On August 24, 2017, the Canadian Securities Administrators (“CSA”) published CSA Staff Notice 46-307 Cryptocurrency Offerings (“Notice”), to address the increasing number of cryptocurrency offerings, either through Initial Token Offerings (“ITOs”) or Initial Coin Offerings (“ICOs”) and sales of securities of cryptocurrency investment funds.
A cryptocurrency is a digital asset designed to work as a decentralized medium of exchange using cryptography to secure the transactions and to control the creation of additional units of the currency. The first cryptocurrency was Bitcoin, which emerged in 2009. Bitcoin and the other cryptocurrencies, such as Ethereum, that have come into use since then, use decentralized control, as opposed to a centralized electronic money or centralized banking systems. [1]
The structures of ICOs/ITOs will vary, and they may be used to raise capital for a variety of projects, including the development of a new cryptocurrency, distributed ledger technology, service or platform. An ICO/ITO is typically open for a set period, during which investors can visit a website to purchase coins/tokens in exchange for fiat currency (US or Canadian dollars) or a cryptocurrency such as Bitcoin or Ethereum.
ICOs/ ITOs are generally used by startup businesses to raise capital from retail investors through the internet. Anyone with internet access can create or invest in an ICO/ITO, in many cases, they can do so anonymously. The coins/tokens can be similar to traditional shares of a company because their value may increase or decrease depending on how successfully the business executes its business plan using the capital raised. Tokens and coins and other cryptocurrencies may be sold on online exchanges that allow investors to buy and sell the cryptocurrencies. Purchases and sales may be made using either fiat currencies (e.g. US or Canadian dollars) or cryptocurrencies (using another cryptocurrency such as Ethereum).
The Notice is intended to help financial technology (fintech) businesses understand their obligations under securities laws. If the cryptocurrency offerings involve sales of “securities” and if the person or company selling the securities is conducting business from within Canada or if there are Canadian resident investors, Canadian securities laws will apply.
According to the Notice, there are significant investor protection concerns related to these markets, due to the volatility, lack of transparency, lack of proper valuations, custodial concerns, and lack of liquidity and the fact that trading occurs on unregulated cryptocurrency exchanges. Investor protection concerns also arise because the ICO/ITO products are so complex and investors may not understand the properties of the investment products they are purchasing which may make them particularly vulnerable to being harmed by unethical practices or illegal schemes.
The Notice warns that, in many instances, the coins/tokens constitute “securities” and or “derivatives” for the purposes of securities laws and are subject to regulation by securities commissions across Canada even though what is being sold is referred to as a “coin” or a “token” instead of a share, stock, or unit. A “coin” or “token” may still be a “security” as defined in securities legislation if the coin or token is similar to a traditional share in that the value of the coin or token increases or decreases depending on how successful the business in which the funds are invested executes its business plan with the capital that is raised. If the value of a token or a coin is tied to future profits or success of a business then they will likely be considered “securities” for the purpose of securities laws.
If the tokens or coins in an ITO or ICO is found to be a “security” under applicable securities laws, the prospectus, registration and/or marketplace requirements apply to the cryptocurrency offerings. These requirements include:
- Tokens and coins may only be sold after a receipt has been received from a securities regulatory authority for a comprehensive disclosure document called a “prospectus,” or pursuant to a private placement in reliance on a prospectus exemption such as to “accredited investors” or under the “offering memorandum exemption”;
- Offering documents used in ICOs and ITOs must comply with securities laws and can trigger certain ongoing obligations and other protections for investors including providing investors with the right to sue for a misrepresentation and the right to withdraw from a transaction;
- Filings of exempt distributions and offering documents must be made with the applicable securities commission where a prospectus exemption is relied upon;
- Tokens and coins sold under a prospectus exemption are subject to restrictions on secondary trading;
- Businesses and individuals in the business of “trading in” or “advising” on the tokens or coins must be properly registered and must meet fundamental obligations to investors, including know-your client (KYC) and suitability; and
- Platforms that facilitate trades in coins/tokens that are “securities” may be a “marketplace” and need to comply with marketplace requirements regarding “exchanges” or “alternative trading systems”.
The Notice also cautions that the offerings may also be “derivatives” under applicable securities rules and subject to the derivatives laws adopted by the Canadian securities commissions, including trade reporting rules.
The Notice also discussed the emergence of cryptocurrency “investment funds”, as defined under securities laws set up to invest in Bitcoin and other cryptocurrencies. One of the key purposes of this type of investment fund is to provide investors with the opportunity to obtain exposure to cryptocurrencies, or baskets of cryptocurrencies, that they may not otherwise have. CSA staff actively encourage these fintech businesses seeking to establish a cryptocurrency investment fund to consider factors such as:
- In certain jurisdictions in Canada, the OM prospectus exemptions cannot be used by investment funds;
- The investment fund must do due diligence on the cryptocurrency exchanges that the fund uses to purchase or cell cryptocurrencies for its portfolios including ensuring compliance with anti-money laundering and counterterrorist financing laws;
- Registration as a dealer, adviser and /or investment fund manager may be required;
- Valuation of the cryptocurrencies in the investment funds portfolio should be carefully valued; and
- Generally, the assets of an investment fund must be held by a custodian that meets certain prescribed requirements.
The Notice encourages business with proposed cryptocurrency offerings to contact the local securities commission including in Ontario the OSC Launchpad Team at osclaunchpad@osc.gov.on.ca.
CSA Staff Notice 46-307 is available from the websites of the participating jurisdictions including the website of the Ontario Securities Commission: http://www.osc.gov.on.ca/en/SecuritiesLaw_csa_20170824_cryptocurrency-offerings.htm
For more information, please call Barbara Hendrickson at BAX Securities Law (416) 601 -1004.
This publication is not intended to constitute legal advice. No one should act on it or refrain from acting on it without consulting with a lawyer. BAX Securities Laws does not warrant or guarantee the accuracy or currency or completeness of the publication. No part of this publication may be reproduced without the prior written permission of BAX Securities Law.
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[1] https://en.wikipedia.org/wiki/Cryptocurrency
