One of the first questions that anyone contemplating an offering of tokens should be asking is whether the token to be offered is a security.
Early proponents of token offerings would often claim that their tokens were not securities and therefore not subject to regulation under the existing legal framework governing equity, debt and other instruments traditionally regarded as securities. If, in fact, tokens were not securities, they would revolutionize the process by which businesses could raise capital.
Several early token offerings demonstrated that millions of dollars could be raised in a matter of days or even hours. But was it legal?
In the early days of token offerings, starting in or about 2013, Canadian securities regulators offered little or no guidance as to how, if at all, token offerings should be regulated. That changed in August 2017 when the Canadian Securities Administrators (“CSA”) published Staff Notice 46-307, outlining how securities law requirements may apply to initial coin and token offerings, cryptocurrency investment funds and token/cryptocurrency trading platforms.
Earlier this month, the CSA weighed in further with CSA Staff Notice 46-308 Securities Law Implications for Offering of Tokens, which supplements the guidance provided in Staff Notice 46-307.
Staff Notice 46-308 provides further and better guidance as to specific circumstances in which a token is likely to be regarded as a security and is based on fact patterns that have been the subject of inquiries that the CSA has received regarding the applicability of securities laws to proposed offerings of coins or tokens. While not ruling out that the characteristics of a particular token might make it less likely to be regarded as a security, the CSA has concluded that the vast majority of the proposed token offerings that it has examined bear hallmarks of securities offerings and should be regulated as such.
One of the principal ways in which token offering proponents have attempted to characterize their tokens so as not to be regarded as securities is to refer to them as “utility tokens.”
A utility token has some degree of functionality within the parameters of a designed “ecosystem,” which may involve gaming or the provision of goods or services. Typically, the token functions as a currency within the ecosystem.
The CSA notes that while a utility token viewed in isolation might not bear the characteristics of a security, the economic realities of the offering as a whole need to be examined in a meaningful analysis focused on substance over form to determine if any of the legally recognized criteria exist that would indicate that the purchase of the token involves an investment contract.
When determining whether or not an investment contract exists, courts espouse a purposive interpretation, with a focus on investor protection. The case law provides that elements of an investment contract include:
- an investment of money;
- in a common enterprise;
- with the expectation of profit;
- to come significantly from the efforts of others.
In the utility token example, the tokens are often offered at a time when the ecosystem in which they are intended to function does not yet exist and the purpose of the offering is to finance the ecosystem’s development. One might readily conclude in these circumstances that the token is an investment contract insofar as it engages most, if not all, of the key elements. If the stated purpose of the offering is to raise capital which will be used to essentially create the functionality of the token, this could indicate the existence of a common enterprise between management and token purchasers and if the functionality of the tokens does not yet exist, then arguably the purchasers are not purchasing the tokens for their utility, but rather to invest in a business with an expectation of profit.
Staff Notice 46-308 provides other illustrative examples of token characteristics or fact patterns that the CSA views as indicative of whether a token offering is more or less likely to be characterized as an offering of securities.
Whether a particular token offering is subject to securities legislation will be determined on a case-by-case basis.
Anyone planning a token offering would be well advised to seek legal advice from experts in the area of securities. The CSA also encourages token offering proponents to contact their local securities regulatory authority for guidance as to how securities regulators are likely to view the proposed offering within the context of applicable securities laws.
The CSA has re-emphasized the willingness of securities regulators to continue taking action against persons offering tokens or cryptocurrencies in a manner that is non-compliant with securities laws. It is therefore of the utmost importance to undertake a thorough analysis of a proposed token offering within the context of securities law compliance in order to mitigate against potentially costly regulatory problems that might arise after the offering has been launched.