News: EY goes after Quadriga’s payment processors, more exchange hacks, and the SEC tells us what we already know

I had to take my website offline for a few hours Tuesday, so if you were searching for one of my stories and got a weird message, my apologies. I asked WordPress to downgrade my site from a business plan to a premium plan, and when they did, a bunch of my content disappeared, so I had to put Humpty-Dumpty back together again.

Big thanks to my now 18 patrons, who are making it easier for me to focus on writing about crypto. If you like my work, please consider supporting me on Patreon, so I can keep doing what I am doing.  

Now onto the news, starting with Quadriga, the defunct Canadian crypto exchange that I won’t shut up about. (Read my timeline to get up to speed.)

Ernst & Young (EY), the court-appointed monitor charged with tracking down Quadriga’s lost funds, released its fourth monitor report, which reveals more money going out then coming in. The closing cash balance for March was CA$23,268,411. Incoming cash for the month was CA$4,232, and total disbursements was CA$1,463,860—most of which was paid to professionals. A full half of that (CA$721,579) went to EY and its legal team.

EY is trying to chase down money held by Quadriga’s payment processors. It has drafted a “Third Party Payment Processor Order” for the court to approve on Monday. If that goes through as is, several payment processors, including WB21, will have five business days to handover funds and/or Quadriga documents and transaction data. If they don’t comply, they will be in contempt of court. A shift from CCAA to bankruptcy proceedings will also give EY more power to go after funds as a trustee

Christine Duhaime, a financial crimes lawyer who worked for Quadriga for six months in 2015 to early 2016, wrote “From Law to Lawlessness: Bits of the Untold QuadrigaCX” for CoinDesk, where she talks about how Quadriga went off the rails following its failed efforts to become a public company.

In the article, Duhaime—who in February called for a government bailout of Quadriga’s creditors (archive)—openly admits to having lost CA$100,000 in funds on the exchange. She claims her involvement with the exchange stopped in early 2016. “I’m glad we were let go by QuadrigaCX for being one of the ‘law and order’ folks,” she said.  

I have been corrected on detail here:

She does not mention this in her article, but in 2015, she also owned 20,000 shares of Quadriga stock. It is possible she has since sold the holdings.

Preston Byrne, an attorney at Byrne & Storm, PC, tweeted, “No offense to @ahcastor but this claim that @cduhaime may have owned shares in Quadriga looks to be incorrect. She’s listed as the principal contact for an SPV, and the SPV is the named purchaser. A retraction is in order.”

SPV stands for special purpose vehicle, typically used by firms to isolate them from financial risk. I’ve reworded the paragraph as follows:

This 2015 British Columbia Report of Exempt Distribution, a document of Quadriga Financial Solutions’ ownership, lists Duhaime as the contact for 1207649 B.C. Ltd, which owns—or owned—20,000 shares of Quadriga. I was unable to find the corporate files for 1207649 B.C. The address in the report matches that of Duhaime’s office.  

Update (April 9): I found the corporate files. The actual company name appears to be 1027649 B.C. Ltd.—with the numbers “2” and “0” transposed. The company was founded on February 16, 2015 and dissolved on August 1, 2017. The sole director is “Anne Ellis,” and the registered office is Duhaime Law.

According to court documents, Cotten and Quadriga co-founder Michael Patryn had been seeking to buy back shareholdings after Quadriga’s public listing failed, so it is possible one of them may have bought back those shares as well. I reached out to Duhaime for comment a few times, but she has not responded. 

Duhaime may have left Quadriga behind, but she continued to have business dealings with Patryn, who we now know is convicted felon Omar Dhanani

She and Patryn co-founded Fintech Ventures Group, which calls itself “an investment bank focused on digital currency, blockchain, and AI-focused technology.” According to a January 2016 archive of the company’s site, Duhaime was Fintech Venture’s “Digital Finance Maven & Co-Founder.” (Interestingly, former Quadriga director Anthony Milewski worked there, too, as the company’s “Investment Relations Extraordinaire.”) 

Duhaime and Patryn were also both advisors at Canadian crypto exchange Taurus Crypto Services, according to this June 2016 archive. (Milewski shows up here again, this time as an advisor.) The exchange was founded in 2014 and shut down in January 2017, when the business shifted to over-the-counter trades.  

Like Duhaime, Patryn also claims his involvement with Quadriga ended in early 2016. Although the Globe and Mail said that in October 2018, “it received an e-mail pitch from an ‘executive concierge’ company called the Windsor Group offering up Mr. Patryn for interviews to discuss virtual currencies and describing him as a Quadriga director.” Patryn told the Globe he did not know what the Windsor Group was, nor had he authorized anyone to pitch him as a Quadriga director, as he never served on the board.

Patryn had a personal website michaelpatryn.com, but it got taken down. Here is a 2011 archive and here is a 2014 archive. From 2016 on, the archives point to his LinkedIn profile, where he now goes by “Michael P.” having dropped all but the first initial of his last name. According to his LinkedIn, he has been an advisor for numerous cryptocurrency platforms going back to November 1999. I guess that means his work at Shadowcrew in 2004 and the 18 months he spent in jail for conspiracy to commit credit and bank card fraud and ID document fraud qualifies as advisory services.

Patryn appears to enjoy the limelight. Several reporters told me they had no trouble reaching him. At one point, Patryn even went into the “Quadriga Uncovered” Telegram group—basically, the lion’s den, where hundreds of pissed off Quadriga creditors sat waiting on their haunches —where I am told he calmly deflected accusations.

Meanwhile, I’ve been practicing my authoritative stare and baritone.

Other exchanges

Elsewhere in cryptoland, there have been a number of exchanges hacks. Singapore-based exchange DragonEx was hacked on March 24 for an undisclosed amount of crypto.

Blockchain data firm Elementus suspects that Coinbene, another Singapore exchange, was also hacked. On March 25, Elementus noted that $105 million worth of crypto was on the move out of the exchange. Coinbene totally denies it’s been hacked, claiming that delays in deposits and withdrawals are due to maintenance issues. 

A third exchange, Bithumb was hacked on March 30. The South Korean crypto exchange lost 3.07 million EOS and 20.2 million XRP, worth around $19 million. Bithumb thinks it was an insider job.

Helsinki-based LocalBitcoins, a once go-to for anonymous bitcoin transactions, has added know-your-customer (KYC) identity checks to comply with new laws in Finland. The change goes into effect in November. Per the company’s announcement, this is actually good news for bitcoin, because it will create a “legal status for crypto assets, which should improve significantly Bitcoin’s standing as a viable and legit financial network.”  

A study by reg-tech startup Coinfirm found that 69 percent of crypto exchanges don’t have “complete and transparent” KYC procedures. And only 26 percent of exchanges had a “high” level of anti-money-laundering procedures.

With crypto markets in the dumps, exchanges are looking for new ways to attract volume. To that end, San Francisco-based Coinbase is launching a staking service to lure in institutional investors. The service, which starts with Tezos (XTZ), will pay investors to park their money in XTZ. The coins are kept in offline cold wallets. The catch is that the interest will be paid XTZ, and of course, crypto is highly volatile. 

The price of XTZ went up 70 percent on the news.

Cryptocurrency exchange Binance is launching a new fiat-to-crypto exchange in Singapore later this month. (It’s been launching these crypto onramps all over the word.)

Binance also says it’s planning to launch its decentralized exchange (DEX) later this month. The DEX is built on a public blockchain, Binance Chain. Basically, Binance is looking to create an economy for binance coin (BNB), which is totally not a security.

Other interesting news bits 

Screen Shot 2019-04-05 at 11.03.29 AMThe the U.S. Securities and Exchange Commission issued a “Framework for ‘Investment Contract’ Analysis of Digital Assets.” There is not a lot new to see here. A footnote in the document makes clear this is “not a rule, regulation, or statement of the Commission,” just some thoughts from the SEC’s staff about how they interpret existing securities laws. 

Stephen Palley, partner at law firm Anderson Kill, appeared on Bloomberg sporting a beard to explain the framework—definitely worth five minutes of your time to listen to.

Justin Sun, the founder of blockchain project Tron, bungled a Tesla promotional giveaway. After a widespread cry of foul play, he decided to make it up to everyone by giving away—two Teslas. This wasn’t the first time a Tron promotion raised eyebrows.

Nocoiner David Gerard wrote a Foreign Policy piece on “How Neo-Nazis Bet Big on Bitcoin (and Lost)” that was translated for Newsweek Japan.

The ever outspoken Jackson Palmer did a good interview with Epicenter Blockchain Podcast on the history of Dogecoin and the state of cryptocurrency in 2019.

Nicholas Weaver, who gave the “Burn it with Fire” talk at Enigma, spoke to Breaker about why cryptocurrencies don’t really work as currencies.

Finally, Dream Market, the last standing marketplace from the once infamous “big four” sites that dominated dark web trading in the mid-2010s, announced plans to shut down.

 

 

Social media startup Kik is kicking back—at the SEC

screen shot 2019-01-29 at 12.23.59 amKik is ready to go to battle. The Canadian social media startup has decided to take on the U.S. Securities and Exchange Commission (SEC). At issue is whether Kik’s digital token kin is a security.

Kik raised $47.5 million in September 2017 by selling kin in an initial coin offering, or ICO — though, Kik prefers to call it a token distribution event. That was after Kik pre-sold $50 million worth of kin to a group of 50 wealthy investors, mainly blockchain hedge funds. The presale was a simple agreement for future tokens, or SAFT, which is basically, a Reg D exemption, where the investors would get the tokens at some point in the future after things were up and running.

What is kin?

On its website, Kik describes kin as a “digital currency” that you can use to “earn points for watching video ads, then use points for stickers and custom emojis.” Kin is different from other in-house loyalty points, because it “can be bought and sold for real money.” In other words, you could use Kin as a utility token in the Kik app and also trade it on crypto exchanges for other coins, like bitcoin and ether.

Kik initially announced its token sale in May 2017, four months ahead of its ICO. At the time, the company banned Canadians from taking part in its public sale, because the Ontario Securities Commission (OSC) had already deemed its token to be a security. But that didn’t stop Kik from opening its sale up to U.S. citizens.

Although Kik consulted with lawyers before its public ICO, as far as what I’m reading, they never actually reached out to the SEC for guidance. And it’s not like they weren’t given fair warning that this might pose a problem. 

Fair warning

By mid-2017, the SEC had already begun its crackdown on ICOs. Two months prior to Kik’s ICO, the regulator issued an investigative report concluding that tokens sold by the DAO (a decentralized investment fund that ran on Ethereum) were securities. That report was a cautionary tale to any other project thinking about raising money in an ICO. In a public statement at the time, the SEC said:

“We encourage market participants who are employing new technologies to form investment vehicles or distribute investment opportunities to consult with securities counsel to aid in their analysis of these issues and to contact our staff, as needed, for assistance in analyzing the application of the federal securities laws.” [Emphasis mine.]

But instead of proactively reaching out to the SEC, Kik sat back and waited to hear from them—not a great strategy. 

The SEC first contacted Kik two days after Kik’s token offering began. “It was a friendly contact for information, which we happily responded to,” Kik CEO Ted Livingston wrote in a blog post. But from there the conversations “ramped up,” and on November 16, 2018, the SEC sent Kik and the Kin Foundation a Wells notice—essentially, a letter stating that the regulator was about to bring an enforcement action against them. On December 7, Kik sent back a 31-page response.

As far as the SEC sees it, Kik is in violation of section 5 of the Securities Act of 1933, which states that it is illegal to sell securities unless you register with the SEC or else apply for an exemption, such a private placement, which limits a sale to accredited investors—i.e., wealthy people who can survive the loss, if things go wrong. 

As mentioned, Kik’s private token sale was a Reg D exemption. (Here is the SEC filing from September 2017.) According to SEC rule 506 of Regulation D, purchasers receive “restricted securities,” meaning that the securities cannot be sold for at least six months to a year. Also, Reg D does not pre-empt something from being a security.  

The problem with SAFTs

In general, the problem with SAFTs is that, for various legal reasons (see SEC rule 144), even after the holding period, you can probably only sell your coins to other accredited investors. In other words, you cannot freely trade those coins on the secondary market. Obviously, that limits kin’s usability. It also makes kin not a very good currency, because you can’t actually buy and sell it for real money—at least not that easily.

The basic rule for determining wether something is a security is the “Howey test,” which states that a security is “an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” In its response letter, Kik claims kin is not a security according to the Howey test, because Kik never marketed its ICO as an investment.

“Simply put, Kik did not offer or promote Kin as a passive investment opportunity. Doing so would have doomed the project, which could only succeed if Kin purchasers used Kin as a medium of exchange (rather than simply holding it as a passive investment). Accordingly, Kik marketed Kin, not as an investment opportunity, but rather as a way to participate in a fundamentally new way for consumers to access digital products and services, and for innovative developers, and their users, to be compensated for the value they provide.”

But Kik’s main rebuttal is that kin is a currency—so securities laws don’t apply.

Let’s take a look at Page 11 of the 1934 Securities Exchange Act. It says:

“The term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, certificate of interest or participation in any profit-sharing agreement… but shall not include currency or any note, draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance.”

Lawyers will have to debate how to define kin. But just as the SEC’s Munchee order in December 2017 made it clear that calling a token a “utility token” does not unmake it a security, calling a token a “cryptocurrency” may prove equally as futile—especially, if the token doesn’t actually work as a currency.