The CSA Issues Notice On Cryptocurrency Offerings
WHAT ARE CRYPTOCURRENCIES AND ICOS?
A cryptocurrency is a data-based currency that can be used in cryptography-secured transactions. Bitcoin is the first, and most famous decentralized cryptocurrency, meaning it is uncontrolled by a central bank. Many other decentralized cryptocurrencies followed bitcoin such as Ethereum, Litecoin and Z-Cash. Bitcoin uses a decentralized database, called the blockchain, to record transactions in multiple places so as to minimize cyberattacks and other risks.
New cryptocurrencies can be issued through initial coin offerings (“ICOs”). These are crowdfunding mechanisms, in which companies and individuals can raise legal tender or one of the major cryptocurrencies (like Bitcoin or Ethereum) in exchange for a new cryptocurrency, much like a public market initial public offering (“IPO”). So far, more than US$2 billion has been raised through ICOs.1 After an ICO is completed, the cryptocurrency issued under the ICO can often be traded on secondary markets.
There are two big differences, between IPOs and ICOs. First, investors typically purchase the new cryptocurrency hoping that it will go up in value, but they are not purchasing an ownership stake in a company.2 The idea is that the capital raised will fund a project and if that project succeeds, the associated coin will increase in value, potentially at a very rapid rate. The second difference is that ICOs have been mostly unregulated, until recently. But that is changing.
THE SEC REPORT SUGGESTS APPLICABILITY OF US FEDERAL SECURITIES LAWS TO ICOS
The US Securities and Exchange Commission (the “SEC”) is the principal agency responsible for creating and enforcing securities regulation. On July 25, 2017, the SEC noted that ICOs may be found to constitute the offer or sale of a security. The report strikes a strong tone, noting that “The automation of certain functions through… “smart contracts or computer code, does not remove conduct from the purview of the U.S. federal securities laws.”3
Offerings and sales should be registered with the SEC, unless issuers can find an exemption. The same is the case for the secondary market exchanges that host post-ICO trading.4 The goal of registration is to protect investors by ensuring they receive proper disclosure. The Canadian Securities Administration (the “CSA”) followed suit with a “Cryptocurrency Offerings” staff notice on August 24, 2017.5
THE CSA NOTICE
The CSA is an umbrella organization of Canadian securities regulators. It co-ordinates the work of the regulators, nationalizing its impact. Its August staff notice, published in all Canadian jurisdictions except for Saskatchewan, is the most important guidance so far about the applicability of Canadian securities laws to ICOs.
WHEN DO CANADIAN SECURITIES LAWS APPLY?
The CSA says that Canadian securities laws apply where there are ICO investors within Canada or if the organization or individual launching the ICO is in Canada. This may capture even Canadian businesses incorporated abroad, should they fail to exclude Canadian investors. There is also a possibility that cryptoproducts might be deemed derivatives, in which case, they would be subject to Canadian securities regulators’ derivatives laws.
WHO DOES THIS AFFECT?
This is of particular consequence to three major types of stakeholders:
- companies raising capital using blockchain (such as ICO issuers in Canada or elsewhere, with Canadian investors);
- companies conducting or facilitating transactions in cryptocurrency (any exchange facilitating secondary market crypto-transactions); and
- companies creating cryptocurrency investment funds (the first Canadian fund, Rivemont, was launched on October 20.6
WHEN DOES CRYPTOCURRENCY CONSTITUTE A SECURITY?
The CSA plans to take a “purposive” approach to determining whether an ICO constitutes a securities offering, meaning that it will keep the central purpose of securities law squarely in mind: protecting investors. Keeping that in mind, the CSA will look at whether the coins are “investment contracts” which give rise to securities law. In determining whether a coin is an investment contract, the CSA will rely on the four-part test from the Pacific Coast Coin Exchange7 case:
- is there an investment of money;
- in a common enterprise;
- with the expectation of profit; and
- to come from the efforts of others.
The fourth prong of the test, that the work must be done by others, is noteworthy. The investor is permitted to contribute to the enterprise to some degree, but the efforts of others are the most important: “[the test is] whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.”
WHAT OBLIGATIONS COULD SECURITIES LAW IMPOSE?
Three of the most significant are:
- the prospectus requirement;
- dealer registration; and
- exchange registration.
THE PROSPECTUS REQUIREMENT
Where a cryptocurrency is a security, it cannot be distributed without a prospectus unless a prospectus exemption can be obtained. Issuers may be able to use the accredited investor exemption if issuing only to accredited investors or, for non-accredited investors, the offering memorandum exemption. The typical whitepaper, often used to describe a crypto-project, is insufficient to meet the prospectus requirement.
DEALER REGISTRATION
Where a cryptocurrency is a security, companies involved in their distribution that are trading in the security for a “business purpose” will need to register as a dealer or seek an exemption. Key considerations for determining whether there is a business purpose include:
- soliciting a broad base of investors, including retail investors;
- using the internet, including public websites and discussion boards, to reach a large number of potential investors;
- attending public events, including conferences and meetups, to actively advertise the sale of the coins/tokens; and
- raising a significant amount of capital from a large number of investors
Where dealer registration is required, companies must meet investor protection obligations such as “know-your-client and suitability.”
EXCHANGE REGISTRATION
Platforms that facilitate secondary market trading of cryptocurrencies, and are located in Canada, may be “marketplaces.” They must ask the appropriate jurisdiction’s securities regulator for recognition or an exemption. If found to be a marketplace, they must comply with the rules governing exchanges or alternative trading systems. There is uncertainty as to how this issue will play out since no cryptocurrency exchange has yet been recognized or exempted.
WHAT CAN STAKEHOLDERS – PARTICULARLY ICO CREATORS – DO?
They should acknowledge that the days of Canadian unregulated ICOs are ending. Beyond speaking to a securities lawyer to ensure compliance, ICO creators can work with the CSA through its regulatory sandbox. This initiative will empower issuers to test their offerings on the Canadian market, in a time and scope-limited fashion. It claims this will be a faster means of ensuring compliance with securities law requirements.8
If you have questions regarding a potential ICO please contact Daniel D. Nauth at 416-477-6031 or dnauth@nauth.com.
1 Inside the Meteoric Rise of ICOs
2 The market in Initial Coin Offerings risks becoming a bubble
3 SEC Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934
4 SEC Issues Investigative Report Concluding DAO Tokens, a Digital Asset, Were Securities
5 CSA Staff Notice 46-307
6 Launch of Canada’s First Cryptocurrency Fund
7 Pacific Coast Coin Exchange v. Ontario Securities Commission, [1978] 2 S.C.R. 112
8 CSA Staff Notice 46-307