C$7.4m worth of bitcoin was traded on the exchange.

In 2016, following the resignation of all other directors, Cotten became the sole director of Quadriga, which had no offices or employees, and engaged only a few general contractors.¹  The company was run from Cotten’s encrypted laptop at his home in Fall River, Nova Scotia. 

As the cryptocurrency markets soared in 2017, so did the trade volume on Quadriga with about C$1.2bn worth of bitcoin exchanged on the platform. While the spike in volume increased commissions, it also caused cashflow problems due to the exchange’s reliance on external payment processors as Quadriga did not have its own Canadian bank account that could  handle these transactions. Increased trading volumes also exposed the weakness of Quadriga’s accounting system. These were the primary causes of Quadriga’s eventual downfall. In June 2017, Quadriga announced that they lost ethereum currency worth C$14m due to a smart contract error, which bridled the confidence of Quadriga’s users in its ability to effectively manage the exchange.²  Following the crash of the cryptomarkets, Quadriga customers reported delays when attempting to withdraw fiat currency from the exchange and critical payment processing issues emerged. The oneman operation of Quadriga had grown so quickly that it wasn’t able to build out its infrastructure to service its growth.

On top of these payment processing and accounting concerns, on December 9, 2018, Cotten passed away at the young age of 30 during a trip to India. Cotten’s death was publicly announced by Quadriga on January 14, 2019. Without Cotten to manage the exchange and without a centralized cash management system and due to frequent issues with withdrawal of funds and payment processing, the market panicked, losing confidence in the viability of the cryptocurrency exchange. Worse yet, Quadriga stored most of its cryptocurrency deposits in digital “cold wallets” on the harddrive of Cotten’s encrypted laptop, which were inaccessible after his death or, if accessible, contained minimal cryptocurrency units. The missing cryptocurrency was estimated to be worth C$190m at the time. In January 2019, C$25.7m in cash held by Custodian Inc., a Quadriga payment processor, was frozen by the Canadian Imperial Bank of Commerce, as the bank could not determine the ownership of the money and could not contact the exchange following Cotton’s death. The money was later paid into court, which subsequently distributed the funds to  Custodian; however, as a result of the temporary loss in liquidity in addition to the missing cryptocurrency, coupled with massive deposit withdrawal demands, Quadriga was unable to satisfy its obligations to its users. On January 28, 2019, the Quadriga website and exchange platform was shut down as a result of liquidity constraints. Quadriga has not carried on business as a cryptocurrency exchange since that date. As a result of the platform shut down, all of Quadriga’s independent contractors, except for three individuals, were terminated effective February 28, 2019.

On February 5, 2019 Quadriga and certain of its affiliates filed for creditor protection under the Companies’ Creditors Arrangement Act (the “CCAA”) to manage Quadriga’s liquidity crisis. According to public filings, Quadriga had 363,000 registered users and owed in excess of C$260m in cash and cryptocurrency balances to 92,000 affected users. The claims ranged from very small amounts up to very large balances of up to C$70m. 

Pursuant to an initial order, the Nova Scotia Supreme Court, amongst other things, issued a general stay of proceedings and appointed Ernst & Young Inc. as the monitor (the “Monitor”) in the CCAA proceedings of Quadriga. Following the CCAA filing, the Monitor started investigating the assets and business of Quadriga and also tried to monetize the trading platform and recover the missing C$190m of cryptocurrency. The Monitor was able to recover all identified cash in the amount of C$25.2m held by various third-party payment processing companies, which were used by Quadriga to operate its business.

But, recovering the lost cryptocurrency was more complicated. To provide some technical background, cryptocurrency is generally stored in digital wallets. A wallet is a virtual address that stores a cryptocurrency trader’s private and public keys, which allows the trader to send and receive cryptocurrency. There are so called “hot wallets”, which are stored online, through a digital currency exchange, and “cold wallets”, which are stored offline on  a hard drive or a removable device such as an encrypted USB. While transactional activity and balances in any wallet are publicly available with  a wallet address, the ability to transfer the cryptocurrency within the wallet is restricted to individuals holding the required passwords or credentials and, in the case of cold wallets, physical custody of the device that the private key of the wallet is stored on. When a user opened an account with Quadriga, as is customary with other cryptocurrency exchanges, the user was provided with a hot wallet address (the “User Wallet”) to which the user could send cryptocurrency to be received by the exchange. The User Wallet address is typically (although not always) an address set up uniquely for a single user. The user’s access only allows for transfers to that address. Following depositing cryptocurrency in the User Wallet, the user does not have direct control over the balance and the exchange has custody of the deposited cryptocurrency. 

As is typical for cryptocurrency exchanges, upon receiving cryptocurrency in a User Wallet, Quadriga credited the user’s exchange platform account with the corresponding quantity of cryptocurrency. Quadriga then controlled the cryptocurrency in the User Wallet, typically pooling the cryptocurrency deposited by users and moving the cryptocurrency to wallets, both hot and cold, under the exchange’s control. Users with account balances can place orders for either other  cryptocurrency or traditional currency. When a user ultimately wanted to make a withdrawal of cryptocurrency from its account with the exchange, the user provided instructions to Quadriga to send cryptocurrency to a specified wallet outside the exchange’s control. Quadriga accessed its cryptocurrency pooled reserves to fulfill the transaction. Similarly, if a user wanted to withdraw fiat currency, the user would provide bank account or address information to the exchange. 

During the course of the investigation, the Monitor was able to recover C$902,743 worth of cryptocurrency from Quadriga’s hot wallets. According to public filings, Cotten generally transferred the pooled cryptocurrency deposits from the platform’s hot wallets into cold wallets on devices in Cotton’s control to protect the assets from possible hacking. Of course, after Cotten’s death and without the appropriate passwords, Quadriga’s cold wallets were inaccessible. To the extent that it was possible for the Monitor to gain access to Quadriga’s cold wallets on Cotten’s computer and USB drives, the Monitor found only nominal amounts of cryptocurrency in Quadriga’s cold wallets. Without the wallet passwords that were only known by Cotten, the Monitor has been unable to gain access to Quadriga’s full cryptocurrency inventory possibly stored on Quadriga’s cold wallets.

The Monitor also became aware of occurrences where the corporate and personal boundaries between Quadriga and Cotten were not formally maintained, and it appeared to the Monitor that Quadriga funds may have been used to acquire assets held outside the corporate entity. The Monitor obtained an asset preservation order, which prohibited Cotten’s wife, the Cotten estate, and other related entities from selling or otherwise disposing of their assets. The appraised value of the assets subject to the asset preservation order is C$12m, which could formally become part of Quadriga’s estate on further order by the Court. As of April 12, 2019, Quadriga had C$28.6m of known assets and around C$216m owing to its creditors, out which C$214.6m was owed to 76,319 unsecured creditors represented by representative counsel.  

In its fourth report to the Court, the Monitor concluded that the possibility that Quadriga would restructure and emerge from CCAA protection was remote. Subsequently, on April 11, 2019, the CCAA proceeding was terminated and the proceeding was converted into bankruptcy proceedings under the Bankruptcy and Insolvency Act (the “BIA”). The Monitor stated that as trustee under the BIA, it would have broader investigative powers to move along the investigation into Quadriga’s missing assets and maximize value for Quadriga’s creditors. The Monitor, now acting as trustee in Quadriga’s bankruptcy proceeding, is still looking to sell Quadriga’s trading platform. 

According to a statement on the website of the United States Federal Bureau of Investigation (the “FBI”) on June 3, 2019, the FBI, the Internal Revenue Service Criminal Investigation division, the US Attorney’s Office for the District of Columbia and the Department of Justice’s Computer Crime and Intellectual Property Section are conducting an investigation into the missing assets of Quadriga. 

The Quadriga case has many of the same complications as past cryptocurrency insolvencies in other jurisdictions relating to proper characterization and valuation of creditor claims, division of distributable assets among claim holders, and dissipation of assets. However, the Quadriga case also adds a layer of complexity that arises when no party remains available to unlock potentially very significant asset value. This will be a significant issue for future cases to ensure that all potential asset value can be preserved and distributed to creditors and other claim holders.