By Calvin Horsten, JD, Osgoode Hall Law School and Articling student at Aird & Berlis LLP and Kaliopi Dimitrakoudis, JD, MBA, MA, Osgoode Hall Law School and Articling student at Borden Ladner Gervais LLP

The emergence of a “cryptocurrency revolution” has disrupted traditional financing and subjected perceived certainties to scrutiny.1 The absence of a robust regulatory framework has led to considerable risk in an insolvency environment, exacerbating fraud, mismanagement, and difficulty recovering assets. In 2019, Canada saw its first insolvency filing by a cryptocurrency trading platform (“CTP”) in Quadriga Fintech Solutions Corp (“QuadrigaCX”).2 Since then, the U.S. has seen a spate of insolvency filings by CTPs, with Canada experiencing tangential effects.3 As evidenced by three landmark U.S. cryptocurrency filings, we are now witnessing a sectoral meltdown, beginning with Voyager Digital (“Voyager”), leading to Celsius Network (“Celsius”), and finally FTX Trading Ltd. (“FTX”).4

To date, a consensus has not been reached on whether cryptocurrency (“crypto”) qualifies as property, a commodity, or a security; who the owner or beneficial owner of crypto assets that are deposited with a CTP is; and how and when crypto assets should be valued.5 With crypto seemingly defying legal classification, insolvency practitioners (“IPs”) have been forced to rely on legislation that does not appropriately contemplate its nuances, giving rise to especially troubling outcomes for customers in an insolvency.

Part XII of Canada’s Bankruptcy and Insolvency Act (“BIA”) deals with “Securities Firm Bankruptcies” and contains provisions that are arguably adaptable to the fair and efficient administration of a bankrupt CTP.6 This article previews the potential application of Part XII to CTP bankruptcies.

I. CTPs and Securities Firms: Apples and Oranges

Echoing the securities landscape prior to the introduction of Part XII of the BIA, time- consuming and costly litigation relating to ownership and valuation have emerged in the crypto context. The Celsius proceeding serves as a striking example, where the U.S. Bankruptcy Court faced challenges identifying the rightful owner of “Earn” accounts.7 Without a crypto framework, the court was left to rely on Celsius’ customer agreements, which led to some creditors being paid from the same fund as customers, reducing potential recovery for customers.8

Amidst these ongoing challenges, regulators have begun treating crypto as a security.9 For instance, on January 5th, 2023, the Securities and Exchange Commission (“SEC”) filed a case against crypto brokerages Genesis Capital and Gemini Co. for being in violation of securities regulations, seeking penalties, injunctive relief, and the return of gains to investors.10 As stated by SEC Chair Gary Gensler, “the charge builds on previous actions to make clear to the marketplace and the investing public that crypto lending platforms and other intermediaries need to comply with our time-tested securities laws. Doing so best protects investors.”11 Additionally, on February 22, 2023, the Canadian Securities Administrators (“CSA”) confirmed that they are regulating CTPs as securities.12 These regulations include a registration requirement, direction to segregate crypto assets held on behalf of Canadian investors, prohibition of offering leverage to customers, and requirements to file financial information with the CSA.13

Treating crypto as a security in some respects provides some clarity, but its legal status in an insolvency remains uncertain, leaving a significant gap in managing CTP bankruptcies.

II. Hallmarks of Part XII

The BIA was drafted with intentional breadth of application so different structures of entities could be efficiently captured. Part XII is no exception.

Section 256(1) expands the parties eligible to seek a bankruptcy order against a debtor securities firm, including securities commissions, exchanges, customer compensation bodies, and receivers. This reflects the oversight of securities firms and prioritizes expedient action.

Section 258 empowers the licensed insolvency trustee (“LIT”) to seek an order designating a customer as a “deferred customer” if their misconduct contributed to the securities firm’s insolvency.14 This designation, pursuant to section 262(3)(d), subordinates deferred customers to other customers and creditors, thereby maximizing the funds available to customers.

Section 261(1) outlines the provisions governing priority and asset distribution for a Customer Pool Fund (“CPF”). Following a consolidation (“pooling”) of customer assets, administrative costs are paid first, followed by a rateable distribution of assets to customers. Any surplus is transferred to the “general fund.” This scheme prioritizes customers’ assets while also protecting the fund from depletion by non-customer creditor claims.

While all other bankruptcies determine proportionality based on a “proven claim,” Part XII looks instead to what a customer’s “net equity” was at the time of bankruptcy, proportionate to other customers.15

III. Application of Part XII to CTPs

By exploring how Part XII would have resolved significant issues arising during crypto firm bankruptcies, the potential utility of Part XII in the liquidation and distribution of CTPs becomes apparent.

In both securities and crypto platform bankruptcies, an important issue is determining the valuation date for the impugned assets. This issue was addressed in MF Global Canada Co. (Re), a conventional securities firm bankruptcy.16 Applying the Part XII definition of “net equity,” the court determined the valuation date to be the date of bankruptcy.17 During the Canadian proceedings for QuadrigaCX, Justice Hainey resolved a similar valuation concern by analogy to Part XII, finding that QuadrigaCX’s bankruptcy was like that of a securities firm.18

Another issue is maximizing recovery for customers who are victims of fraud. In QuadrigaCX, the company’s CEO, Gerald Cotten, operated a Ponzi scheme and withdrew funds for personal use. Part XII’s “deferred customer” remedy would operate to prevent fraudsters like Cotten from gaining a priority position following such wrongdoing. By subordinating the claim of a party whose actions contributed to the CTP’s insolvency, the assets available for customer recovery are maximized.

Section 259 can empower the LIT to sell securities, or in our case, crypto assets. This enables the LIT to quickly convert crypto assets to cash, mitigating losses for customers where the value of the crypto declines rapidly alongside the insolvency of the firm, as has been a consequence of each of the major crypto filings.

As previously discussed, Part XII could have resolved various issues faced during the Celsius proceeding. Specifically, it may have eliminated the need for numerous hearings. By applying section 261, courts could have avoided arguments about assets in Earn accounts, despite Celsius’ Terms of Use assigning ownership to the company. This would have expedited customer recovery substantially. Moreover, section 261 would have helped maximize recovery and safeguard customer funds from being distributed to non-customer creditors by preserving assets in customer accounts for customers only. The assets of customers would have been consolidated in a CPF and made exclusively available for distribution to customers, instead of being tied up in hearings and ultimately used to pay other creditors. This would also have been particularly equitable in situations like FTX, where the firm represented to customers that their assets were insured and guaranteed. However, this was a heinous misrepresentation.

The loan default by Three Arrows Capital in Voyager resulted in a liquidity crisis, as there were insufficient assets to pay out customers. However, had there been a framework in place – a Part XII equivalent that dealt with cryptocurrency – the remaining assets could have been managed effectively. Specifically, the unsatisfied net equity would have formed a claim out of the general fund, ranked in priority between preferred and ordinary creditors, after pooling and distributing the assets. FTX and others could have been handled similarly, resulting in a more predictable and equitable distribution scheme and asset preservation mechanism.

IV. Setting the Record Straight

The application of Part XII to CTPs may be challenged on the basis that proposing a securities framework implies reimagining the very nature of crypto itself, which was designed to be distinct from any other form of capital. This article is not about crypto’s classification as a security, as this classification still carries controversy.19 We acknowledge that securities commissions are now treating crypto as de facto securities20 and argue that the next installment in the series is for IPs to borrow from bankruptcy procedures that relate to securities firms, which may assist in the orderly administration of bankrupt CTPs.

V. Concluding Remarks

In the film ‘My Big Fat Greek Wedding’, the father of the bride likens the two families to apples and oranges. He highlights that while they may be different, they are ultimately all fruit. Drawing inspiration from the film, securities and crypto are like apples and oranges. While meaningfully distinct, they share important similarities that warrant similar treatment in an insolvency.