Canadian securities regulators have published detailed guidance on initial coin offerings. While not demonstrating advances that some in the industry may have been hoping for, the guidance provides a degree of regulatory certainty surrounding initial coin offerings and what is required to pursue them in Canada.
Gowling WLG Focus
"Initial coin offerings" or "initial token offerings" (ICOs) are rapidly gaining popularity as a method of financing projects, with more than US$2 billion raised to date globally since 2013. Many more ICOs are scheduled for the coming months. As ICOs have gained mainstream attention, increasingly large sums of money are being raised in individual offerings as well. For example, with 13 days remaining in its ICO, Filecoin (a decentralized storage network) has raised over US$200 million.
While ICOs have been on the radar of securities regulatory authorities for some time (see the Ontario Securities Commission's March 2017 press release), due to the speed at which ICOs have gained traction in the capital markets and the growing amounts of capital raised through ICOs, securities regulators in North America and beyond have been forced to focus on these developments and undertake a comprehensive review of how existing securities regulation applies to these types of offerings.
On July 25, 2017, the U.S. Securities and Exchange Commission published a report concluding that the tokens offered by The DAO, an unincorporated organization created by Slock.it UG, a German entity, were securities under U.S. federal securities law. On August 24, 2017, Canadian securities regulators published Staff Notice 46-307, which among other things, outlines the factors they will consider when assessing whether Canadian securities laws apply to a particular ICO.
What is an initial coin offering?
ICOs can vary in structure, but generally they are a method used by organizations to raise funds from purchasers online. Purchasers can visit a webpage and purchase digital coins or tokens during a set timeframe with either cryptocurrency (e.g. Bitcoin or Ether) or traditional fiat currency. Typically, the funds raised from the ICO will be utilized to create or further develop a new project, platform, protocol or distributed ledger technology.
ICOs can be similar to initial public offerings (IPOs) both in name and the manner in which purchasers of tokens are treating them. Many token purchasers are flocking to ICOs with the hope of catching the upside value of a token in the same way they would as an investor in shares of a widely publicized IPO.
Is a token a "security"?
Although ICOs utilize new technology and methods of distribution, and a "coin" or "token" rather than a share, stock or unit is being sold, Canadian securities regulators have now definitively stated that "in many cases, when the totality of the offering or arrangement is considered, the coins/tokens should properly be considered securities". Furthermore, in assessing whether or not securities laws apply, they will look at the economic realities of a transaction and consider substance over form.
This does not necessarily mean that all tokens are securities. For example, Canadian securities regulators comment that if an individual purchases a token that allows him or her to play video games on a new platform, it is possible that the token will not be a security. However, if a token is tied to the profits or success of a business, it will likely be considered a security.
Not surprisingly, Canadian securities regulators have confirmed that the traditional test set out in Pacific Coast Coin Exchange for determining whether or not an "investment contract" is a security will be applicable when determining whether a token is a security. Specifically, does the ICO involve:
- An investment of money
- In a common enterprise
- With the expectation of profit
- To come significantly from the efforts of others
Other elements of the definition of a security may apply and Canadian securities regulators also advise that a token may be a derivative.
We note that certain Canadian securities regulators have not been shy in taking aggressive action where they view an ICO as being offside Canadian securities laws. The Autorité des marchés financiers (AMF) in Québec recently took extensive steps to shut down an ICO by PlexCoin (a virtual currency).
Accordingly, an organization considering an ICO should engage with legal counsel to assist in the analysis of whether or not the coin or token is a security, and, if so, how the ICO can be conducted in compliance with Canadian securities laws.
If a token is a "security", then what…
Canadian securities regulators generally have a mandate to protect investors and the integrity of our capital markets. One of the ways this mandate is achieved is by prohibiting the distribution of securities without the filing with securities regulators, and delivery to potential purchasers, of a preliminary and a final prospectus, which is a very comprehensive disclosure document. This is the process a business undertakes in completing an IPO.
There are exemptions to the prospectus requirement. Some of the more common prospectus exemptions include: (i) selling securities to individuals who qualify as "accredited investors" (i.e. sophisticated investors who should not need the protections afforded through the prospectus regime); and (ii) selling to retail investors in reliance on the offering memorandum (OM) exemption, which is also a detailed disclosure document.
In order to comply with these prospectus exemptions, organizations conducting ICOs must meet all of the conditions of the applicable exemption. In the case of the OM exemption, this includes preparing a disclosure document with specified content, obtaining signed risk acknowledgement forms from each investor, restricting the investment amounts for certain investors, providing audited annual financial statements and ongoing disclosure to investors, complying with resale restrictions (which Canadian securities regulators note will generally preclude tokens from trading on cryptocurrency exchanges), and filing reports of exempt distributions with applicable Canadian securities regulators.
Is a whitepaper an adequate disclosure document?
While many organizations proposing to conduct an ICO publish a whitepaper that includes details about the token, the organization issuing the token and the ICO, most, if not all, whitepapers fail to include all of the disclosure required in an OM.
In their notice, Canadian securities regulators provide examples of material that should be included in an OM such as a detailed description of the business, the ecosystem on which the token operates, a minimum or maximum offering amount, the intended use of proceeds, features of the token, including potential return on investment, exit strategies and liquidity, how long the offering will remain open, how the tokens will be valued on an ongoing basis, the number of tokens that will be held by management, the identities and backgrounds of management, details of management's compensation, the timeline for achieving milestones and ongoing updates that will be provided, and all material risks of investing.
Importantly, there are civil and statutory remedies available to investors in the event an organization selling tokens fails to comply with applicable securities law or the disclosure document (whether an OM or otherwise) includes a misrepresentation.
Engaging in the business of trading in securities…
Canadian securities regulators also protect investors and the integrity of our capital markets by requiring persons or companies trading in securities for a business purpose to be registered and to fulfil certain compliance obligations.
In considering whether an organization selling tokens is trading in securities for a business purpose (and therefore must be registered or must be able to rely on a registration exemption), Canadian securities regulators will consider various factors, including whether the organization is soliciting a broad base of investors (including retail investors), whether it is using the internet (including public websites, discussion boards, etc.) to reach a large number of potential investors, whether it is attending public events (such as conferences and meetups) to advertise the sale of its tokens and whether it is raising a significant amount of capital from a large number of investors.
If an organization selling tokens is trading in securities for a business purpose and no registration exemption is available, it will have registration and compliance obligations to fulfil, including know-your-client (KYC) and suitability obligations which Canadian securities regulators acknowledge may be fulfilled through a "robust, automated, online process that incorporates investor protections". Identity verification and collection of information sufficient to determine suitability of the investment for the purchaser will be required. Canadian securities regulators are also very concerned about cybersecurity and that organizations operating in the cryptocurrency space have strong measures in place to protect the business and its investors.
Canadian securities regulators also caution participants that cryptocurrency investment funds may trigger securities adviser and investment fund manager requirements and the way an ICO is structured or how tokens may be exchanged or traded on a platform may trigger compliance with marketplace requirements under Canadian securities laws.
Gowling WLG has already been working with organizations contemplating ICOs to determine whether or not Canadian securities laws apply to their ICOs and if so, how they can conduct their ICOs in compliance with Canadian securities laws.
We have also been engaged with securities regulators across Canada, through the CSA Regulatory Sandbox and otherwise, on issues relating to ICOs and other innovations in the fintech, securities crowdfunding and alternative finance space. While clear on the need to fulfil their regulatory mandate, Canadian securities regulators want to encourage innovation and facilitate capital raising by fintech businesses.
Organizations contemplating an ICO should consult with legal counsel - the following members of Gowling WLG's Capital Markets/Crypto team would be pleased to assist:
Vancouver - Brett Kagetsu, Stefan McConnell, Denis Silva
Calgary - Gord Chmilar, Alisha Virk
Toronto - Shawn Blundell, Ian Palm, Kathleen Ritchie, Jason Saltzman, Usman Sheikh
Waterloo - Bryce Kraeker
Montreal - Naim Antaki, Michael Garellek
Gowling WLG is the only international law firm to be a partner and co-founding member of the Blockchain Research Initiative, a multi-million dollar research initiative into blockchain, led by the Tapscotts, and which includes the Government of Canada, Bank of Canada, Nasdaq, the TMX Group, IBM and many others.
 Pacific Coast Coin Exchange v. Ontario (Securities Commission),  2 S.C.R. 112