Insights & Articles

Uncharted Territory - Application of Securities Law to Cryptocurrency Offerings

by Natalia Vandervoort, PCMA E-News Brief

Cryptocurrency is a hot commodity. Bitcoin, the original cryptocurrency created in 2009, is currently trading at approximately $10,400 per Bitcoin and, according to Forbes, the market capitalization for all cryptocurrency is over $130 billion as of September 2017.[1] Based on a review of recent news coverage, it appears that new cryptocurrencies are entering the market at record speed and businesses are turning to cryptocurrencies to raise substantial capital through initial coin/token offerings (which will be referred to as “ITOs” for ease of reference). As an example, in mid-October, Bloomberg reported that companies have raised over $3 billion through ITOs in 2017 alone.[2]

Yet, the burgeoning cryptocurrency market remains largely unregulated. Ontario does not have any securities law tailored specifically to the cryptocurrency market and the existing law regulating more conventional securities can be difficult to apply to cryptocurrency. Until the Ontario Securities Commission (the “OSC”) begins creating regulation geared to cryptocurrency, or begins rendering decisions on the application of securities law to cryptocurrency, the uncertainty as to whether, and in what circumstances, securities law applies will continue.

In late August 2017, the Canadian Securities Administrators finally provided guidance to the market on the application of securities law to cryptocurrency offerings with the publication of Staff Notice 46-307 Cryptocurrency Offerings (the “Staff Notice”). The message is clear. Staff’s priority is investor protection and cryptocurrency offerings will likely be subject to securities law if the value of tokens sold to individuals as part of an ITO is tied to “future profits or success of a business”. Given the regulatory risk, companies and individuals involved in the cryptocurrency market should take precautions to ensure that their activities are not offside securities law by seeking timely professional advice. The days of assuming that the virtual world of cryptocurrency falls outside the reach of a securities regulator are over.   

At a high level, a cryptocurrency is a digital decentralized currency that is reliant on blockchain technology.[3] Cryptocurrencies can be used to buy goods and services online, or in stores that accept digital currency, and are traded on cryptocurrency exchanges.[4] ITOs, also known as cryptocurrency offerings, are used by companies to raise capital through the sale of ‘tokens’ in exchange for other cryptocurrency such as Bitcoin or Ethereum. The tokens can then be traded on a cryptocurrency exchange along with other cryptocurrencies. The structure of an ITO varies from company to company.

In the Staff Notice, Staff compare ITOs to initial public offerings by noting that “coins/tokens can be similar to traditional shares of a company because their value may increase or decrease depending on how successfully the business executes its business plan using the capital raised.” Staff further note that “if an individual purchases coins/tokens whose value is tied to the future profits or success of a business, these will likely be considered securities.” [emphasis added]       

The definition of “security” in the Securities Act, R.S.O. 1990, c. S.5 (the “Act”) is broad and includes “any investment contract”. Staff urges that the commonly accepted test[5] be applied to determine whether an investment contract exists, that is, does the ITO involve (a) an investment of money; (b) in a common enterprise; (c) with the expectation of profit; (d) to come significantly from the efforts of others.    

In July 2017, the Securities Exchange Commission (the “SEC”), in its first decision on this issue, concluded that a token sold pursuant to an ITO was a security by applying the same test as set out above to determine whether an investment contract exists.[6] At issue was a company that sold tokens to investors to raise capital for projects where the holders of the tokens “stood to share in the anticipated earnings from these projects as a return on their investment” and could re-sell their tokens on online platforms. The SEC decision is instructive on the application of the test to determine whether a security exists to the cryptocurrency market and provides insight into how the OSC may approach this issue in the future.  

If it is determined that securities law applies to an ITO, the issuing business will need to file a prospectus with the regulator or seek an exemption from the prospectus requirements, such as the offering memorandum exemption. In August and October 2017, the first two offering memorandum exemptions were approved for companies wishing to raise capital through ITOs (Impak Finance Inc.[7] and Token Funder Inc.[8]).

The Staff Notice also warns that businesses (and individuals) completing ITOs may trigger the registration requirement under securities law if they are found to be trading in securities for a business purpose. The terms “trade” and “trading” are defined in subsection 1(1) of the Act to include “any act, advertisement, solicitation, conduct or negotiation directly or indirectly in furtherance of” a sale of security. By way of example, in the Staff Notice, the following factors are flagged as “important considerations” for determining whether there has been trading in securities for a business purpose:

1. Soliciting a broad base of investors, including retail investors;
2. Using the internet, including public websites and discussion boards, to reach a large number of potential investors;
3. Attending public events, including conferences and meetups, to actively advertise the sale of the coins/tokens; and
4. Raising a significant amount of capital from a large number of investors.

On the OSC website promoting the “OSC Launch Pad”, which is an initiative to assist fintech businesses with navigating securities law requirements, the following further examples are provided of activities that may trigger compliance with securities law[9]:

1. Connecting investors with companies looking to raise capital;
2. Arranging or participating in organized groups (e.g. meet up groups) or pitch sessions, where companies present their businesses, products, services, or applications to potential investors;
3. Setting up means for investors and companies looking to raise capital to interact, including chat rooms, message boards, and other forms of social media; and
4. Helping to prepare offering documents, marketing materials, or other similar documents for companies looking to raise capital.

The above is by no means an exhaustive list of activities that may constitute registerable activity requiring compliance with securities law. If the registration requirement is triggered, barring any applicable exemption, the registrant has certain obligations to investors, which includes knowing your client, knowing your product (“KYP”) and ensuring that the investment is suitable. Although it is beyond the scope of this paper to review each of these obligations, the KYP obligation is worthy of brief mention. In circumstances where a company conducts an ITO on the assumption that securities law does not apply, it may be that only a “white paper” will be available, which Staff have noted is insufficient from a regulatory perspective. As such, registrants must ensure that they are able to meet their KYP obligations to clients prior to trading in cryptocurrencies that may be considered securities. Reliance on a company’s “white paper” may not be sufficient.

Due to the fact that the cryptocurrency market is largely unregulated, investor protection may also be jeopardized due to, as noted by Staff, “issues around volatility, transparency, valuation, custody and liquidity, as well as the use of unregulated cryptocurrency exchanges”.

A recent OSC decision granting exemptive relief from the dealer registration requirement relating to an ITO highlights how investor protection concerns may develop the law in this area. In October, 2017, the OSC granted exemptive relief to Token Funder Inc. for a limited period of time until the company sought registration following completion of the offering. However, despite the exemptive relief, Token Funder Inc. was still required to conduct know-your-client and a suitability review, with each investor undergoing a “comprehensive onboarding process, which will include the collection of information such as its investment needs and objectives, financial circumstances and risk tolerance.” Token Funder Inc. was also required to provide a survey to ensure that each investor had a “detailed understanding of cryptocurrency and digital token offerings.”[10]   

The law will likely play ‘catch up’ with the developing cryptocurrency technology as it transcends international borders and raises novel issues for regulators and market participants. The Staff Notice does not offer a complete answer on the application of securities law to cryptocurrencies. Until ITOs become more commonplace, participants can expect the OSC to take a strict position regarding ITOs and to monitor participants in that space closely. In the meantime, given the regulatory risk, businesses and individuals are encouraged to seek timely professional advice, and work with the regulator as may be appropriate, to determine whether securities law may be applicable to their specific activities