Andrew Burke & Divya Subramanian

Securities markets around the world are grappling with new concerns: As fintechs make cryptocurrency offerings such as Initial Coin Offerings (ICOs), Initial Token Offerings (ITOs) or other digital token offerings, there are various securities regulatory issues that have been grabbing much attention. Response across the globe has been varied – the United States and Singapore securities regulatory authorities would like to engage in a framework that controls, but does not restrain cryptocurrencies, Japan seems to be geared up to introduce a stringent oversight on cryptocurrencies, while China has gone a step further and imposed a complete ban on cryptocurrency offerings and exchanges in its jurisdiction.

On August 24, 2017, the Canadian Securities Administrators other than Saskatchewan, released a Notice (CSA Staff Notice 46-307 Cryptocurrency Offerings) in response to the many regulatory issues that are likely to impact cryptocurrencies. The Notice reveals that the Canadian securities regulators recognize cryptocurrencies as an inevitable part of the future of the Canadian economy, and that fintechs are actively using cryptocurrencies to raise funds for investment.

Threshold question: is it a “security”?

The CSA in its Notice takes an open-ended view that, if not all, many cryptocurrencies fall within the broad definition of “securities” under Canadian securities laws. The Notice states that this is a question to be determined on a case-by-case basis, depending on the various uses of the cryptocurrencies.

In assessing the applicability of securities laws, the CSA will consider substance over form. According to the Notice, they will apply a purposive interpretation to the law, and investor protection will be the primary objective. The assessment conducted by the CSA will be on a case-by-case basis following the test applied by the Supreme Court in Pacific Coast Coin Exchange v. Ontario Securities Commission. Regulators would consider whether the cryptocurrency offering involves: (i) an investment of money, (ii) in a common enterprise, (iii) with the expectation of profit, (iv) to come significantly from the efforts of others. The Notice urges businesses and fintechs to work hand-in-hand with local regulatory authorities to avoid “regulatory surprises”. The Notice recognizes that Canadian securities laws would apply if the person or company selling the securities is conducting business from within Canada or there are Canadian investors in the cryptocurrencies.

Regulatory issues

If a cryptocurrency is a “security”, there are several securities law issues to be considered, including the following:

• any offering must be qualified by a prospectus, or fit within a prospectus exemption such as the accredited investor exemption or offering memorandum exemption
• if the offering is exempt, the cryptocurrencies will not be freely tradeable, and subsequent transfers will also need to consider the prospectus requirements or fit within an exemption
• those in the business of trading or advising in cryptocurrencies may require registration as a dealer or adviser, which would include fund managers
• a platform that facilitates trades in cryptocurrencies that are securities may be an “exchange” or a “marketplace” under Canadian securities laws
• cryptocurrencies may be derivatives, and subject to the derivatives laws adopted by the Canadian securities regulatory authorities

The Notice also provides that significant due diligence will be required regarding the exchanges on which the cryptocurrencies trade. It acknowledges that considering these exchanges are in their infancy, valuations may be difficult.

In an endeavour to assist fintechs to meet regulatory requirements, the Notice advises them to contact their local securities administrators and seek their assistance in determining various requirements and applicable exemptions. The local regulatory authorities may also approve some business owners to go through the CSA Sandbox programme, which will expedite applications and accord exemptions to companies that meet certain regulatory requirements.

Industry response

The current regulatory regime has translated into companies taking divergent strides. Impak Finance Inc., who is offering the cryptocurrency MPK under the offering memorandum exemption, approached securities regulators through the CSA Regulatory Sandbox and obtained an order, dated August 16, 2017, granting them exemptions from the dealer registration requirement and first-trade prospectus requirement. Some of the highlights of the order (which is effective for 24 months), include:

• MPK issued by Impak’s offering will not be listed and traded on any exchange, cryptocurrency exchange or organized market, unless the listing is in compliance with securities legislation and approved in advance by the Principal Regulator
• Impak will provide the Regulator with any report, document or information requested for the purpose of monitoring compliance with securities laws
• prospectus requirements are to apply to the first trade in MPK, unless the trade is made between a Participant and Merchant (as defined in the order)
• Impak will be required to make available Quarterly Information to its Participants
• Impak will be required to conduct know-your-client and suitability reviews and apply fair dealing policies and standards

First Block Capital Inc. manages an investment fund FBC Bitcoin Trust that invests exclusively in bitcoin. First Block was granted registration as an investment fund manager and an exempt market dealer in British Columbia and Ontario, making it the first registered investment fund manager in Canada dedicated solely to cryptocurrency investments.

On the other hand, Kik Messenger Inc., which opened its token (KIN) distribution event on September 12, 2017, excluded Canadians from participating in the Token sale. Kik Messenger attributes the exclusion to lack of direction from the securities regulators on the applicability of securities laws. The Ontario Securities Commission, in response stated that they actively engaged in discussions with Kik Messenger, and provided the view that Kik Messenger would require exemptive relief. They also stated that they are open to any further discussions on working out flexible measures that will ultimately result in offering appropriate protections to Canadian investors.

The way ahead

As a first step, fintechs will have to examine their transactions in cryptocurrencies from a securities law perspective. This may require working closely with regulatory authorities to acquire suitable guidance, or make critical decisions regarding their cryptocurrency offerings in Canada.

What remains to be seen is how other fintechs will respond and the strategies they will adopt, in view of the current ambiguity in securities regulations around cryptocurrencies. It appears that in most cases the cryptocurrencies will fall under the broad definition of “securities” and accordingly the offering will trigger securities law implications.

However, regulatory bodies appear keen to work with individual businesses and fintechs to avoid regulatory surprises. It will be interesting to monitor the extent to which exemptions, concessions and obligations will be imposed on fintechs and their cryptocurrencies, and whether the Canadian securities regulatory model can adapt to accommodate the new world of cryptocurrencies. The pace at which cryptocurrencies are evolving will be a challenge for securities regulation.