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With blockchain radically transforming the way in which the world conceptualizes transactions of value, various sectors have focused heavily on the research and development of blockchain-based solutions. In particular, crypto’s fundamental capability to circumvent the double-spend issue of digital assets has the power to create a significantly more streamlined and transparent technological infrastructure in capital markets. As a result, the financial industry has been a trailblazer in blockchain experimentation with banking organizations across the globe exploring how distributed ledgers can best be leveraged.
One key blockchain innovation that substantially altered the traditional financial landscape is the emergence of the initial coin offerings (ICOs). Also known as an initial token offering (ITO), token sale, or crowdsale, ICOs enable entities to raise capital through the sale of digital assets to the public. Requiring less than 100 lines of computer code, anyone can create these blockchain-based digital assets and sell them to buyers online.
Since the first ICO in 2013, token sales began to grow exponentially, with many technology entrepreneurs opting to execute an ICO in lieu of more conventional fundraising strategies. By mid-2018, blockchain startups had raised over $7B through initial coin offerings, compared to the $1B that flowed into the space from traditional venture capital. Overall, the total amount raised by token sales in 2018 was $11.4 billion USD and constituted 45% and 31% of the amount raised by initial public offerings and venture capital, respectively. However, the extreme growth of token sales was in part, due to a lack of regulatory oversight.
Unlike traditional financing channels which require centralized institutions to facilitate and monitor transactions, ICOs issue assets directly to investors. No longer imperative to the process, the regulated financial incumbents that previously played an important role in managing transactions are largely bypassed in token offerings. Yet although the efficiency gains driven by disintermediation may appear advantageous to entrepreneurs, the lack of supervisory measures introduces an array of compliance issues. In particular, the lack of scrutiny over ICOs and the unprecedented access to capital drastically increases risks of manipulation and fraud against investors.
This article will examine the extent to which token offerings have value within capital markets beyond being simply a way to circumvent securities law requirements and provides an overview on the current regulatory landscape in Canada.
The novel flexibility in the structure of rights attached to ICO issuances caused many crypto companies to assume that the distribution of tokens did not constitute a securities offering. Indeed, virtually all of the token offerings that took place in 2017 occurred without any of the securities filings ordinarily required in a public offering event. By 2018, after most securities regulators had formally addressed how ICOs fit within their respective legislative frameworks, it became unequivocally clear that an overwhelming majority of ICOs involved the sale of securities disguised in new technology. In spite of the fact that some token offerings are obvious investment vehicles, a more careful analysis reveals that many ICOs are unable to fit the standard investment paradigm and truly do represent an innovative shift in public capital markets.
The mechanism underpinning ICOs enables issuers to specify the terms and conditions for the supply of tokens (including thresholds, prices, caps), which are subsequently executed on the blockchain. Using a smart contract, the software acts as a digital agent for the issuer and subsequent token holder, automatically keeping track of ownership throughout the sale process and requiring little to no oversight once executed. Unlike a traditional equity fundraise, tokens can be assigned various economic, voting, participation, consumptive, or utilization rights. While holder rights vary between offerings, the majority of ICOs do not necessarily represent an ownership stake in the project, but instead, can be principally intended to confer some form of functional ‘utility’ such as access to participate in future services or solutions developed on the issuer’s platform.
An example of a utility based token is the Status Network Token (SNT) associated with the Status messaging platform. Purchasers of SNT tokens obtain access to advanced features on Status including push notification settings, username registration rights, and digital stickers. In addition, SNT tokens provide holders with governance rights over the technology and can influence the network and future projects by voting on management decisions.
The ability to raise funds by selling custom consumptive privileges as a ‘utility’ token instead of strictly an investment ‘securities’ token caused many issuers to forego the expected securities law registration and prospectus requirements. Compared to the stringent legal standards that a registered company must adhere to when providing information to investors, token issuances rely on unstandardized documents to provide information about their venture to prospective buyers. Parties seeking to conduct a token sale typically draft a white paper, which contains a technical description of the project and the terms and conditions of the sale. After the release of a white paper on the issuers website, the organization supporting the token releases the code to the public to enable trusted technical experts to check that the application code does not contain errors or bugs. Many projects incentive developer participation in the review by issuing compensation to those who find flaws.
However, in the absence of established authorities to oversee the due diligence process, there is no guarantee that a white paper or the underlying code is properly audited. While third-party research services frequently report on whether a project even has open source code available for review, without legally mandated disclosure or investor protections, ICOs carry the significant risk of being used as a vehicle for defrauding investors. Considering the lack of regulatory scrutiny, concealment or omission of material concerns that typically must be addressed in disclosure documents often occurred in white papers released prior to 2018. In addition, some issuers began using white papers purely as a promotional tool rather than a disclosure instrument meant to inform an educated investment decision. Consequently, the rise in ICO popularity caused many investors to fall prey to scams and suffer considerable financial losses. From 2016 to 2018, ICO exit scams have been estimated to have stolen $96.8 million from investors.
However, the presence of fraud and cases of poor business practice does not signify that a new technology is worthless or detrimental. Acknowledging that ICOs do represent significant risk, an examination of the current legal regime is necessary in order to protect public investors and to improve regulatory certainty for businesses.
The surge of interest in ICO fundraising soon caught the attention of regulators, who became concerned with the lack of consumer protection, and the potential for cryptocurrencies to compromise the protection provided by current anti-money laundering and terrorist financing regulations. Confluent with vastly differing interpretations of the law between jurisdictions and considerable ambiguity about the nature of ICO structures, there has been high inconsistency in securities law reporting practices. In particular, since the duality in the function of many of the tokens issued is unique to ICOs, prior to guidance from regulators, it was unclear the extent to which token offerings would be caught under securities laws.
Canada in particular has been one of the leading legal systems working to address issues around blockchain technology and has adopted or modified legislation on the subject matter. On June 19, 2014, the Canadian Parliament passed the first national law on digital currencies in the world, Bill C-31, An Act to Implement Certain Provisions of the Budget Tabled in Parliament on February 11, 2014 and Other Measures.
Bill C-31 is intended to reform Canada’s previous Proceeds of Crime (Money Laundering) and Terrorist Financing Act, S.C. 2000, c. 7 to include digital currency financial transactions under anti-money laundering legislations. Since then, the Canadian government has remained fairly active in its approach towards cryptocurrency, while also attempting to remain transparent in its regulatory initiatives. With a large quantity of blockchain startups centered in Canada, it is important for Canadian lawmakers to strike a balance between creating legislation that is permissive enough to promote opportunities for innovation but strict enough to protect investor and public interest.
In response to the increase in number of cryptocurrency token offerings in 2017, the Canadian Securities Administrators (“CSA”) published CSA Staff Notice 46-307 Cryptocurrency Offerings on August 24, 2017 and CSA Staff Notice 46-308 Securities Law Implications for Offerings of Tokens on June 11, 2018. Both Notices provide guidance for issuers seeking to raise capital on the obligations that may apply under securities laws. In general, the Canadian approach to cryptocurrency offerings applies the current regulatory system for securities to the individual set of characteristics associated with the token offering on a case-by-case basis.
The central analysis related to offerings of digital assets pivots on whether the cryptocurrency in question is considered an investment contract under Canadian law. The ability to market tokens as the sale of a software product, or an application to purchase goods and services rather than purely a financial investment caused many crypto businesses to take the position that such tokens could be classified as a utility and therefore, did not constitute a security. “Utility tokens” are meant to represent an application-specific token more akin to a ‘gift card’ to be used for a service on the platform rather than an investment in the company.
While utility tokens are not meant to represent an investment, the ability to later sell most tokens on a secondary market creates potential to realize economic profits for investors based on the forces of supply and demand. Indeed, the duality of a token’s potential to function as a means of representing future value and as a means to transact on the platform makes it difficult to quantify the extent to which it can be considered an investment. However, the structure underlying each ICO is different and therefore must be assessed on its own individual characteristics. In Canada, the leading test for determining whether an investment contract exists is from the Supreme Court’s decision in Pacific Coast Coin Exchange of Canada v. Ontario (Securities Commission) (“Pacific Coin”). Premised on the American Howey Test, the four prong test established in Pacific Coin qualifies an instrument as a security if it involves:
If the sale of cryptocurrency does constitute an investment contract under the Pacific Coin test, then compliance with securities law regulations is necessary.
While recognizing that tokens do not necessarily fit neatly within existing judicial frameworks, the CSA has clarified that when assessing whether or not securities laws apply, substance takes precedence 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.”
Thus, the fact that a token has a utility, does not on its own, repudiate the possibility that the offering meets the criteria for classification as a security.
When considering the totality of the circumstances surrounding many token arrangements, securities laws should be applied. Although a developer may intend to issue a utility token to constitute a type of access to the platform, often the token also provides investors with economic benefits such that purchasers are ostensibly buying in order to realize a profit. These cases are straightforward and clearly fit the criteria of a security. However, the analysis becomes more ambiguous in cases where a token confers only a functional use and no extrinsic economic rights. The limited quantity of tokens combined the high liquidity of a secondary market causes the digital representation of consumptive goods to resemble securities because they can appreciate in value, and present opportunities for speculation. The ease with which tokens can be traded globally on cryptocurrency exchanges means that even utility tokens can generate profits if sold for more than the purchase price.
While regulators have contended that the evaluation of whether a utility token is considered a security depends on how it is packaged and sold to prospective buyers, a variety of facts are relevant when determining if purchasers are motivated by an expectation of profits or a desire to use the platform. Indeed, the law surrounding digital token financing is by no means final or clear and a cautious approach is necessary to ensure that a proposed token offering is within the boundaries of the law.
While each case is analyzed on its individual characteristics, the rebuttable presumption will be that the majority of ICOs involve the sale of securities and are thus subject to meet specific requirements under securities law. The distribution of securities in Canada requires sales made to investors to take place either under a prospectus, or by way of an exemption pursuant to National Instrument 45-106 – Prospectus Exemption (“NI 45-106”). These exemptions include sales to investors who qualify as accredited under Section 2.3, or sales made in accordance with the offering memorandum exception in Section 2.9.
In addition to the prospectus requirements, issuers that are trading securities for a “business purpose” must register as a securities dealer with an applicable securities regulator or obtain an exemption from dealer registration. Whether or not an offering meets the business purpose standard (“business trigger”) is fact specific, however, section 1.3 of the companion policy to National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations sets forth five relevant factors that suggest the business purpose has been triggered:
While factors are non-exhaustive, Staff Notice 46-308 provided further guidance on activities that can be used to inform whether a person or company is trading in securities for a business purpose:
Registering as a dealer involves compliance with securities regulations that require the business to have strong measures in place to safeguard the business and its investors. This includes fulfilling requirements that are designed to protect investors such as know-your-client (“KYC”) and suitability. Under the recognition that the majority of tokens are in fact securities, some crypto issuers have chosen to leverage the advantages of raising capital through an ICO, while remaining compliant with the appropriate securities regulations. Although the electronic representation of securities was technically possible prior to the introduction of the ICO, blockchain-based networks dramatically reduce the costs associated with managing the sale of both securities and other assets worldwide. In particular, the inherent transparency of cryptocurrency has extraordinary potential to streamline the once cumbersome process of raising funding. As these tokens can be distributed and traded globally, they become more fairly priced and are thus, attractive to investors.
The initial surge of enthusiasm and subsequent fraudulent activity surrounding cryptocurrency makes it difficult to parse down its true value as a financing tool beyond a means to evade securities law regulations. However, if appropriately regulated, blockchain-based solutions do offer real potential to innovatively impact and transform financial markets. To begin with, the efficiency, transparency and security intrinsic to the blockchain can be implemented in already existing industry structures to address challenges associated with high structural costs and heavy capital charges. The legacy structure maintained by investment banks is no longer viable and blockchains have extraordinary capability to streamline the once cumbersome process of raising funding.
More importantly, the power to sell consumptive and and functional value to raise funds presents opportunity to build networks of parties with a desire to fund a common goal. Anyone with access to the Internet can now issue assets in the form of tokens to buyers around the world. The ability to exchange value securely across jurisdictions without third-party clearing mechanisms opens financial markets in an unparalleled manner. By making it increasingly easier to create, disseminate, and trade assets, blockchains impact finance the same way the availability of information on the Internet transformed copyright. Peer-to-peer file sharing platforms on the Internet ultimately led to a re-alignment of the music and media industries. Likewise, the global nature of the Internet in combination with the asset management power of the blockchain has the power to democratize access to capital and unleashing untapped entrepreneurship. Raising funds through ICOs may end up stimulating innovation in sectors that previously had problems accessing capital. For example, the pharmaceutical industry can stand to benefit from an increased investor base when developing experimental drugs that may not be profitable. Social enterprises have much to gain from global cooperation – just this year nearly $1 billion USD was raised in less than a day by millions of individuals who pledged to help rebuild Notre Dame cathedral.
Although still in the early stages of adoption and experimentation, it is important to investigate the possibilities of blockchain-based funding mechanisms to explore how traditional models can be improved. The future of ICOs is likely to reshape the landscape of open innovation and ultimately change how value is created and exchanged within societal structures. Yet despite these potentials, ICOs do carry significant risks that must be appropriately mitigated to adequately protect consumers. Equally important is a legal infrastructure that can support a broad implementation of cryptocurrency in the financial sector. While blockchain is predicted to revolutionize the global capital market by functioning seamlessly across national borders, there are accompanying legal implications that must also be carefully considered. As the blockchain continues to evolve and disrupt traditional capital raising models, policymakers have an essential role in developing the necessary conditions to create a suitable framework for ICOs to operate safely. Although each jurisdiction differs in its approach, governments and regulatory authorities must continue to balance regulatory clarity and innovative freedom to ensure public and individual interests remain protected.
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