In light of the recent interest in cryptocurrency and the increase in the number of cryptocurrency offerings, on August 24, 2017, staff of the Canadian Securities Administrators (Staff) published a notice to help financial technology (fintech) businesses understand what obligations may apply to their operations under Canadian securities laws (the Notice). The Notice sets out Staff’s experience with cryptocurrency offerings and highlights potential pitfalls and recommendations for fintech companies seeking to engage in cryptocurrency offerings or participate in the markets for cryptocurrency. The Notice focuses on three types of transactions and their intersection with cryptocurrency exchanges: initial coin offerings (ICO), initial token offerings (ITO) and the acquisition of cryptocurrencies by investment funds. Although not explicitly touched upon, Staff suggests that the Notice is also relevant to other cryptocurrency and distributed ledger technology-based offerings.
The Notice appears in the wake of a report of investigation released by the U.S. Securities and Exchange Commission (the SEC) on July 25, 2017, which found that an online organization and its founders were guilty of contravening U.S. securities laws in operating their ICO. The SEC confirmed that it would be regulating ICOs and other distributed ledger-based ventures on a case-by-case basis. Pursuant to the Notice, Canadian regulators appear to be following a similar approach and will base their determination on whether a “security” is involved. Such determination will be substantive rather than form-based. The Notice also notes that, based on Staff's assessment, many ICOs and ITOs will be securities offerings and subject to applicable securities laws.
The Notice makes clear that where cryptocurrency offerings are found to involve sales of securities, securities legislation in Canada will apply where the person or business selling the securities is located in Canada or if sales are made to a Canadian investor. Pursuant to the Notice, businesses should consider if and how the Canadian prospectus, registration and/or marketplace requirements apply to their cryptocurrency offerings. The Notice provides key guidance relating to securities law requirements as they relate to ICOs and ITOs, cryptocurrency exchanges and investment funds that are investing in cryptocurrency. In addition, the Notice notes that depending on the nature of specific transactions, a transaction may also involve derivatives and be subject to applicable derivatives laws.
Guidance on specific types of offerings
While not all coins or tokens will be considered securities under Canadian securities law, Staff has confirmed that as cryptocurrency offerings could sometimes be categorized as a distribution of an investment contract and are substantially similar to a share offering, they will often be considered to result in a distribution of securities. In order to determine whether or not an investment contract exists, businesses are required to consider whether an ICO or ITO involves “an investment of money in a common enterprise with the expectation of profit to come significantly from the efforts of others.”
In the event a cryptocurrency offering is subject to Canadian securities law, the Notice provides specific guidance on the ability to conduct such offerings, including:
- Businesses looking to sell coins or tokens may do so under prospectus exemptions;
- Sales may be made to investors who qualify as “accredited investors” as defined under securities laws, in reliance on the accredited investor prospectus exemption;
- For retail investors who do not qualify as accredited investors, sales will typically need to be made in reliance on the offering memorandum (OM) prospectus exemption;
- Businesses completing ICOs or ITOs may be trading in securities for a business purpose and, thus, requiring dealer registration or an exemption from the dealer registration requirement. In the event registration is required, the registrant must comply with applicable obligations to investors, including know-your-client and suitability requirements; and
- It is possible that a business that is trading in securities for a business purpose could fulfill its obligations through an online process that incorporates robust and automated investor protections.
The Notice also provides certain cautions:
- While whitepapers are a form of disclosure document for investors, they will not always be structured in the same way as prospectuses or OMs, and therefore may not comply with the requirements of securities laws; and
- Investors may have civil remedies against persons or companies that fail to comply with securities laws, including a right to withdraw from the transaction and/or damages for losses on grounds that such transactions were conducted in breach of securities laws.
In addition to the foregoing guidance, businesses must ensure that they comply with additional Canadian securities requirements not flagged by Staff. As an example, if a white paper is utilized, certain provinces will require such document to be filed with the securities regulatory authority.
The Notice provides that where a cryptocurrency exchange offers cryptocurrencies that are securities, the exchange is required to determine whether it is a marketplace and, if it is, to comply with applicable marketplace regulations under securities law. If an exchange is doing business in Canada, it must apply to a securities regulator for recognition or for an exemption from recognition. Allowing coins or tokens that are securities issued as part of an ICO or ITO to trade on these cryptocurrency exchanges may also place businesses offside regulations, including restricted periods mandated under securities laws which, in many circumstances, would continue indefinitely until after the date that the business issuing the coins or tokens became a reporting issuer in Canada.
Cryptocurrency investment funds
The Notice provides the following specific guidance on investment funds investing in cryptocurrency. Businesses looking to establish such funds should consider the following:
- In certain jurisdictions of Canada, the OM prospectus exemption cannot be used by investment funds to distribute securities to investors. Therefore, if investors in the investment fund will include retail investors, businesses will need to consider prospectus requirements, applicable investment fund rules and whether the investment is suitable;
- Due diligence must be completed on any cryptocurrency exchange that the investment fund uses to purchase or sell cryptocurrencies for its portfolio, including on whether it is regulated in any way and the exchange’s policies and procedures for identity verification, anti-money laundering, counter-terrorist financing and recordkeeping;
- Businesses must consider appropriate registration categories in respect of the investment fund, including dealer, adviser and/or investment fund manager registration;
- How will cryptocurrencies in the investment fund’s portfolio be valued? How will securities of the investment fund be valued? Will one or multiple cryptocurrency exchange(s) be used, and how will such exchange(s) be selected? Will there be an independent audit of the investment fund’s valuation; and
- Securities legislation in Canada generally requires that all portfolio assets of an investment fund be held by one custodian that meets certain prescribed requirements. The Staff expect a custodian to have expertise that is relevant to holding cryptocurrencies.
Support of Staff
In the Notice, Staff confirmed that it is seeking to encourage financial market innovation and to facilitate capital raising in Canada. In light of such objectives, the Notice encourages fintech businesses to contact Staff in order to engage in discussions on issues relating to cryptocurrency offerings and securities law compliance.
Recent application of Canadian securities laws to an ICO
In addition to the guidance provided by the Notice, on August 16, 2017, a decision was issued under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a dual application) (the Decision) in connection with Impak Finance Inc.'s (Impak) ICO of Impak Coins, a new digital currency based on the Waves blockchain platform (MPKs), by way of a private placement in reliance on the prospectus exemption contained in Section 2.9 of National Instrument 45-106 - Prospectus Exemptions. Pursuant to the Decision, proceeds raised in connection with the ICO will be used to fund the development of impak.eco, an online social network created by Impak and entirely dedicated to the impact economy.
Pursuant to the Decision, Impak received an exemption from the dealer registration requirements under applicable Canadian securities legislation (the Registration Relief) and an exemption from the prospectus requirement on the first trade of MPK to provide that participants in impak.eco are able to utilize the MPK for trades with impact organizations (i.e. businesses, non-governmental organizations, not-for-profit corporations and social enterprises (each, a Merchant)) (the Prospectus Relief).
While Impak received the requested relief for a period of 24 months, the Canadian securities regulators imposed conditions on Impak's reliance on both the Registration Relief and the Prospectus Relief. In order to rely on the Registration Relief, among other things, Impak is required to: (i) conduct know-your-client and suitability reviews for each participant and determine, for each participant who represents itself as either an accredited investor or an eligible investor and seeks to invest an amount exceeding a prescribed limit of $2,500, whether the participant is an accredited investor or an eligible investor, as the case may be; (ii) ensure that neither Impak nor any of its directors, officers, employees, agents or representatives will provide investment advice to the participants with respect to a distribution in MPK; (iii) deal fairly, honestly and in good faith with the participants; and (iv) establish, maintain and apply policies and procedures that establish a system of controls and supervision sufficient to manage the risks associated with its business in accordance with prudent business practices, including with respect to the Waves Blockchain, cybersecurity and conflicts of interest between Impak and the participants.
In order to rely on the Prospectus Relief, the first trade must be made between an Impak participant and a Merchant, which allows the participants in impak.eco to utilize the MPK within Impak's online social network.
In addition, while Impak is not a reporting issuer in Canada or subject to ongoing continuous disclosure requirements, the Decision provides that Impak must make the following information reasonably available to all participants via its website and on the impak.eco network, on a quarterly basis: (i) the value of MPK and the exchange rate for Canadian dollars; (ii) the description of the basket of goods and services used to determine the value of the MPK; (iii) the number of MPK outstanding; (iv) the number and value of MPK issued, repurchased or cancelled during the period; (v) the modifications to the rewards structure; and (vi) the balance of the “reserve fund” maintained by a governance body composed of third-party members established by Impak to oversee the value and use of MPK in the impak.eco network, as described in the Impak’s offering memorandum, for conversions of MPK into Canadian dollars.
Staff’s positive response to the emerging cryptocurrency market provides evidence of the growing interest of the public in and associated importance of cryptocurrencies. In addition, the Notice provides beneficial guidance to businesses that propose to engage in the growing cryptocurrency market and a clear indication that Staff is committed to assisting businesses in complying with the complex regulatory environment surrounding cryptocurrency.
However, while the Notice is encouraging, the Notice together with the Decision make it clear that digital innovation in the financial sector must be balanced with the need to protect investors. The Decision confirms that the overarching application of Canadian securities laws presents a number of legal determinations that will need to be made in advance of a business proceeding with a cryptocurrency offering in Canada or that involves investors in Canada, including a determination of whether coins or tokens will be subject to customary restrictions on transfer as prescribed by Canadian securities laws. In addition, depending on the nature of the offering and whether Canadian securities laws will apply, businesses will be subject to certain traditional securities law compliance and reporting obligations, and may wish to seek exemptive relief in a fashion that is similar to that described in the Decision.