Law in Quebec

Cryptocurrency offerings can provide new opportunities for business to raise capital and for investors to access a broader range of investments but they also raise investor protection concerns due to its volatility, lack of transparency, custody, liquidity and the use of cryptocurrency exchanges, notes the Canadian Securities Administrators in a recently published Staff Notice 46-307.

“Investors may (also) be harmed by unethical practices or illegal schemes, and may not understand the properties of the investment products that they are purchasing,” said the notice.

Cryptocurrencies like Bitcoin and Ether have become increasingly popular over the past decade which in turn has sparked an increase of cryptocurrency offerings such as initial coin offerings (ICO), initial token offerings (ITO) and sales of securities cryptocurrency investment funds. They can be purchased using either another cryptocurrency or a fiat currency.

But while many businesses market their coins or tokens as software products that are not subject to securities laws, the CSA staff notice warns that they may still be viewed as securities. Though new technology is involved, the existing definitions that establish whether an instrument is a security also apply to coins or tokens generated from an ICO or ITO, added the notice.

“The notice is helpful and welcome because it tells us that the securities regulators are looking into this,” said Manoj Pundit, a securities and capital markets lawyer with Borden Ladner Gervais LLP in Toronto. “At least they are speaking to the need of having a balanced approach to making sure that our regulations are enforced for the purposes of investor protection but at the same time recognizing that this is an innovative and legitimate business that is evolving in our economy.”

Heeding guidance from case law, and in particular from a Supreme Court of Canada decision in Pacific Coast Coin Exchange v. Ontario (Securities Commission), [1978] 2 S.C.R. 112, the CSA points out that it has found “many instances” of cryptocurrency offerings that constitute securities for the purposes of securities laws, including because they are investment contracts. Although the term “investment contracts” is not defined in legislation, the SCC in Pacific Coast Coin Exchange held it to be “an investment of money in a common enterprise, with a reasonable expectation of profits to be derived from the entrepreneurial efforts of others.”

The implications for cryptocurrencies to be considered as a security are significant. If cryptocurrencies offered through an ICO or ITO constitutes securities, they will need to file a prospectus, which provides details of the venture and the securities being offered, with securities commissions. There are however prospectus exemptions that allow issuers to offer securities on a private placement basis without a prospectus. While so far no business has used a prospectus to complete an ICO or ITO in Canada, the CSA anticipates that businesses looking sell coins or tokens “may do so” under prospectus exemptions.

Whitepapers, which may describe things such as the fundraising goal, the business, the project for which the capital is being raised, and how long the offering will remain open, are a form of disclosure but are not prospectuses and do not fulfill the disclosure requirements under Canadian securities laws, warns the CSA.

Moreover businesses completing ICOs or ITOs may be trading in securities for a business purpose (referred to as the business trigger) are required to register as a dealer or to seek an exemption from the dealer registration requirement. Whether or not an activity meets the business trigger is fact specific. But if individuals or businesses meet the business trigger, then they must comply with fundamental obligations to investors such as know-your-client and anti-money laundering requirements.

Cryptocurrency exchanges, online exchanges that allow investors to buy and sell cryptocurrencies, also come under scrutiny by the CSA. These exchanges operate across the world, in many cases without government oversight or regulation. But the CSA states that such exchanges that offer securities must determine whether it is a marketplace. That’s important because marketplaces are required to comply with the rules governing exchanges or alternative trading systems. “If an exchange is doing business in a jurisdiction in Canada, it must apply to that jurisdiction’s securities regulatory authority for recognition or an exemption from recognition,” states the notice. So far, no cryptocurrency exchange has been recognized in any jurisdiction in Canada or exempted from recognition.

But points out Simon Romano, a Toronto lawyer whose practice focuses on securities, public and private mergers and acquisitions, and corporate finance, the CSA notice makes it a point of encouraging these new businesses to use the regulatory sandbox, which allows firms to register and obtain exemptive relief from securities law requirements under a faster and more flexible process than through a standard application to test their products or services.

“There are costs to regulating things and it may discourage some people,” said Romano. “But regulatory authorities are willing to work with you to achieve goals in a carefully structured arrangement designed to protect investors. Hopefully it stops the Wild West, at least coming out of Canada.”

According to Pundit, the CSA staff notice is a step in the right direction.

“It’s good they came up with this staff notice because it shows they are on it, that they are considering these issues, that they’re open to consultation, and that they are granting some discretionary and exemptive relief in certain fact situations,” said Pundit. “It didn’t present anything that was adverse or that’s not conducive to allowing these innovative products to be made available to Canadian investors.”