Issuing an ICO from Canada
This is not legal advice, just my opinion.
Tonight’s blog is meant to provide a brief explanation of the Canadian Securities Laws and the procedure required to engage in an Initial Coin Offering (“ICO”) from a Canadian province.
The Ontario Securities Commission (“OSC”) put out a guidance publication on August 24, 2018 that follows the United States Securities and Exchange Commission (“SEC”) guidance very closely. See http://www.osc.gov.on.ca/en/SecuritiesLaw_csa_20170824_cryptocurrency-offerings.htm#N_1_1_1_8_.
The primary takeaway is that the OSC will follow the Howey Test to determine if an Initial Coin Offering is a Security. They stated:
Staff is aware of businesses marketing their coins/tokens as software products, taking the position that the coins/tokens are not subject to securities laws. However, in many cases, when the totality of the offering or arrangement is considered, the coins/tokens should properly be considered securities. In assessing whether or not securities laws apply, we will consider substance over form.
Although a new technology is involved, and what is being sold is referred to as a coin/token instead of a share, stock or equity, a coin/token may still be a "security" as defined in securities legislation of the jurisdictions of Canada. Businesses should complete an analysis on whether a security is involved. Legal and/or other professional advice may be useful in making this determination.
Every ICO/ITO is unique and must be assessed on its own characteristics. For example, if an individual purchases coins/tokens that allow him/her to play video games on a platform, it is possible that securities may not be involved. However, if an individual purchases coins/tokens whose value is tied to the future profits or success of a business, these will likely be considered securities.
We have received numerous inquiries from fintech businesses and their legal counsel relating to ICOs/ITOs. With the offerings that we have reviewed to date, we have in many instances found that the coins/tokens in question constitute securities for the purposes of securities laws, including because they are investment contracts. In arriving at this conclusion, we have considered the relevant case law, which requires an assessment of the economic realities of a transaction and a purposive interpretation with the objective of investor protection in mind.
In determining whether or not an investment contract exists, businesses should apply the following four-prong test. Namely, does the ICO/ITO involve:
1. An investment of money
2. In a common enterprise
3. With the expectation of profit
4. To come significantly from the efforts of others
Other Important Considerations:
To date, no business has used a prospectus to complete an ICO in Canada.
Sales may be made to investors who qualify as "accredited investors" as defined under securities laws, in reliance on the accredited investor prospectus exemption. (Very similar to American standards – requires $1 Million net worth or $200,000 individual income, and several other standards for businesses. See http://venturelawcorp.com/accredited-investor-definition-canada/)
For retail investors who do not qualify as accredited investors, sales will typically need to be made in reliance on the offering memorandum prospectus exemption.
Whitepapers must be accompanied by a prospectus and/or Offering Memorandum that complies with the Canadian Securities Laws disclosure requirements.
Investors have civil remedies against companies that fail to comply with the securities laws.
The Offering Memorandum/Prospectus Exemption (“OM Exemption”):
This exemption was created on October 29, 2015 to allow retail investors access to a wider range of investment opportunities. It is applied by Alberta, New Brunswick, Nova Scotia, Ontario, Québec and Saskatchewan (“the participating jurisdictions”). The other provinces apply slight variations, but basically follow the same exemption.
The key features of the OM Exemption:
Offering Memorandum. Issuers must prepare and deliver to investors an offering memorandum that discloses certain information about the issuer and include audited financial statements. An investor has certain rights, including a two-business-day withdrawal right and a right of action for rescission or damages if the offering memorandum contains a misrepresentation.
Issuers that rely on the OM Exemption will generally be required to provide audited annual financial statements, as well as a notice outlining how the money raised has been used. The issuer must make this information available to investors within 120 days of each financial year-end.
The participating jurisdictions also must notify investors within 10 days of: (i) a discontinuance of the issuer’s business; (ii) a change in the issuer’s industry; or (iii) a change of control of the issuer.
Marketing materials must be incorporated by reference into the offering memorandum and filed with the securities regulatory authority. These materials may not be misleading or contain any misrepresentations.
Marketing materials are defined as any written communication, other than an “OM standard term sheet” (i.e., a standard document containing only prescribed information regarding the issuer, the securities and the offering), intended for prospective purchasers that contain material facts relating to an issuer, securities, or an offering.
See http://www.osc.gov.on.ca/documents/en/Securities-Category4/rule_20090918_45-106_3238-supplement.pdf (Page 13, Section 2.9 (1)-(18) details requirements for an OM prospectus).
See also https://nerlandlindsey.com/files/docs/2015-12-11-Offering-Memorandum-Exemptions-Attachment.PDF
Examples of material information to be disclosed in an OM are:
A description of the business itself;
The ecosystem on which the coin/token operates;
Any minimum or maximum offering amounts;
The intended use of proceeds;
How long the offering will remain open;
Features of the coins/tokens, including potential returns on investment, exit strategies and liquidity;
How the coins/tokens will be valued on an ongoing basis;
The number of coins/tokens that will be held by management compared to the number that will be offered for sale to the public;
The timeline for achieving different milestones and any ongoing updates that will be provided;
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.
Any disclosure provided to investors, whether an OM or otherwise, must not be false or misleading. The disclosure must focus on material facts and be relevant, clear, balanced, in plain language, and not overly promotional.
For an OM template, see: https://www.bcsc.bc.ca/Securities_Law/Policies/Policy4/PDF/45-106F2_Proposed/. See also: http://venturelawcorp.com/part-three-offering-memorandum-exemption/
Why follow the OM Exemption:
ICO companies are likely going to be considered as selling securities based on the “trading in securities for a business purpose” (also referred to as the "business trigger"). If they fall in this category, they must either apply for a dealer registration, or an exemption from the dealer registration requirement (the OM Exemption). Whether or not an activity meets the business trigger depends on the facts, however the OSC has provided the following factors as consideration:
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 a large number of investors.
If a company meets the “business trigger” they must also follow know your customer (“KYC”) and investor suitability. To meet these standards, the ICO issuer needs to collect more than just the name, email, and/or IP address. They must also collect and verify the customer’s identity, and establish whether or not the investment is suitable based on the investor’s investment needs and objectives, risk profile, and financial circumstances. This can be accomplished by collecting data with an automated online process that asks a series of questions and the customer must fill it in honestly. The automated process would need to place limits on investment amounts based on the investors income and should include risk warnings. The ICO issuer must also have a strong cybersecurity policy to safeguard the investors.
Caselaw on Canadian ICOs:
To date, there have been no cases against Canadian ICO launches. The most relevant caselaw is derived from a 1978 case against a Silver Exchange that was using margin trading, and manipulative advertising practices. The OSC held that these were securities and not commodities, because at the time of purchase the investor had to pay a $0.35 premium which created an investment contract. The Silver company was required to cease business operations and file a prospectus. Their Appeal was denied. See Pacific Coast Coin Exchange v. Ontario Securities Commission, 2 S.C.R. 112 1978. See also https://scc-csc.lexum.com/scc-csc/scc-csc/en/item/4380/index.do.
If the company wishes to launch an ICO out of Canada, I would recommend following the OM Exemption. Based on the four-prong Securities Test as well as the “business trigger,” the argument that Tokens are not Securities would be a very difficult one to win. On the contrary, however, it is a risk the company can assess for themselves, because it does not appear Canada has actively prosecuted any ICO issuer who has followed the traditional Utility Token model, and not complied with the Securities Laws.
The OM Exemption is quite do-able for the token launch, and contrary to the United States, has less restrictive resale restrictions of four months (depending on the province), where the United States requires a one-year lock-up for Tokens sold to Accredited Investors under Regulation D. The downside of issuing the Tokens under the OM Exemption is that the Tokens will forever be considered securities, which may pose a challenge to listing them on a traditional Cryptocurrency exchange that has not got it’s securities license. I do believe these types of secondary exchanges that can support Security Tokens will be established in the near future, either as decentralized exchanges that are not within any country’s jurisdiction, or as compliant exchanges with the proper securities licenses.