On August 24, 2017, the Canadian Securities Administrators (CSA) issued Staff Notice 46-307 – Cryptocurrency Offerings. The Notice provides guidance with respect to the applicability of securities laws to:
- Cryptocurrency exchanges;
- Cryptocurrency offerings, including
- Initial Coin Offerings (ICOs)
- Initial Token Offerings (ITOs); and
- Cryptocurrency investment funds.
While they clearly have some concerns about awareness of compliance requirements in this area, the CSA also expresses its support for “digital innovation” and urges industry participants to seek regulatory input proactively before entering into new types of cryptocurrency business. Staff recommends the use of the CSA Regulatory Sandbox with respect to novel fintech enterprises of all kinds.
Despite money-laundering and anti-terrorism concerns, there is still very little regulation of the world’s cryptocurrency exchanges, which offer investors the opportunity to buy or sell cryptocurrencies online. To date, no exchanges of this type have been recognized by Canadian regulators and none have been exempted from recognition. CSA Staff point out that the compliance concerns that arise from this are not limited to the exchanges: coins or tokens to be traded on a cryptocurrency exchange may be subject to resale restrictions under securities laws.
Cryptocurrency Offerings (ICOs and ITOs)
The CSA notes that cryptocurrency offerings, in which coins or tokens are offered in exchange for ordinary currency (or other forms of cryptocurrency), are in many cases similar to initial public offerings (IPOs) of shares, stock or equity, in the CSA’s view, and will in such cases be regulated as offerings of securities.
In determining whether or not securities laws apply, the CSA will look to substance rather than form: it gives the examples of a sale of coins that allow a customer to play a video game (probably not a security) versus a sale of coins the value of which is tied to the future profits or success of a business (likely a security, given that the existence of an expectation of profit is one of the defining characteristics of a security).
Offering memorandum requirements
Where an offering is of a security, it must be made by prospectus or pursuant to a private placement in reliance on a prospectus exemption. In the case of ICOs and ITOs involving retail investors who do not qualify as accredited investors, the exemption that could be used would be the Offering Memorandum (OM) exemption. The CSA notes that the “whitepapers” that are often published by fintech firms with respect to such offerings are often lacking the disclosure that is required in an OM. The Notice gives a long list of examples, including disclosure regarding:
- A description of the business;
- The ecosystem within with the coin or token operates;
- The intended use of proceeds;
- Features of the coin or token, including potential ROI, exit strategies and liquidity;
- Valuation methodology for the coin or token;
- The number of coins or tokens to be held by management vs. the number offered to the public;
- Timelines for achieving milestones;
- Remuneration payable to the management team and/or any advisers;
- Management background information, including any legal or regulatory proceedings; and
- All material risks of investing.
The Notice also indicates that the OM exemption is available only where the document contains all required information and where certain additional requirements are met, including signed individual risk acknowledgment forms, audited financial statements and ongoing investor disclosure, compliance with resale restrictions and the filing of reports of exempt distributions with the regulator (among others).
Dealer registration requirements
Moreover, businesses completing ICOs or ITOs may require dealer registration, or an exemption therefrom, if their trades in coins or tokens are seen to be trading in securities for a “business purpose”. The Notice gives examples of how marketing coins or tokens at public events or via the Internet, or to a broad base of retail investors, can in the view of the CSA trigger the dealer registration requirement, which in turn will require compliance with “know your client” (KYC) rules, suitability requirements and cybersecurity risk management protocols, among other things.
Cryptocurrency Investment Funds
The Notice also considers investment funds that are being established to invest in cryptocurrencies, such as Bitcoin. While not wishing to discourage innovation in this area, the CSA notes that fintech businesses setting up such funds must be prepared for discussions with regulators with respect to a range of compliance issues, including:
- Where fund investors are to include retail investors, the inapplicability in certain Canadian jurisdictions of the OM exemption. In other words, distributions involving retail investors in those jurisdictions may require a full prospectus.
- Due diligence with respect to any cryptocurrency exchange that the fund will use to buy or sell coins or tokens, including with respect to its policies and procedures in relation to money-laundering, counter-terrorist financing, record-keeping and identity verification, and regarding liquidity and trading volumes.
- Obtaining appropriate registrations as dealer, adviser and/or investment fund manager.
- Valuation methodologies and audits thereof.
- Choice of a qualified custodian.
As the Notice indicates, these are only examples of the types of question that those setting up cryptocurrency investment funds can expect to receive from Canadian securities regulators.