Contained within several notices from the Canadian Securities Administrators (CSA), are clarifications of the regulations in place that can determine the legality of Initial Coin Offerings (also called Initial Token Offerings). The CSA's main concern with ICOs in their current form will most certainly be the lack of investor protection for Canadians. Like securities laws in the United States that provide investor protection, Canada also has regulations regarding the sale of ICO tokens to its citizens.
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Securities laws will apply to any unregistered ICO that conducts business within Canada or does so outside of the country but has sold tokens to Canadian investors. The writing may already be on the wall for Initial Coin Offerings, as the CSA has stated that many of them involve the sale of securities. The sale of unregistered securities not only violates Canadian securities laws, it gives the investor the right to pursue legal action against the issuer. This includes "a right to withdraw from the transaction and/or damages for losses on the grounds that such transactions were conducted in breach of securities laws." CSA Staff Notice 46-307
Is the ICO a Security?
Regardless of what an ICO claims to be (or do) to sidestep registration as a security, each one will be examined by Canadian regulators based on its own unique characteristics. Using a four-prong test that is almost identical to the U.S. Howey Test to determine if an investment contract exists, the following criteria would indicate that the ICO is most likely a security.
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
The "Business Trigger"
The activities or circumstances of an ICO may activate what is known as the "business trigger". If it is determined that an Initial Coin Offering is selling securities for business purposes, all securities laws will apply, including registration, filing a prospectus, and financial statement submission. The CSA lists the following as some of the factors used in determining if the token sale sets off the business trigger:
- Soliciting a broad base of investors, including retail investors;
- Using the internet, including public websites and discussion boards, to reach a large number of potential investors;
- Attending public events, including conferences and meetups, to actively advertise the sale of the coins/tokens; and
- Raising a significant amount of capital from multiple investors.
The factors listed above resemble the exact funding path taken by almost every ICO to date.
"Businesses conducting ICOs/ITOs that meet the business trigger must verify investors’ identities and collect sufficient information to ensure that purchases of coins/tokens are suitable, including on investment needs and objectives, financial circumstances and risk tolerance." - CSA Staff Notice 46-307
There are also very specific requirements on information that must be gathered from potential investors. While many in the cryptocurrency industry are familiar with the KYC (know your customer) rule, they may not be aware of other investor protections in place such as Canada's KYP (know your product) and investment suitability obligations. This obligation requires that distributions of securities to investors can only be done after an in-depth suitability analysis is carried out with the client. Do they understand the risk, does it meet their goals and objectives, and does it fit in with their investment timeline? Those are just some of the things that need to be determined when assessing suitability.
KYP (know your product) is an obligation requiring thorough knowledge of the product being recommended to ensure it is suitable for a client. The issuer or dealer must keep adequate records of the suitability process in order to prove all obligations to the investor/client were carried out. Part of the suitability obligation is to ensure that the client is not at risk because of a lack of diversification from an over-concentration of a single or similar securities, those that have low liquidity, or those with too much exposure to a single asset class.
"Most CSA staff will consider investments (either individually or taken together with prior investments) in securities of a single issuer or group of related issuers that represent more than 10% of the investor's net financial assets as potentially raising suitability concerns due to concentration." - CSA Staff Notice 31-336
If an exchange sells ICO tokens that are securities, the exchange may be determined to be a "Marketplace" under Canadian Securities Law. This could put the exchange at risk of violating the securities laws that govern marketplace exchanges, such as restrictions on secondary trading.
"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. To date, no cryptocurrency exchange has been recognized in any jurisdiction of Canada or exempted from recognition." CSA Staff Notice 46-307
1.) Accredited Investor Prospectus Exemption
A prospectus does not have to be filed if the tokens are sold only to accredited investors including financial institutions, investment funds, pension funds, and other qualified large institutions. For an individual to be considered an accredited investor, he/she (or with their spouse) must have either financial assets over $1 million, net income over $200,000 (or $300,000 combined with spouse), or net assets of $5 million.
2.) Offering Memorandum (OM) Prospectus Exemption
To sell to retail investors that don't meet the wealth requirements of an accredited investor, an ICO business could avoid registration by using the OM Prospectus Exemption. Some of the information that needs to be disclosed with this exemption is, for the most part, quite similar to details contained in a whitepaper - purpose, token details, fundraising goals, etc. With an Offering Memorandum, the ICO issuer will also have to include information that is generally not included in whitepaper such as:
- Exit strategies and liquidity
- How the coins/tokens will be valued on an ongoing basis
- Management members’ identities and backgrounds, including any regulatory or legal proceedings against them
- Remuneration paid or payable to the management team and/or any advisors; and
- All material risks of investing.
The next set of requirements will stop most ICOs from ever using this type of exemption. It is unlikely very many would be willing to comply with the investor protection conditions that have to be met, proof of financial integrity through the filing of audited financial statements, ongoing disclosure, and any restriction that limits their ability to dump the coins on an exchange. For those that choose to proceed honestly, in order to qualify for the OM prospectus exemption, the business must meet all of the following requirements:
- Meeting the content requirements for the document;
- Obtaining a signed risk acknowledgement form from each investor;
- Complying with investor investment limits, as required;
- Providing audited annual financial statements and ongoing disclosure to investors, as required;
- Complying with resale restrictions, which will generally preclude coins/tokens from trading on cryptocurrency exchanges; and
- Filing reports of exempt distribution with the securities regulatory authorities.
- CSA Staff Notice 46-307 Cryptocurrency Offerings - http://www.osc.gov.on.ca/documents/en/Securities-Category4/csa_20170824_cryptocurrency-offerings.pdf
- National Instrument 21-101Marketplace Operation - http://ccmr-ocrmc.ca/wp-content/uploads/21-101_ni_en.pdf
- National Instrument 45-106 Prospectus Exemptions- https://www.bcsc.bc.ca/Securities_Law/HistPolicies/HistPolicy4/PDF/NI_45-106/
- CSA Staff Notice 31-336 - Guidance for Portfolio Managers, Exempt Market Dealers and Other Registrants on the Know-Your-Client, Know-Your-Product and Suitability Obligations - http://www.osc.gov.on.ca/en/SecuritiesLaw_csa_20140109_31-336_kyc-kyp-suitability-obligations.htm