Pragmatic Numismatics? CSA Review of Cryptocurrency OfferingsFriday, September 8, 2017
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On Monday, September 4, 2017, the People’s Bank of China (“PBOC”), through a joint decree with a variety of Chinese regulatory agencies, announced that it was imposing an immediate ban on initial coin offerings (each, an “ICO”) and the operation of cryptocurrency exchanges in China.
This follows the August 24, 2017 publication by the Canadian Securities Administrators (“CSA”) of CSA Staff Notice 46-307 Cryptocurrency Offerings (the “Staff Notice”) which adopted a somewhat less draconian approach in its review of ICOs and cryptocurrency exchanges and the applicability of securities laws in Canada.
The Staff Notice, in turn, was issued several weeks after the U.S. Securities and Exchange Commission published an investigative report concluding that tokens issued through an ICO by a "virtual" organization known as "The DAO" were securities and therefore subject to U.S. federal securities laws.
Globally, the use of ICOs by fintech and start-up businesses has become increasingly popular as a means of raising capital from investors online, with companies estimated to have raised approximately USD $1.6 billion in the past year (Bloomberg). ICOs are very similar to initial public offerings in that issuers offer coins, tokens or other cryptocurrencies, rather than shares, to investors in exchange for fiat currency or other cryptocurrency for a set period of time. Additionally, the cryptocurrency offered may increase or decrease in value based on the success of the business, similar to shares of a company.
The Staff Notice seeks to highlight investor protection concerns with respect to ICOs and cryptocurrency exchanges given that anyone with internet access can create or invest in an ICO, in many cases anonymously. Although several jurisdictions have established requirements on cryptocurrency exchanges in respect of identity verification and recordkeeping in order to combat money laundering and terrorist financing, the CSA’s primary focus is on the ease of access by retail investors to these investments and the lack of transparency on many unregulated cryptocurrency exchanges.
Many businesses offering coins or tokens market them as software products, claiming they are not subject to securities laws. However, when considering the totality of the offering, in many cases the coins or tokens being issued are investment contracts, subjecting issuers within Canada or issuers with Canadian investors to securities laws in Canada. The CSA propose to review whether an ICO is subject to securities laws on a case by case basis, with the litmus test continuing to be the age-old principle as to whether or not an investment contract exists (e.g., an investment in money in a common enterprise with the expectation of profit to come significantly from the efforts of others). The Staff Notice provides guidance on how the CSA will review ICOs and regulate cryptocurrency exchanges going forward in respect of prospectus, registration and marketplace requirements under Canadian securities laws.
Coin and Token Offerings: Obligations under Securities Laws
To date, no business has used a prospectus to complete an ICO in Canada. Several fintech businesses have published whitepapers in advance of their ICOs, providing investors with general information on how the capital will be used and how many coins or tokens management will retain. Going forward, businesses intending to issue coins or tokens that are securities will need to abide by prospectus disclosure requirements or rely on a prospectus exemption under National Instrument 45-106 – Prospectus Exemptions, such as the accredited investor and offering memorandum (“OM”) exemptions. Alternatively, issuers may pursue an ICO under the crowdfunding exemption, which limits the amount raised per investor. The CSA’s perspective on ICOs is likely to limit direct access by retail investors to this type of security. Businesses seeking to raise capital through an ICO should ensure that, at minimum, any prospectus or OM, contain full, true and plain disclosure of all relevant material facts, as well as a statement of the associated rescission rights, in order to comply with securities laws.
The Staff Notice states that any business completing an ICO of cryptocurrency may require registration as a dealer (or the engagement of a dealer on its behalf), or will be required to rely on an exemption from dealer registration, if its activity constitutes trading in securities for a business purpose.
The CSA propose that they will review dealer registration on a case by case basis, considering such factors as (i) solicitation to a broad base of investors, (ii) using the internet to reach a large group of investors, (iii) actively advertising the sale of coins or tokens and (iv) raising a significant amount of capital from a large number of investors.
Registered dealers must verify an investor’s identity and collect sufficient information about the investor in order to ensure the security is suitable.
With the increase in frequency of cyberattacks, any business completing an ICO of cryptocurrency will also want to ensure that strong cybersecurity measures are in place to protect its investors.
Cryptocurrency exchanges that offer coins, tokens or other cryptocurrency that are considered a security may be subject to the marketplace rules governing exchanges or alternative trading systems, requiring recognition of the cryptocurrency exchange by the appropriate securities regulator in its jurisdiction or reliance on an exemption from recognition.
Businesses offering coins or tokens which are deemed to be securities should be aware of resale restrictions applicable to non-reporting issuers, which will restrict their broad-based issuance and distribution until all of the other constituent elements identified in the Staff Notice come together, such as exchange regulation, clearing and settlement and custody.
Cryptocurrency Investment Funds
Investment funds seeking to obtain or provide exposure to cryptocurrencies will not be entitled to rely upon the OM exemption in Ontario and will need to consider whether any distributions of coins or tokens which are securities are made to retail investors.
Further, more investment fund managers will need to consider the extent of due diligence required in respect of the policies and procedures of the cryptocurrency exchange through which it intends to trade coins or tokens for its portfolio, in particular policies and procedures relating to the identity of investors, recordkeeping, anti-money laundering and counter-terrorist financing. Custodians of investment funds which invest in cryptocurrency are expected to have relevant expertise in the safe-keeping of cryptocurrency securities in order to satisfy their prescribed requirements.
The CSA have clearly indicated that they will be taking an expansive view towards the regulation of ICOs and cryptocurrency exchanges, with the intention of reviewing ICOs on a case by case basis and focusing on the substance of the cryptocurrency or ICO over the form. Businesses seeking to raise capital through an ICO or to operate a cryptocurrency exchange, must confirm whether their coins, tokens or other cryptocurrencies are considered securities and subject to the securities law requirements outlined in the Staff Notice.
If you have any questions with respect to the matters discussed above, please contact Geoffrey Cher by email at email@example.com or any other member of our Structured Finance or Corporate Finance practice groups.
This update is intended as a summary only and should not be regarded or relied upon as advice to any specific client or regarding any specific situation.
If you would like further information regarding the issues discussed in this update or if you wish to discuss any aspect of this commentary, please feel free to contact us.