An extract from The Virtual Currency Regulation Review, 3rd Edition
Securities and investment laws
Securities regulation in Canada is primarily a matter of provincial jurisdiction. While each province and territory has its own rules and securities regulators, the securities regulatory framework is largely streamlined and harmonised across Canada, with certain provincial or regional variances.2 However, legislative jurisdiction in the area of derivatives is divided between the federal and provincial governments, and the harmonisation of rule-making in this area has been more elusive.
Generally, the basic purposes of the securities laws are to provide protection from unfair, improper or fraudulent practices, foster fair and efficient capital markets, and confidence in those capital markets, and contribute to the stability of the financial system and the reduction of systemic risk.3 Securities regulation in Canada generally governs the distribution and trading of both securities and derivatives. The distribution and trading of securities and derivatives is primarily regulated through the imposition of prospectus requirements, dealer, adviser and investment fund manager registration requirements, and certain requirements imposed upon those operating exchanges, alternative trading facilities or other marketplaces that facilitate their trading, as well as related reporting and disclosure requirements.
The Canadian Securities Administrators (CSA) is an umbrella organisation of Canada's provincial and territorial securities regulators whose objective is to improve, coordinate and harmonise regulation of the Canadian capital markets. The CSA has published three staff notices with respect to virtual currencies with a view to being responsive to the evolving activity related to virtual currencies: Staff Notice 46-307 – Cryptocurrency Offerings,4 Staff Notice 46-308 – Securities Law Implications for Offerings of Tokens;5 and Staff Notice 21-327 – Guidance on the Application of Securities Legislation to Entities Facilitating the Trading of Crypto Assets.6 The CSA and Investment Industry Regulatory Organization of Canada (IIROC) also published a more comprehensive joint consultation paper7 (the Consultation Paper) seeking input on various considerations relating to the potential regulation of virtual currencies. Jointly, the Staff Notices and the Consultation Paper have helped provide insight into the evolution of securities law as it applies to cryptoassets. Some contextual insight was also provided through the report (the Quadriga Report) published by the Ontario Securities Commission (OSC) of the collapse of Quadriga Fintech Solutions Corp (Quadriga).8 While ultimately no enforcement action was taken (given the passing of the main principal at Quadriga), the Quadriga Report signals that although investor protection remains the utmost priority, Canadian regulators are also committed to fostering innovation and competition in this industry.i Applicability of Canadian securities laws to virtual currencies
Virtual currencies may be subject to Canadian provincial securities laws to the extent that a virtual currency is considered a security or a derivative for the purposes of such laws, such as the Securities Act (Ontario). The Securities Act defines a security to include, among other things, an investment contract. The seminal case in Canada for determining whether an investment contract exists is Pacific Coast Coin Exchange v. Ontario (Securities Commission),9 where the Supreme Court of Canada identified the four central attributes of an investment contract, namely:
- an investment of money;
- in a common enterprise;
- with the expectation of profit; and
- which profit is to be derived in significant measure from the efforts of others.
If an instrument satisfies the Pacific Coin test, it will be considered an investment contract and, therefore, a security under Canadian securities laws.
The application of the Pacific Coin test to virtual currencies is not always straightforward, however. Industry participants have taken the position that utility tokens, which have a specific function or utility beyond the mere expectation of profit (such as providing their holders with the ability to acquire products or services) should not be considered securities.10 This position appears to have been accepted by the CSA and IIROC in the Consultation Paper, in which it was acknowledged that proper utility tokens may not be securities. However, the CSA has also noted that most of the offerings of virtual currencies purporting to be utility tokens that its staff had reviewed involved the distribution of a security, usually in the form of an investment contract.11
The CSA and IIROC have also acknowledged that it is widely accepted that some of the well-established virtual currency assets that function as a form of payment or means of exchange on a decentralised network, such as Bitcoin, are not currently in and of themselves, securities or derivatives and have features that are analogous to commodities such as currencies and precious metals.12 In assessing whether a particular virtual currency will be considered a security subject to Canadian securities laws, the CSA will consider the substance of the virtual currency over its form.13 The CSA has outlined a number of considerations in determining whether an investment contract exists. While no single factor is determinative, the CSA has stated that the existence of some or all of the following circumstances may cause a virtual currency to be considered an investment contract:14
- the underlying blockchain technology or platform has not been fully developed;
- the token is immediately delivered to each purchaser;
- the stated purpose of the offering is to raise capital, which will be used to perform key actions that will support the value of the token or the issuer's business;
- the issuer is offering benefits to persons who promote the offering;
- the issuer's management retains a significant number of unsold tokens;
- the token is sold in a quantity far greater than any purchaser is likely to be able to use;
- the issuer suggests that the tokens will be used as a currency or have utility beyond its own platform, but neither of these things is the case at the time the statement is made;
- management represents or makes other statements suggesting that the tokens will increase in value;
- the token does not have a fixed value on the platform;
- the number of tokens issuable is finite or there is a reasonable expectation that access to new tokens will be limited in the future;
- the token is fungible;
- the tokens are distributed for a monetary price; and
- the token may be reasonably expected to trade on a trading platform or otherwise be tradable in the secondary market.
A particular virtual currency that meets the criteria of the Pacific Coin test or has certain of the characteristics described in the CSA guidance discussed above may be properly considered an investment contract and therefore a security, subject to Canadian securities laws.ii Virtual currency offerings in Canada
Canadian securities laws generally require the filing of a prospectus to qualify any distribution of securities. No person or company may trade in a security where the trade constitutes a distribution unless a prospectus has been filed or the trade is made in reliance upon a prospectus exemption. Securities originally distributed under a prospectus exemption are generally subject to resale restrictions that require the issuer to have been a reporting issuer (i.e., a public company) for a specified period of time and, in some cases, that the securities be held for a specified period of time. To the extent that a virtual currency is considered a security or a derivative, the issuance or distribution to the public is subject to prospectus, qualification or similar requirements, or must be effected pursuant to applicable exemptions from prospectus or derivatives qualification requirements.
There are a number of options available for distributing securities in Canada on a prospectus-exempt basis, generally referred to as exempt distributions or private placements. Most of these are harmonised under National Instrument 45-106 – Prospectus Exemptions.15 The CSA has indicated that persons wishing to distribute virtual currencies may do so pursuant to these exemptions.16 Specifically, distributions may be completed pursuant to the accredited investor exemption, which provides a prospectus exemption for trades of securities to entities and individuals that are qualified accredited investors.17
Distributions may also be made to investors who do not qualify as accredited investors in reliance on the offering memorandum prospectus exemption.18 To rely on this exemption, investors must be provided with a written document that contains certain prescribed disclosure, but this exemption does not require the same level of disclosure as a prospectus. Importantly, an investor has certain rights in connection with this type of investment, including a two-business-day withdrawal right and a right of action for rescission or damages if the offering memorandum contains a misrepresentation.19 Non-reporting issuers (generally, unlisted companies) that rely on the offering memorandum exemption will generally be required to provide to the applicable securities regulatory authority audited annual financial statements and a notice describing how the money raised has been used. The financial statements and notice must be made available to investors within 120 days of each financial year end.
A number of companies have successfully completed virtual currency offerings in compliance with applicable securities law requirements and bespoke exemptions from such requirements. Montreal-based Impak Finance Inc (Impak) was the first Canadian company to complete a virtual currency offering with the approval of Canadian securities regulators. Impak issued Impak Coin (MPK), a virtual currency based on the Waves blockchain platform, for gross proceeds of over C$1 million by way of private placement, in reliance on the offering memorandum exemption.20
A few months later, Token Funder Inc (Token Funder) completed the first virtual currency offering under the oversight of the Ontario Securities Commission (OSC). Token Funder was established for the purpose of creating a smart token asset management platform that is intended to, inter alia, facilitate capital raising by third-party issuers through the offering of blockchain-based securities, including tokens and coins.21 Token Funder issued its virtual currency, FNDR, in reliance on the offering memorandum exemption. In this case, the OSC granted an exemption from the dealer registration requirement for a period of 12 months from the date of the decision, subject to a number of conditions similar to those imposed on Impak.22
In May 2019, ZED Network Inc (ZED) became the first company to obtain exemptive relief from the prospectus and dealer registration requirements (discussed below) under Canadian securities laws for the distribution and trading of the ZED digital remittance and foreign exchange blockchain tokens to (1) money transfer operators (MTOs) registered as money services businesses in Canada with the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC Registered MTOs), and (2) MTOs appropriately registered or authorised to operate as money services businesses, or its equivalent, in accordance with the laws of foreign jurisdictions (Foreign Registered MTOs), as applicable.23
More recently, on 27 March 2020, the OSC granted a time-limited exemption to B2C2 OTC Ltd (B2C2) from the dealer registration and prospectus requirements that would otherwise be applicable to a trade in or distribution of an over-the-counter (OTC) derivative between B2C2 and a 'permitted counterparty' in Ontario, New Brunswick, Newfoundland and Labrador, Prince Edward Island, the Northwest Territories, Yukon and Nunavut.24 The underlying interest of the OTC derivatives that will be entered into between B2C2 and a permitted counterparty may consist of, among others, 'a currency, including fiat and cryptocurrency'. B2C2 will also become a 'market participant' under Ontario securities law and, as such, must comply with applicable books and record-keeping requirements.
It is important to note, however, that B2C2 is a London-based OTC market maker that is regulated by the Financial Conduct Authority (FCA) in the United Kingdom and licensed to transact with institutional and other non-retail clients in relation to certain specified investments. It is likely that the regulation by the FCA and the restriction of the regulated activities to non-retail permitted counterparties were material factors in the B2C2 decision. In an important decision, the OSC granted TokenGX Inc (TGX), an affiliate of Token Funder Inc (TFI), a time-limited exemption to facilitate secondary trading on a platform known as Freedom (FRX). TGX obtained registration as an exempt market dealer until 16 April 2021, subject to some restrictive terms and conditions. This enables qualified investors in Ontario to purchase and sell certain tokens on the FRX platform.
Importantly, TGX cannot distribute securities of investment funds without prior OSC approval, must treat all tokens traded as securities, must not take custody of tokens for its clients and must ensure that purchasers of tokens on FRX who are not accredited investors are subject to the same eligible and non-eligible caps as outlined above. Additionally, TGX must file the requisite forms to seek membership with IIROC and become an alternative trading system for securities law purposes, both within six months of the date of the order.25
The experiences of Impak, Token Funder, ZED, TokenGX and B2C2 demonstrate the importance of bespoke exemptions in ensuring Canadian securities laws are met while meeting the demands of Canadian investors.iii Regulatory considerations for intermediaries
Any person or company engaging in, or holding themselves out as engaging in, the business of trading or advising in securities, and, in certain Canadian jurisdictions, in derivatives, must register as a dealer or as an adviser or, where available, conduct these activities pursuant to an exemption from the dealer or, as the case may be, adviser registration requirement under the applicable securities laws. A person or entity that directs the business, operations and affairs of an 'investment fund' must comply with the investment fund manager registration requirements or obtain an exemption from such requirements. Registration requirements are generally harmonised under National Instrument 31-103 – Registration Requirements, Exemptions and Ongoing Registrant Obligations,26 which sets out requirements for dealers and advisers dealing with capital, proficiency, insurance, financial reporting, know your client, investor suitability, client disclosure, safekeeping of assets, record-keeping, account activity reporting, complaint handling and other compliance matters.
In Canada, the requirement to register as a dealer or adviser is triggered where a person or company conducts a trading or advising activity with respect to securities or derivatives for a business purpose.27 The mere holding out, directly or indirectly, as being willing to engage in the business of trading in securities may trigger the requirement to register as a dealer; however, a number of factors must be considered when determining whether registration is required, including whether a business:
- engages in activities similar to a registrant;
- intermediates trades or acts as a market maker;
- carries on an activity with repetition, regularity or continuity;
- expects to be remunerated or compensated; and
- directly or indirectly solicits.28
In the context of virtual currency distributions, the CSA has noted the following additional factors in determining whether a company may be considered to be trading in securities for a business purpose:29
- soliciting of a broad range of investors, including retail investors;
- using the internet to reach a large number of potential investors;
- attending public events to actively advertise the sale of a virtual currency; and
- raising a significant amount of capital from a large number of investors.
The CSA has stated that persons facilitating offerings of virtual currencies that meet the business trigger must collect know your client information and perform suitability assessments to ensure that purchases of virtual currencies are suitable, including with respect to investment needs and objectives, financial circumstances and risk tolerance.30
The creation and marketing of products related to virtual currencies are also subject to derivatives-related regulatory requirements, including in relation to qualification, registration and trade data reporting in a number of Canadian jurisdictions, including specifically Quebec, where the rules in relation to OTC and exchange-traded derivatives are more fully developed.31
The CSA has also issued proposals to establish a harmonised framework of registration and business conduct requirements for OTC derivatives market participants.32 The proposals expressly define a commodity to include a cryptocurrency.iv Exchanges and other platforms
As marketplaces, exchanges are regulated pursuant to their applicable provincial securities statutes, as well as National Instrument 21-101 – Marketplace Operation (NI 21-101),33 National Instrument 23-101 – Trading Rules (NI 23-101)34 and their related companion policies.
NI 21-101 defines a marketplace as a facility that brings together buyers and sellers of securities, brings together the orders for securities of multiple buyers and sellers, and uses established non-discretionary methods under which the orders interact with each other.35
An exchange is a marketplace that may:
- list the securities of issuers;
- provide a guarantee of a two-sided market for a security on a continuous or reasonably continuous basis;
- set requirements governing the conduct of marketplace participants; or
- discipline marketplace participants.36
To operate as an exchange in Canada, a person or company must first apply for recognition as an exchange or for an exemption from the recognition requirement.37 As another type of marketplace, alternative trading systems, which provide automated trading systems that match buyer and seller orders, are also regulated under NI 21-101 and NI 23-101.
It follows that exchanges or other platforms that facilitate the purchase, transfer or exchange of virtual currencies that are considered securities or derivatives may be subject to recognition requirements as securities or derivatives exchanges or marketplaces.38 In the institutional market, prescribed or negotiated exemptions may be available in respect of platform-related recognition requirements under securities or derivatives laws, subject to the satisfaction of certain conditions and acceptance by the applicable regulators.
The guidance set out in Staff Notice 21-327 further expands upon the circumstances in which the CSA will consider 'any entity that facilitates transactions relating to crypto assets' to be subject to securities legislation requirements relating to platform recognition. Mainly, the CSA has cautioned that securities legislation may also apply to platforms that facilitate the buying and selling of cryptoassets, including cryptoassets that are commodities, because the user's contractual right to the cryptoasset may itself constitute a derivative. This will generally be the case where the platform is determined to be merely providing users with a contractual right or claim to an underlying cryptoasset, rather than immediately delivering the cryptoasset.39
While regulators will consider all the terms of the relevant contract or instrument, the CSA has taken the view that if there is no immediate delivery of the cryptoasset, then securities legislation will generally apply. Immediate delivery will be considered to have occurred if:
- there is immediate transfer of ownership, possession and control of the cryptoasset and the user is free to use, or otherwise deal with, the cryptoasset without any further involvement with, or reliance on the platform or its affiliates, and the platform or any affiliate retaining any security interest or any other legal right to the cryptoasset; and
- following the immediate delivery, the user is not exposed to insolvency risk (credit risk), fraud risk, performance risk or proficiency risk on the part of the platform.
Other factors to be considered include:
- contractual arrangement between the platform and the user;
- immediate settlement of transaction;
- margin and leverage trading;
- typical commercial practice with regard to immediate delivery;
- immediate transfer to a user's wallet; and
- ownership, possession or control over the transferred cryptoasset.
To date, no virtual currency trading platform has been recognised as an exchange, or otherwise authorised to operate as a marketplace or dealer in Canada.40 As such, the CSA has kept a watchful eye, however, and urged Canadians to be cautious when buying virtual currencies. The CSA has issued a steady stream of market advisories alerting market participants to risks related to products linked to virtual currencies, including futures contracts, on both regulated and unregulated platforms.41,42v Asset management and investment funds
The demand for economic exposure to virtual currencies is high and investment funds have been a popular vehicle for obtaining this exposure. However, persons operating or administering collective investment structures that hold or invest in virtual currencies may also be subject to investment fund manager registration requirements in addition to dealer, adviser and prospectus or private placements requirements. The structures themselves may also be subject to reporting and conduct requirements that apply to investment funds.
In September 2017, First Block Capital Inc became the first registered investment fund manager (IFM) in Canada for a fund dedicated solely to investments in virtual currencies.43 The British Columbia Securities Commission (BCSC) granted First Block Capital registration as an IFM and exempt market dealer in order to operate a Bitcoin investment fund, subject to certain bespoke exemptions from the applicable regime.44 In its decision, the BCSC imposed a number of conditions on First Block Capital, including the requirement to seek the prior approval of the BCSC to:
- establish or manage any virtual currency investment fund;
- change the investment objective of the virtual currency investment fund;
- change the entity that maintains custody of the specified virtual currencies held by any investment fund;
- change the entity responsible for the execution of trades in specified virtual currencies; and
- change the firm's policies and procedures used to value any virtual currency held by any investment fund managed by the firm.45
The BCSC also imposed a number of other obligations on First Block Capital with respect to oversight of the third-party custodians and brokers.46
Additional investment fund managers have also been approved by the CSA since the First Block Capital decision.47
The CSA has encouraged fintech businesses interested in establishing a virtual currency investment fund to consider:
- the prospectus requirements when distributing securities to retail investors;
- the legal and operational suitability of virtual currency exchanges;
- the registrations required with respect to the investment fund;
- the valuation methodology for the virtual currencies; and
- the virtual currency expertise of the custodian for the virtual currencies.48
Although certain virtual currency investment fund applications have been successful, it has proven difficult for these funds to become accessible to the general public. In October 2018, 3iQ Corp (3iQ) filed a non-offering preliminary prospectus on behalf of the Bitcoin Fund (3iQ Fund), a non-redeemable investment fund established as a trust under the laws of the province of Ontario, in its capacity as investment fund manager of the Fund.49
On 15 February 2019, the Director, Investment Funds and Structured Products (the Director) of the OSC decided that it would be contrary to the public interest to issue a receipt for the 3iQ Fund's preliminary prospectus.
On 15 March 2019, 3iQ and the 3iQ Fund made an application to the OSC seeking an order to set aside the decision of the Director to refuse to issue a receipt for the final non-offering prospectus of the 3iQ Fund and an order directing the Director to issue the receipt.50 The hearings were held in June and July 2019 before an OSC panel consisting of a single commissioner. The panel ordered that the Director's decision be set aside and that a prospectus receipt be issued for the 3iQ Fund.51 A preliminary prospectus was filed and a receipt issued on 27 November 2019.
Importantly, the 3iQ decision challenges the recent trend of expansive interpretation of the 'public interest' under securities legislation, offering a more restricted interpretation. Concerns about market manipulation and valuation were assuaged by the Fund's investment in Bitcoin, as opposed to all cryptoassets; its pursuit of a buy-and-hold strategy; and trading of Bitcoin only on regulated markets. The panel also found sufficient evidence of trading in Bitcoin for it to be considered a liquid asset, including trading on regulated exchanges. Furthermore, the decision signalled that the underlying regulatory objectives may ultimately be better serviced by encouraging market participants to enter through the 'front door', engaging regulatory oversight from the outset, rather than through transactions such as reverse takeovers.