Écrit par Conrad Druzeta and Michael R. Whitt Q.C.
Was there ever any doubt? On August 24, 2017, the Canadian Securities Administrators (CSA) issued Staff Notice 46-307 – Cryptocurrency Offerings providing guidance on the applicability of Canadian securities laws to cryptocurrency offerings and trading. The message is less equivocal than in the past: "Many of these cryptocurrency offerings involve sales of securities".
Are Digital Coins/Tokens Securities?
Initial coin offerings (ICOs), token offerings (ITO), virtual currencies, token generation events and other digital offerings come in a wide variety of flavours. It has been estimated that as of the end of July 2017, 102 such offerings and projects have raised approximately US$1.3 billion.
The guidance in the CSA Notice should be considered in the context of cryptocurrency or blockchain based offerings regardless of the nomenclature used or the ‘flavour’ of the day. Whether a particular coin/token crosses over to becoming a security will depend on the substance of the scheme in its totality rather than form. The fact that new technology is being employed is not relevant.
We have previously commented that Canada Pacific Coast Coin Exchange of Canada v Ontario (Securities Commission),  2 SCR 112 establishes a four-part test to determine whether an "investment contract" exists, which is a form of security under Canadian regulatory systems:
- An investment of money (or other means of transferring value) is made to acquire the instrument in question.
- A common enterprise exists in relation to the invested instrument.
- There is an expectation of profit from the common enterprise that will accrue to the holder of the instrument.
- The profit comes significantly from the efforts of others involved in the enterprise and not the holder of the instrument.
The CSA acknowledges that every ICO/ITO is unique and its characteristics must be carefully assessed to determine if the coin/token is a security. A digital token that is purely a utility, such as tokens used to play video games or to gain access to a website service may not be a security, while tokens with value tied to the future success of a business, project or scheme likely are securities. The analysis should look beyond the token itself, at the totality of the enterprise or project, based on the substance of the token and its contextual framework.
Securities Law Ramifications
Securities laws in Canada apply to persons or companies selling securities from within Canada as well as anyone regardless of where they are located if they are selling securities to persons resident in Canada.
The CSA notes that many ICOs bear more than a passing resemblance to initial public offerings of securities. Under Canadian securities law, securities can only be sold after a receipt has been issued from a securities regulatory authority for a prospectus providing a regulated standard of disclosure about the investment, the organization and risks associated with the security, or pursuant to a prospectus exemption by way of private placement.
To date there have been no prospectus offerings of coins/tokens in Canada. This is likely to change in the future. The CSA suggests that sales of coins/tokens that are securities may also be made to (a) accredited investors without using a prospectus or (b) to non-accredited investors, subject to investment limits, if an offering memorandum complying with securities laws (again meeting prescribed standards of disclosure) is used. If a prospectus exemption is relied upon for the ICO/ITO, further complexities arise because such privately placed securities are not freely tradable and secondary trades may require another prospectus exemption.
Registration of Advisors, Brokers and Dealers
Persons in the business of trading or advising on securities must be registered with the applicable securities regulator or must rely on an exemption from registration. Indicators that registration of persons involved in the business of trading or advising about ICO/ITO’s may be required include:
- Soliciting a broad base of investors including retail (general consumer type) investors
- Using technology to reach a large number of people
- Publicly advertising offerings of securities
- Raising significant amounts of capital from a broad base of investors
Dealers and advisors are subject to know-your-client rules and suitability of investment requirements for their clients. These rules and concepts are in tension or conflict with the anonymous nature of many ICOs and ITOs, and the attraction to some investors to anonymity and aversion to regulations and controls.
A platform that facilitates trading of securities may be a "marketplace" and need to comply with securities law requirements or obtain an exemption from the applicable securities regulator(s). If many coins/tokens qualify as securities as the CSA suggests, any cryptocurrency exchange offering trading of many varieties of cryptocurrency is likely offside securities laws meant to protect the investing public against perils associated with unrestricted trading platforms with no oversight or scrutiny. This problem is in addition to issues with identity verification, anti-money laundering, counter-terrorism financing and recordkeeping and audit requirements. Additional questions arise regarding "wallets" and other applications that facilitate further decentralized and potentially uncontrollable trading of cryptocurrencies. The nature of these applications should be carefully assessed, according to the CSA guidance, based on the substance of what they do, the way they function and the functions they perform, in order to determine whether securities laws are applicable.
The CSA noted that investment funds are being established to provide investors a means of investing in cryptocurrencies or a portfolio of cryptocurrencies. An investment fund can be either a mutual fund (redeemable) or a non-redeemable investment fund. A non-redeemable investment fund is any instrument offered by an issuer that permits the issuer to invest money provided by its securities holders. Investment funds are regulated under Canadian securities laws and absent an exemption its manager(s) must be registered.
The CSA notes that some cryptocurrencies may also qualify as derivatives (value is based on an external source or event) which would subject them to additional securities laws including trade reporting.
Securities laws in Canada are applied purposefully, the principal purpose being investor protection. The CSA notes that issues around cryptocurrency volatility, transparency, valuation, custody and integrity, and liquidity all engage investor protection concerns. Investors, particularly unsophisticated investors, often do not understand the properties of the investment product they are asked to purchase and may be vulnerable to unethical practices and illegal schemes. Securities laws are a direct means of addressing some of these concerns, as the CSA suggests, and securities regulators will apply the law, or adapt the law, to prevent historical problems with unregulated investment.
Although the general tone of securities regulators in Canada continues to be welcoming and supportive of blockchain technology ventures, this latest guidance from the CSA more firmly cautions market participants about compliance with Canadian securities laws. Securities regulators will continue to protect the public from "speculative schemes which have no more basis than so many feet of blue sky."
Recently, the security regulator in Quebec took significant enforcement action against a group offering a cryptocurrency called PlexCoin. Although regulators have generally avoided enforcement activity to date in Canada, market participants should prepare themselves for increased regulatory scrutiny. Regulators are gaining a more sophisticated understanding of blockchain, cryptocurrency, and related topics both technologically and with respect to potential for investor harm, whether intended or not.
Businesses considering raising capital through an ICO, ITO or similar transaction should consult qualified legal and investment counsel to understand the regulatory framework, including whether a business or business model, or a novel instrument or scheme is required to comply with prospectus, registration or marketplace requirements or whether a valid exemption from such requirements may be available under Canadian securities laws.