On June 11, 2018, Canadian Securities Administrators (CSA) issued Staff Notice 46-308 Securities Law Implications for Offerings of Tokens (the “Notice”). This Notice is intended to provide further clarification to those wishing to offer tokens for sale in Canada, particularly in regards to whether such tokens constitute “securities”.
Almost a year ago, CSA (in Staff Notice 43-307) affirmed the analysis of token offerings should be conducted in relation to the “investment contract” test, first set forth in Canada in the Pacific Coin case:
- An investment of money;
- in a common enterprise;
- with the expectation of profit;
- to come significantly from the efforts of others.
According to CSA, if a token offering satisfied these four prongs, the tokens were securities, and the activities relating to their sale constituted an offering of securities. And since at least the date of 46-307, industry has analyzed token offerings with a view to how such offerings might fail one or more of those prongs, thus not satisfying the test for an investment contract and determining such token was not a security. A common argument was that tokens which were sold to be used or consumed by purchasers on the issuer’s web-based platform would not satisfy the four prong test, and the term “utility token” was born.
The notion of utility tokens, as opposed to a token that is a security, is a valuable one to industry, due to restrictions on the sale (and, more importantly, resale) imposed on securities by securities regulations. The argument flows that if the tokens are not investment contracts, they are not securities, and therefore not subject to the restrictive rules applicable to securities, meaning they can be sold to the world at large and can be resold in secondary markets without limitation.
Staff Notice 46-308 is the first regulatory recognition of the concept of utility tokens, and the bulk of the notice is a table dedicated to listing token (or offering) attributes, and their resulting effect on their status as security tokens, or utility tokens. To many in industry, few if any of these factors will be new, and they generally represent a summary of guidelines or factors which have been the subject of recent legal discussion and commentary. Though, some may say that the views set out in the Notice are situated near the more conservative end of the spectrum.
While the factors are not necessarily new, and their conclusions generally do not differ from those reached by industry, their express inclusion in an analysis by regulators is novel, and, for that reason alone, is worthy of note. What was previously a ”best-guess” by industry, at least in terms of “what you can’t do”, is now effectively settled from a regulatory standpoint. And, although the Notice stops well short of providing a path forward, one can glean from the 14 factors listed by CSA Notice what is important to regulators in the security vs. utility token analysis. For issuers wishing to create and sell utility tokens, our review of these 14 factors suggests four main themes:
1. Functionality at the Time of Sale: Token and platform functionality at the time of sale are of critical importance. Utility tokens and the platforms on which they are to be used must be functional at the time of sale. Even if the platform is functional, if significant intended functions are not yet available or there are material steps to be completed in the future, the Notice suggests it will be very difficult to avoid characterization as a security.
2. Marketing Language: The marketing and sale language used by the token issuer will be closely reviewed. While language may not be enough to avoid being a security, it certainly can give rise to one. Any language in a white paper, slide deck or other issuer-generated material (including on social media, messaging platforms and online communities) that deals with investment, increases in price or value, profit by purchasers, or secondary trading is likely to create an irreversible presumption that the tokens are indeed securities.
3. Purchaser Motives: Purchaser behaviour and motives may be relevant. If purchasers’ buying patterns or other behaviour are found to support a finding that tokens were bought for the purpose of resale, not consumption, this may trigger a finding of a token being a security, regardless of other attributes that may be consistent with a utility token. Examples would include purchasers acquiring a number of tokens which is disproportionate to what they could reasonably use, or purchasers who would not reasonably be expected to use the token for its intended purpose acquire the token in any event.
4. Multi-step Sales (SAFTs): Multi-step sale processes, like simple agreements for future tokens (SAFTs), will not, in and of themselves, mean the resulting tokens are not securities. A review of the offering language, token attributes and functionality at the time of token issuance will still be determinative.
The CSA has specifically noted certain practices which will support the view that the token is a security:
- The stated purpose of the offering is to raise capital to support the value of the token, the business or the platform’s functionality.
- Management retains a significant number of unsold tokens.
- A “bounty” program which incentivises participants to potentially make inappropriate statements about the token.
- There is a finite number of tokens to promote scarcity.
While much of the Notice provides caution with respect to practices which could deem a token a security, it does point to some limited factors which would lessen the likelihood of such tokens being deemed a security. These factors include:
- Delivering the tokens for free.
- Unique or non-fungible tokens which derive value from their own characteristics.
- Tokens that have a fixed value which do not increase over time (or “stable coins”).
- Conducting know-your-client procedures to ensure appropriate purchasers.
Finally, CSA has again stressed that no bright line or check-box solution exists to determine whether a token is or is not a security. This determination will always be made on a case-by-case basis, having regard to all of the facts in their totality. However, as the guidance now provides clear instances of what the regulators may view as off-side, the importance of experienced legal counsel in any token offering may be more critical now than before publication of the Notice.