Cryptocurrencies have been in the news recently. By one estimate, over US$1.2 billion has been raised worldwide in initial coin offerings (“ICOs”) and initial token offerings (“ITOs”). This increase in activity has also captured the attention of Canadian securities regulators.
ICOs/ITOs are generally used by start-up businesses to raise capital from investors through the internet. In an ICO/ITO investors can visit a website to purchase crypto coins/tokens in exchange for fiat currency or another cryptocurrency such as bitcoin or ether. An ICO/ITO can be very similar to a traditional initial public offering (“IPO”) of shares by a business, because the value of the coins/tokens may increase or decrease depending on how successfully the business executes its business plan.
The Canadian Securities Administrators (the “CSA”) are concerned about ICOs and ITOs because they raise investor protection concerns, due to issues around volatility, transparency, valuation, custody and liquidity, as well as the use of unregulated cryptocurrency exchanges.
Is a Crypto Coin or Token a Security?
To date, most organizations have either taken the position that securities laws do not apply to their ICO/ITO or have ignored the issue. CSA Staff have confirmed that crypto coins and tokens may be securities, and may be subject to the same securities laws that apply to an IPO of shares.
If a crypto coin or token is deemed to be a security, then:
- an ICO or ITO would be subject to Canadian prospectus requirements, unless a prospectus exemption is available for the ICO or ITO;
- businesses and individuals in the business of trading in or advising on crypto coins or tokens would need to be properly registered or rely on an exemption from registration; and
- A platform that facilitates trades in crypto coins or tokens may be a marketplace and would need to comply with marketplace requirements or obtain an exemption from those requirements.
The CSA acknowledge that each ICO/ITO is unique and will be assessed on its own characteristics. For instance if an individual purchases coins/tokens that allow him to play video games on a platform, then those coins/tokens would likely not be securities. On the other hand, if an individual purchases coins/tokens whose value is tied to the future profits or success of a business, they will likely be considered securities.
To determine whether the coins/tokens being sold in an ICO/ITO are securities, the CSA will consider whether the ICO/ITO involves:
- an investment of money;
- a common enterprise;
- the expectation of profit; and
- if the profit would come significantly from the efforts of others (i.e., not the efforts of the investors).
Compliance with Prospectus Requirements and Ongoing Disclosure Requirements
If a business and its advisors conclude that its coins/tokens are securities, then they must either comply with the prospectus requirements of Canadian securities laws or rely on an exemption from the prospectus requirements, such as the accredited investor exemption or the offering memorandum exemption.
The CSA noted that some fintech businesses publish whitepapers for their ICOs/ITOs, which describe things like their fundraising goals, their business, the project for which they are raising funds, how many coins/tokens management will keep and how long the ICO/ITO will remain open. These whitepapers do not contain all of the information required by a prospectus or offering memorandum and do not comply with securities laws.
Even if a prospectus exemption is available for an ICO/ITO, the business would still be subject to the requirements of securities laws, such as providing audited annual financial statements and other ongoing disclosure to investors. Some prospectus exemptions, such as the offering memorandum exemption contain restrictions on the amount that each investor can invest. In addition, ICO/ITO coins/tokens would be subject to resale restrictions, so that investors would not be allowed to resell them unless they could rely on a prospectus exemption.
Failure to comply with securities law requirements could result in the persons involved in an ICO/ITO being liable to the investors for damages or to refund their investment.
Trading in Securities and Registration as a Dealer
In addition to complying with the prospectus requirements, businesses doing an ICO/ITO may also be trading in securities for a business purpose. If that is the case, then they will need to either be registered as a dealer or be able to rely on an exemption from registration.
If the sale of coins/tokens by a business is considered trading in securities, then the business will need to comply with certain fundamental obligations to its investors, such as know-your client and investment suitability. This would require these businesses to verify each investor’s identity and collect sufficient information to ensure that the purchase of coins/tokens are suitable for the investor, taking into account his or her investment needs, objectives, financial circumstances and risk tolerance. The CSA acknowledge that it is possible that a business could fulfil these obligations through a robust, automated, online process that incorporates investor protections. These investor protections could include limits on investment amounts and concentration, as well as risk warnings.
Cryptocurrency exchanges are online exchanges that allow investors to buy and sell cryptocurrencies, such as s bitcoin and ether, and they may also offer coins/tokens that have been sold pursuant to ICOs/ITOs. A cryptocurrency exchange that offers coins/tokens that are securities will be deemed to be a marketplace under Canadian securities laws. Marketplaces are required to comply with the rules governing exchanges, such as those applicable to the TSX, or alternative trading systems. If an exchange is doing business in Canada, it must apply to its local securities commission for recognition or an exemption from recognition. To date, no cryptocurrency exchange has been recognized in any jurisdiction of Canada or exempted from recognition.
CSA Regulatory Sandbox
The CSA have set up an initiative that it calls the Regulatory Sandbox, to support fintech businesses seeking to offer innovative products, services and applications in Canada. It allows firms to register and/or obtain exemptive relief from securities law requirements, under a faster and more flexible process than through a standard application, in order to test their products, services and applications throughout the Canadian market on a time-limited basis.
The CSA want to encourage financial market innovation and facilitate capital raising by fintech businesses, while at the same time ensuring fair and efficient capital markets and investor protection. To avoid costly regulatory surprises, businesses considering doing an ICO/ITO should first consult legal counsel and then approach their local securities commission to discuss how they can comply with securities laws.
This blog post was written by Paul Franco, a member of the Business Law team. He can be reached at 613-369-0363 or at firstname.lastname@example.org.