Corporate Law Author: Rosalyn Chan & Zakhir Nathoo In recent months, the popularity of initial coin offerings or initial token offerings (“ICOs”) have increased significantly as a mechanism for raising capital, utilized primarily in the technology sector and, more specifically, by financial technology (“fintech”) companies. These ICOs have resulted in companies raising widely varying amounts, anywhere from tens of thousands of dollars to over USD $200 million by issuing their own proprietary digital tokens or coins in exchange for either fiat currency or other cryptocurrencies, such as bitcoin or ether, the cryptocurrency built on the Ethereum blockchain.
Blockchain, who? Cryptocurrency, what?
In general terms, a cryptocurrency is an encrypted, digital “item” that functions as a transparent peer-to-peer exchange. Cryptocurrencies are designed to exchange value between consumers without having to engage intermediaries, such as financial institutions. The value of such cryptocurrencies, like bitcoin, is based on their exchange rate with fiat currency, in the same way that foreign currencies are valued. In order to facilitate the exchange of value, cryptocurrencies use blockchain technology to record transactions, and track and verify ownership. Blockchain is a method of openly, yet securely, maintaining a decentralized database, using consensus-based shared ledgers. This means that the blockchain is monitored by thousands of independent nodes that confirm transactions and “blocks” of information. Whenever ownership of an item, including a coin or token, is transferred, a record is created and distributed throughout the blockchain network. The principal virtue of decentralization (i.e. a network of numerous replicated databases) is that the database is considered quite secure and immutable.
An ICO for every Joe Blow
Due to the wide acceptance of bitcoin, ether and blockchain technology in general, many emerging technology and fintech companies began creating and issuing their own proprietary digital coins to raise capital as an alternative to obtaining traditional angel or venture capital financing. Not only did an ICO offer an opportunity to access funding that may not otherwise have been available, but the novelty of the technology appeared to allow companies to take the position that ICOs offered assets, rather than securities or investment contracts, which are not subject to securities regulation or the scrutiny and disclosure obligations imposed by securities commissions. Companies not yet at the IPO stage could raise funds quickly and inexpensively, and without the need to rely on a prospectus exemption. We beat the system!… Or did we?
If it Walks the Walk and Talks the Talk…Is it?
Many companies that have completed ICOs have marketed their digital coins or tokens as a method of accessing goods or services from that company in the future. For example, Company A would present a business idea for a new video game. Potential customers of this video game would purchase coins during Company A’s ICO (with ether, bitcoin or fiat currency) and Company A would use those funds to build the business and develop the video game. Once up and running, the coins could be used to purchase or otherwise access the video game. These companies took the position that their coins or tokens were in no way similar to shares, and therefore could not be considered a security nor be subject to applicable securities regulations. The coins or tokens, it was argued, were a utility or an asset, and not a security. However, given that the coins and tokens are distributed using blockchain technology, the issued coins can also be easily traded amongst consumers. Because a company only issues a specific number of coins at any given time, when demand for that company’s coins exceeds its supply, the value increases and owners of the coins can make a profit by selling the coins to other customers of the potential business at a price greater than they paid. Purchasers knew this. Companies knew this. Companies used this information as a selling point to entice purchasers to participate in their ICO, and purchasers gobbled up the coins in such vast quantities that it was highly unlikely the purchases were for consumption of the eventual products or services of the issuing company. Generally speaking, companies were marketing to investors, not consumers. The economic reality was that these purchases were made with an expectation of profit, rather than buying access to a product or service in a pre-sale. Although these digital coins do not necessarily confer ownership rights upon their holder, when one takes into consideration the ability to make a profit from their purchase and sale, the marketing materials surrounding the ICOs, and all other relevant facts, these coins walk and talk a lot like securities. Accordingly, securities regulators in Canada, the United States, and across the globe have struggled with whether to deem digital coins and tokens as securities and impose applicable securities requirements over their issuance, sale and trading.
The Answer? It Depends.
On July 25, 2017, the United States Securities and Exchange Commission (“SEC”) provided its Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO. The investigation focused on the Decentralized Autonomous Organization’s (“DAO”) ICO in 2016, which aimed to create a for-profit entity that would fund “projects” through the sale of DAO Tokens. The holders of such DAO Tokens could then share in the anticipated earnings from the projects, but could also sell their tokens through certain web-based platforms. In its report, the SEC concluded that issuers of blockchain technology-based securities must register their offering of such securities unless a valid exemption applies. The DAO Tokens were deemed to be securities due to the existence of an investment contract, being “an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” This definition was established in SEC v WJ Howey Co (Howey)[1]. Howey also outlined the need to look at the substance, rather than just the form, of an investment scheme and consider the “economic realities” of an offering and purchase. On August 24, 2017, the Canadian Securities Administrators (“CSA”) issued CSA Staff Notice 46-307: Cryptocurrency Offerings. The CSA stated that in determining whether an ICO is a securities offering, each such offering is unique and must be assessed on its own characteristics. If the coins or tokens underlying an ICO, and the offering as a whole, exhibit the characteristics of a security, then it will be considered an issuance of securities and be subject to applicable securities laws. This contextual approach was adopted in Ontario Securities Commission v Tiffin[2]. Aligning with its American counterpart, the CSA stated that one such characteristic is the existence of an investment contract, which is determined based on the four-prong test set out in Pacific Coast Coin Exchange of Canada v OSC[3], a slight variation on the Howey test: (i) investment of money; (ii) in a common enterprise; (iii) with the expectation of profit; and (iv) derived significantly from the efforts of others.
What Now?
Given that Canadian securities regulators are now paying very close attention to ICOs, companies need to be mindful of applicable securities laws when contemplating an issuance of coins. While most securities commissions seek to encourage innovation in the market, their mandate is also to protect consumers and investors. Investors should also be cautious of ICOs that are not issued under a prospectus or reliance on a prospectus exemption since sparse disclosure and ample volatility import risk. An analysis of whether such issuance of tokens or coins amount to securities should be conducted, which may require engaging legal professionals to help in the process. This post is for informational purposes only and does not constitute legal advice or an opinion on any issue. If you are interested in receiving additional details on the topic above or advice about specific circumstances, please contact MEP Business Counsel at 604-669-1119 or info@meplaw.ca. [1] 328 U.S. 293, 301 (1946). [2] (2016) 133 OR (3d) 341 (OCJ). [3] [1978] 2 SCR 112.