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With the increasing popularity of blockchain-based digital currencies, many businesses see them as a unique way to raise funds, while investors consider them to be part of a diversified investment portfolio. Recognizing that securities law may, in some circumstances, apply to these types of investments, the Canadian Securities Administrators (the “CSA”) recently published Staff Notice 46-307 – Cryptocurrency Offerings (the “CSA Notice”). Interestingly, the CSA Notice attempts to establish a broad analytical and regulatory framework with respect to (i) cryptocurrency exchanges; (ii) initial Coin/Token Offerings (“ICO/ITOs”); and (iii) cryptocurrency investment funds. More importantly, the CSA Notice makes it clear that in certain circumstances, securities regulators may view cryptocurrencies as “securities” and that dealing in such cryptocurrencies (including operating exchanges or conducting an ICO/ITO) would generally be subject to existing securities law.
Broadly speaking, cryptocurrency exchanges allow investors to buy and sell cryptocurrencies online by using either fiat currency (e.g., using CAD or USD to buy bitcoins) or other cryptocurrencies (e.g., using bitcoins to buy other cryptocurrencies).
The CSA Notice recognizes that cryptocurrency exchanges operate across the world, generally with little to no governmental regulation or oversight. It cautions that where an exchange offers cryptocurrencies that are securities, the exchange must determine whether it is a “marketplace.” Marketplaces are required to comply with the rules governing exchanges or alternative trading systems. If an exchange is doing business in a jurisdiction of Canada, it must apply to that jurisdiction’s securities regulatory authority for recognition or an exemption from recognition.
While the CSA Notice notes that, to date, no cryptocurrency exchange has been recognized in any jurisdiction of Canada or exempted from recognition, it clearly provides notice to the industry that such an exchange may need regulatory approval to operate in Canada.
Initial Coin or Token Offerings
ICO/ITOs are commonly used by start-up businesses to raise capital from investors (often retail investors) through the internet. An ICO/ITO is typically open for a set period, during which investors can visit a website to purchase coins in exchange for fiat currency (e.g., CAD or USD) or a cryptocurrency such as bitcoin.
The CSA Notice describes ICO/ITOs as being similar to an initial public offering and considers coins to be similar to traditional shares of a company because their value may increase or decrease, thereby potentially being deemed to be offerings of securities and subject to securities law requirements.
The analysis provided in the CSA Notice with respect to ICO/ITOs provides insight into how regulators will determine whether a cryptocurrency is a “security” for the purposes of securities law. Not surprisingly, regulators will rely on the existing securities law framework, rather than look to any novel approach. In determining the status of a cryptocurrency, regulators will consider substance over form by looking at the totality of the offering or arrangement and assessing the economic realities of the transaction. In the context of an ICO, simply naming a product a coin or token (rather than a share or security), or describing it as software, will not be determinative in assessing whether securities law applies.
The CSA Notice provides helpful examples of when a coin or token offered through an ICO/ITO may be considered a sale of securities. For instance, where a coin or token provides the right to utilize a specific service, such as allowing the purchaser to play a video game, such product would not likely be viewed as being a security. However, with respect to the sale of a coin or token whose value is tied to future profits or success of a business, the CSA would likely consider these to be securities. Remarkably, the CSA Notice indicates that in the CSA’s view, a number of the proposed ICO/ITOs they reviewed would fall within the definition of an “investment contract” (a form of security) under securities law.
In determining whether or not an investment contract exists, businesses should apply the following four-prong test, namely, does the ICO/ITO involve:
- an investment of money
- in a common enterprise
- with the expectation of profit
- to come significantly from the efforts of others.
Where it is determined that the ICO/ITO is caught under applicable securities law, the business will be required to prepare a prospectus or rely on an exemption from the prospectus requirement. Likely exemptions would include the “accredited investor” exemption and the offering memorandum exemption. A prospectus or other filings and documentation required in order to rely on one of the prospectus exemptions must be prepared in accordance with securities law. The CSA is aware of businesses issuing whitepapers for their ICO/ITOs and cautions that such whitepapers are not generally compliant with the specific disclosure requirements of a prospectus or offering memorandum.
Investment Funds and Regulatory Sandbox
Recognizing that many businesses are interested in setting up investment funds that provide investors with the opportunity to obtain exposure to cryptocurrencies, or baskets of cryptocurrencies, the CSA Notice provides a list of factors that such businesses should consider, including:
- prospectus requirements for retail investors;
- due diligence on cryptocurrency exchanges;
- appropriate registration categories;
- methodology for currency valuation; and
- prescribed requirements for maintaining custody of cryptocurrencies.
We note that the CSA launched the Regulatory Sandbox initiative in February 2017 to support fintech businesses seeking to offer innovative products, services and applications in Canada. The CSA encourages businesses to work with securities regulators at an early stage through the program, with the stated intention of discussing possible approaches to complying with securities law, including the possibility of registering and/or obtaining exemption relief from securities law requirements.
The CSA Notice recognizes that there are circumstances where a cryptocurrency may be considered a “security” and, in such cases, existing securities law will be applicable. The CSA Notice serves to put the industry on notice that anyone considering operating a cryptocurrency exchange, conducting an ICO/ITO or otherwise dealing in cryptocurrencies should contact their local securities regulator through the Sandbox initiative or seek legal counsel before engaging in such business.