As cryptocurrency nears a ‘Lehman Brothers’ moment, lawyers look at how insolvency law will cope

Davies report outlines how Canadian insolvency law can accommodate the unique features of crypto

As cryptocurrency nears a ‘Lehman Brothers’ moment, lawyers look at how insolvency law will cope
Natasha MacParland, Davies

With the FTX Group’s recent Chapter 11 filing for bankruptcy protection in the United States, on the heels of Celsius Network filing for the same respite, a report by Davies suggests that we could be entering what would be described as a “Lehman Brothers moment” for the crypto industry.

Davies’ review of Q2 insolvency data published notes that there has been an increase in most types of insolvencies other than receiverships during that period. However, it also provides insight into the digital asset marketplace regarding cryptocurrency.

It adds that all crypto stakeholders “should remain vigilant as market conditions and case law are changing rapidly.”

Remembering the fall of Lehman Brothers

The Davies report even refers to the 2008 financial meltdown of Lehman Brothers, when the financial services firm filed for bankruptcy. When a full-blown financial crisis erupted, the head of the U.S. Federal Reserve at the time, Ben Bernanke, encouraged Congress to bail out the biggest banks while creating new money to pour into the financial system.

This policy, which was repeated at the start of the pandemic, proved effective in quelling financial panic but puts monetary policymakers “in a very difficult position” in an environment of rising inflation. To bring down inflation, central banks need to withdraw money from the economy and raise interest rates, increasing the likelihood of another recession. The failure of cryptocurrency exchange could augment that.

With recent drops in crypto prices severely affecting several digital asset lenders and exchanges, the report says there’s a need to explore “what this could mean in the Canadian context – in particular, what could be in store for the key players in a cryptocurrency exchange insolvency.”

Natasha MacParland, a partner with Davies and one of the report’s authors, says the fall of cryptocurrencies poses many questions.

“How are crypto claims valued? How are crypto assets distributed? Are they monetized? IN a typical insolvency, you take the assets, you realize against them, and you distribute the cash. And in a securities firm type insolvency, there is a mechanism for returning actual securities, but we haven’t yet seen that kind of crypto insolvency.”

Since the beginning of 2022, the total value of cryptocurrencies in the global market has plummeted to less than US $1 Trillion from US $3 trillion. This sharp downturn hugely impacted cryptocurrency trading and lending firms, with major players such as Three Arrows Capital, Voyager Digital and Celsius Network suspending user withdrawals and filing for bankruptcy.

MacParland says these bankruptcy cases present “novel” issues regarding the treatment of cryptocurrency assets and the relief available to stakeholders in insolvency proceedings.

She adds, “what we’re seeing now has moved on from the ‘fraud stage’ of crypto – it’s more about volatility and poor management, what I’d call ‘real’ insolvencies.”

Concerns over Crypto

There are a lot of unique concerns when it comes to cryptocurrency and insolvency, MacParland says. These include:

  • Classification. “Classifying assets is important in insolvencies and crypto is hard to classify as it shares similarities with various assets classes.”

  • Volatility. “Because of the volatility, value is difficult to determine.”

  • Location. “The digital nature of crypto makes the actual location difficult to determine.”

  • Access. “Depending on how the crypto is held, passwords or private keys may be required in order to access the crypto.”  

  • Non-reversible transactions. “The irreversibility of transactions, while attractive to crypto holders, causes issues for insolvency practitioners, as pre-filing preferences or undervalued transactions cannot be unwound.”

  • Anonymity. “While the anonymity of cryptocurrency holders and transactions is appealing to the crypto community, it can cause problems in an insolvency, as holders of claims may be impossible to identify.”

Canadian crypto-related cases

However, the Davies report says the Canadian insolvency and bankruptcy system “is well-suited to deal with the failure of cryptocurrency exchanges.

In one case, Quadriga, the Ontario Superior Court of Justice recognized cryptocurrency as “property” for the purposes of the BIA. Section 67(1)(c) of the BIA also mandates that in the case of bankruptcy, a cryptocurrency with monetary value should go into the estate of the bankrupt. Crypto is seen as being analogous to debts in a currency other than in Canadian dollars, meaning that section 215.1 of the Business Insolvency Act would apply.

The Quadriga case also illustrates that if a licensed insolvency trustee (LIT) can locate and take possession of the cryptocurrency, it is an asset for the purposes of bankruptcy liquidation. “For valuing claims denominated in cryptocurrency, the LIT uses the date of bankruptcy and can convert claims to dollars using the prevailing exchange rate as of the date of bankruptcy,” the Davies report says.

In Quadriga, Justice Glenn Hainey, who passed away in 2021, ruled that the principles of efficiency and economy support valuing cryptocurrency as of the date of bankruptcy to reduce the administrative burden and cost to the estate. For distribution purposes, all unsecured creditors who were affected users ranked pari passu (meaning that multiple parties to a contract, claim, or obligation are equally treated). No affected user of the exchange opposed the ranking scheme, and Justice Hainey endorsed it.

MacParland says a security interest may also exist with cryptocurrency. This would allow a secured creditor to realize the asset upon insolvency. Cryptocurrency does not fall into an established asset category under provincial personal property legislation in Canada, but it can be argued that it should qualify as an “intangible” asset under Ontario’s Personal Property Security Act (PPSA).

As set out by the Supreme Court of Canada in Saulnier v Royal Bank of Canada, the PPSA facilitates the creation of a security interest that enables holders of personal property to use it as collateral. It also allows lenders to accurately predict the priority of their claims against the assets in question.

On the topic of jurisdiction, cryptocurrency’s digital characteristics “create uncertainty” on where secured lenders should register their security interests, the Davies report says.

The Saulnier case held that a non-enumerated asset was an intangible capable of perfection by registration, but that case dealt with an interest created by statute. Cryptocurrency may not satisfy the test outlined in Saulnier.

As for the law relating to the administration of the exchange estate, the decision in British Columbia Securities Commission v Einstein Capital Partners Ltd. raises questions concerning the estate not having the resources to pursue an intensive investigation into missing assets, MacParland says.

The exchange owed $16 million in a mix of cryptocurrency and cash, and there were ongoing investigations into anti-money laundering and improper use of customer assets. The interim receiver found that an effort to sell the estate’s assets would outweigh any recovery and applied for an order to discharge its duties as the interim receiver.

The Supreme Court of British Columbia granted the interim receiver’s application, but questions remain over navigating the administration of a debtor exchange’s estate when there is a significant shortfall in funds or allegations of fraud. In the future, this may be an area worth exploring through third-party litigation funding.

In addition to crypto exchange users’ claims over their deposits, there are potential claims against a debtor relating to trading – specifically, a failure to execute a transaction due to insolvency or the suspension of users’ access to their accounts may affect the cryptocurrency value.

“These claims could cover losses resulting from an inability to transact with the cryptocurrency held in the custodial wallet until the value is returned,” the report says. It notes exchanges could mitigate the risk of such claims by excluding liability contractually when users sign up for the exchange’s services.

Cryptocurrency exchanges could also consider segregating the exchange’s operating capital from customer deposits. This would reduce uncertainty in determining the value of customer deposits and the value of losses due to hacking or theft.

The report points out that because exchanges often operate with few staff and cybersecurity professionals, hacking or theft has sometimes depleted cryptocurrency exchanges’ assets, harming all stakeholders.

In one high-profile case, BitMart - a Singapore-based centralized digital asset exchange platform - in 2021 announced that hackers withdrew almost US $200 million from the company’s account. “Unfortunately, most exchange hackers are not caught,” the report says, especially when the cryptocurrency is stored in ‘hot wallets’ and connected to the Internet.

Experts also say that even though the blockchain is public, investigators face obstacles in tracing transactions to their ultimate destination and beneficiaries. Says the Davies report: “Even during an insolvency proceeding, without careful advice, the monitor or LIT could see substantial loss of assets due to hacking; this could reduce the likelihood of a successful restructuring or reorganization.”

MacParland says that while federal and provincial jurisdictions have acknowledged some of the challenges facing cryptocurrencies, including a federal private member’s bill now making its way through Parliament, “there’s a gap in the insolvency legislation in Canada.” She says it would be good, for instance, to have a “transparent” set of guidelines in the insolvency legislation for dealing with digital assets.

The big picture in insolvencies

On the broader topic of overall insolvencies in Canada, the report says the number of proceedings under the Companies’ Creditors Arrangement Act (CCAA) in 2022 grew significantly during the year’s first half, from four in Q1 to nine in Q2.

Manufacturing and retail trade had the most CCAA filings in Q2 2022. And contrary to historical trends, British Columbia experienced an unusually high number of CCAA filings in Q2 2022 (five) compared to Canada’s largest province, which had three.

As well, while the number of business insolvencies in Q2 2022 was like that in Q1 2022, the total number of business insolvencies in July 2022 was 45 percent higher than the total number of insolvencies in July 2021. Business insolvencies for the 12 months ending July 31, 2022, increased by 20.2 percent compared to the 12 months ending July 31, 2021.

In addition, there were 303 Bankruptcy and Insolvency Act (BIA) proceedings in June 2022, the highest month since February 2020, just before health authorities proclaimed a global COVID-19 pandemic.

When we break down the number of business insolvencies into bankruptcies and proposals, the Davies report notes that business proposals in Q2 2022 decreased slightly from Q1 2022. In contrast, bankruptcies in Q2 2022 experienced a small increase from Q1 2022.

The sectors that registered the most significant increases in insolvencies were construction, accommodation and food services, and transportation and warehousing. The sectors with the biggest decreases in insolvencies were mining and gas extraction and management of companies and enterprises.

The provinces with the most business insolvencies were Ontario, Québec, Alberta and British Columbia, consistent with historical trends.

The number of arrangements under the Canada Business Corporations Act (CBCA) from May to July 2022 significantly increased year over year, with 18 arrangements reported in 2022 compared with three arrangements over the same period in 2021.

As for receiverships, activity has remained low so far this year. There were fewer receiverships in each month of 2022 than in the same period in 2021 and declared assets in 2022 receiverships have stayed about the same as in 2021.

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