OSC found Quadriga’s mysterious collapse was due to fraud

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Toronto (June 12, 2020) – The Ontario Securities Commission (OSC) found out that the cryptocurrency exchange QuadrigaCX collapsed in 2019 due to a fraud committed by its late founder Gerald Cotten, according to an investigative report published on June 11. When the Quadriga platform had ceased operations, over 76,000 clients were owed a combined $215 million in assets but Quadriga had almost no funds to cover these liabilities. After the liquidation, the Quadriga clients were left with a collective loss of at least $169 million. The OSC report disclosed that about $115 million of the client losses arose from Cotten’s fraudulent trading, which he started to cover with other clients’ deposits, which resulted in a Ponzi scheme. Furthermore, the report said that Cotten misappropriated millions in client assets to fund his lavish lifestyle. The OSC pointed out that the findings and views in the report have not been tested before a Panel of the Commission or a court.

The Ontario Securities Commission (OSC) concluded in an investigation that the collapse of the crypto asset trading platform QuadrigaCX was the result of fraud by its late founder Gerald Cotten. The investigative report, which was published on June 11, found that he had started running a Ponzi scheme.

Quadriga’s collapse

Quadriga presented itself as a platform for Canadians to access Bitcoin and other crypto assets with its launch in December 2013. The Vancouver-based cryptocurrency exchange shut down in January 2019, only a few weeks after its 30-year-old founder, Cotten, died unexpectedly. Reportedly, his death was caused by complications of Crohn’s disease during his December 2018 honeymoon in India.

When Quadriga ceased operations and filed for creditor protection on February 5, 2019, it owed its clients assets worth collectively $215 million, the OSC report said. Leaving behind a mystery of what happened to the cryptocurrencies on the platform of over 76,000 clients from Canada and around the world– about 40 percent of them Ontarians. Ernst & Young, who was Quadriga’s bankruptcy trustee only recovered or identified $46 million of assets to pay out to clients, leaving a $169 million shortfall.

The people who trusted Quadriga had to deal with massive losses, which came completely unexpected for them. ‘It never came across my mind that something like this would ever happen in Canada,’ stated a client who was interview by the Commission staff for the report. Another investor said that ‘while he was using Quadriga, he thought it was monitored, protected and guaranteed by the government. He did not consider that if something went wrong with the platform, he could lose all his money.’

In February 2019, the OSC announced that it would review Quadriga’s downfall given its magnitude, the harm that was done to Ontarians, and the novel issues surrounding crypto asset trading platforms. To reconstruct what was going on at Quadriga, a multi-disciplinary team analyzed trading and blockchain data as well as the records from third-party payment processors and banks, interviewed key witnesses, and collaborated with numerous regulatory bodies in Canada and abroad.

Quadriga was a fraud and Cotten was running a Ponzi scheme

The OSC staff determined in their investigation that Quadriga collapsed due to a fraud committed by Cotten. ‘It has been widely speculated that the bulk of investor losses resulted from crypto assets becoming lost or inaccessible as a result of Cotten’s death,’ said the report. ‘In our assessment, this was not the case. The evidence demonstrates that most of the $169 million asset shortfall resulted from Cotten’s fraudulent conduct, which took several forms.’

The regulator’s report revealed that by November 2016 – two years before Cotten died – the young fraudulent entrepreneur had injected so many fake assets into the platform that its eventual insolvency was all but assured. The agency calculated that about $115 million, which was the bulk of the $169 million in client losses, arose from Cotten’s fraudulent trading.

‘In essence, Cotten was trading with an unlimited credit facility: he could trade as much as he wanted, without any of his own or Quadriga’s assets backing his trades. Quadriga clients were his unknowing creditors. They bore the risks, and eventually the impact, of Cotten’s trading losses,’ read the report. ‘Cotten accumulated significant trading losses yet we saw no indication that Cotten brought any funds that were not client funds onto the platform to cover his losses.’

For his fraudulent trading activity, Cotten opened Quadriga accounts under aliases such as Chris Markay, Sceptre Gerry, Aretwo Deetwo, and Seethree Peaohhh. On these accounts, he credited himself with fictitious currency and crypto asset balances, which he traded with unsuspecting Quadriga clients. This fraudulent trading activity created a shortfall between the total amount owed to clients and the pool of underlying assets held by Quadriga.

Furthermore, Cotten used client assets on three external crypto asset trading platforms without authorization or disclosure, which resulted in a $28 million loss. ‘In our assessment, Cotten’s undisclosed and unauthorized trading with client funds was fraudulent,’ concluded the agency.

Additionally, he misappropriated millions in client assets to fund his lavish lifestyle. ‘Between May 2016 and January 2018, he transferred approximately $24 million of client funds to himself and Robertson. This was despite the fact that Cotten’s salary was set at $65,000 per year according to his January 2015 employment agreement. Cotten bought a Tesla, a Lexus, a luxury yacht, a plane, a share in a private jet, and multiple properties. Cotten and Robertson traveled frequently,’ according to the report.

Quadriga was ‘operating like a revolving door’

As crypto asset prices fell, many Quadriga clients wanted to cash out. Cotten struggled to keep up with increasing withdrawal requests, and started operating Quadriga ‘like a revolving door.’ This means that Cotten immediately re-routed new client’s deposits to fund other clients’ withdrawals, in the manner of a classic, old-fashioned Ponzi scheme.

From 2016 onwards, Cotten was in sole control of a company that had hundreds of thousands of clients and transacted over a billion dollars of fiat currency-denominated assets and over five million crypto asset units, according to the agency. He ran the business ‘as he saw fit’, with no proper system of internal oversight or controls or proper books and records.

‘In our review, we found that Quadriga did not maintain adequate books and records regarding its operations. The trading platform itself tracked some information—including funding of client accounts, trades, withdrawals, and balances. In this sense, the platform tracked Quadriga’s liabilities to its clients. However, the evidence we reviewed indicated that, from 2016 onwards, Quadriga had no accounting ledger or other accounting records relating to its financial situation or the assets that it controlled.’

Furthermore, the Commission investigation found that Quadriga did millions of dollars of business in cash: ‘One of Quadriga’s major clients was a Canadian Bitcoin ATM company. The president of the company would personally deliver suitcases of cash to Cotten to fund his Quadriga account, sometimes using private jets to meet quickly. Ultimately, Quadriga received over $20 million in cash from this ATM company, which Cotten knew, with this origin, would not be accepted by any banks in Canada.’

The commission discovered that he used cash to fund client withdrawal requests by mailing envelopes of cash across the country. The platform data indicates that $14 million of client withdrawals were fulfilled by cash delivery. The absence of proper books and records facilitated Cotten’s ability to covertly spend and trade client assets, according to the Commission.

Quadriga’s clients entrusted money and crypto assets to the platform. However, Quadriga provided ‘no meaningful insight’ into how those assets were being stored, moved, and spent. Instead, they gave false assurances about asset storage. This lack of transparency also facilitated Cotten’s fraud, said the Commission’s report.

‘Whether Cotten was seeking to profit, generate volume, bolster liquidity on the platform, or had some other purpose, his trading had a catastrophic effect on Quadriga’s finances, and ultimately brought down the entire platform.’

The OSC report – a unique situation

The Commission explained that on the grounds of the findings of the OSC Enforcement Staff 10-month investigation, the OSC would likely have pursued an enforcement action against Cotten and Quadriga. ‘However, this is not practical given that Cotten is deceased and Quadriga is bankrupt, with its assets subject to a court-supervised distribution process.’

Under these circumstances, the investigators sought and obtained approval from a Panel of the Commission to publish the report. Otherwise, this would not be possible since the report contains information, which would be protected by confidentiality restrictions.

‘While public release of an investigative report is rare, we believe the tens of thousands of Ontarians who entrusted Quadriga with their money and crypto assets deserve to know what happened,’ said Jeff Kehoe, Director of the Enforcement Branch at the OSC. ‘Our aim in making this information public is also to prevent this type of situation from recurring.’

The report outlines the events from Quadriga’s inception, to its eventual collapse with focus on what happened to client assets and how the Quadriga platform involved trading in securities or derivatives, among others, and finally, provides regulatory considerations for investors and crypto asset platform operators. Nevertheless, the regulator points out that the findings and views in the report have not been tested before a Panel of the Commission or a court.

Crypto asset trading platforms – what investors need to know

Crypto trading platforms are an emerging area operating in an evolving regulatory landscape. According to the Commission, bad actors can take advantage of these circumstances to defraud investors. ‘What happened at Quadriga was an old-fashioned fraud wrapped in modern technology.’

The report found out that Quadriga did not consider its business to involve securities trading and it did not register with any securities regulator. ‘This lack of registration facilitated Cotten’s ability to commit a large-scale fraud without detection. So did the absence of internal oversight over Cotten.’

The regulator recommends platform operators to be aware that securities legislation may apply to their business, and where applicable, to take appropriate steps to comply with Ontario securities law. ‘The information presented in this report highlights the unique risks that can arise when using crypto asset trading platforms,’ stated Kehoe of the OSC. ‘These risks are magnified when platforms trading securities and derivatives do not register with regulators and do not disclose critical information about their practices.’

The OSC reminds that in Canada, many crypto asset trading platforms are not registered with securities regulators and have taken the position that they are not required to register. Important safeguards typically in place at firms regulated by securities regulators may not be in place. Furthermore, investors should be aware that platforms may maintain custody and control of the investor’s assets. This means the client depends on the platform to deliver the assets when requested. There is also no guarantee that the platform will have enough cash on hand to manage the withdrawal requests.

Moreover, platforms may not disclose important information, such as whether they maintain custody and control of your assets, and how they store and handle the assets, according to the OSC. Clients may not be aware that a platform’s practices are exposing their assets to risks of loss, theft, or misuse.

Before entrusting their assets to a crypto asset trading platform, it is recommended that investors do their research and watch for signs of potential fraud. A good practice is to take steps to learn about the platform’s operations and approach to risk management. If the platform does not disclose this important information, it is considered a red flag.