December 22, 2017
Blockchain technology has already been a transformative force in a number of sectors. Its most prominent use to date has been as the foundational technology of cryptocurrencies such as Bitcoin. Current market capitalization of all cryptocurrencies has soared over 2017 and now exceeds USD $600 billion – over $450 billion of which was generated over the last quarter of 2017. Blockchain is now transforming other sectors, most significantly financial technology businesses (a.k.a. “fintech”). Fintech is already impacting the corporate finance and securities world, leading to the emergence of a new way for companies to use cryptocurrencies to raise capital: Initial Coin Offerings or “ICOs”. The enormous capital influx in 2017 via ICOs is attracting the interest of companies seeking new ways to attract investment in a competitive market. It is also attracting the scrutiny of securities regulators grappling with a range of issues, chief among them whether ICOs are regulated securities or unregulated “tokens”.
Initial Coin Offerings is a rapidly emerging area for raising funds – but one that also carries legal uncertainty and risk. It is critical that those contemplating an ICO to raise capital understand just what they’re getting into – and the legal risks to which they’re exposed. To help evaluate if an ICO is the right tool for your company to raise capital, here the answers to five frequently asked questions about ICOs.
ICOs are a tool for companies to raise money from the public, similar to initial public offerings (IPOs). Companies around the world have raised over USD $3 billion in 2017 alone, far surpassing early stage venture capital raised during the same period. Some companies have raised hundreds of millions of dollars in their first ICO. In an ICO, a business (the Offeror) invites the public to buy coins or tokens (both of which we will refer to as “coins”). The sale can last from a few hours to a few weeks. In a typical ICO, a purchaser uses fiat currencies (typically using a credit card) or other cryptocurrencies (a virtual currency that uses cryptography for security, such as Bitcoin or Etherium) to purchase digital coins from the Offeror. These coins can take different forms: they can be created to primarily facilitate trading activities (like Bitcoin) or to provide access to a computer program or technology the Offeror intends to construct. Generally, the Offeror will provide a detailed whitepaper describing how the coins will have value or usefulness when inviting the public to buy them.
Blockchain is the underlying technology on which companies rely to facilitate ICO transactions. Blockchain and a coin are different things: blockchain is the infrastructure or highway and coins are the infrastructure users (like the cars travelling on the highway). Blockchain acts as both a ledger that determines who owns which coins, and as the medium to allow the exchange of coins. At any given time, the ledger determines who owns which coins. With the transfer of coins, the ledger is updated; the ledger forms a block and the sequence of blocks form a chain, hence the name “blockchain”.
Blockchain’s innovation is its provision of tamper-proof digital ledgers (if it is a distributed ledger blockchain) that promise security, predictability and instant and automated validation of transactions. According to the Harvard Business Review, cryptocurrencies that rely on a distributed ledger blockchain use an “open distributed ledger” that store transactions in a digital format “in transparent, shared databases, where they are protected from deletion, tampering, and revision”. However, not all blockchain platforms are distributed ledger blockchain. A distributed ledger blockchain’s security, and that of any coins users hold, derives from the fact the ledger is distributed to many computers across the world. Where a blockchain isn’t a distributed ledger platform, its security, and that of any coins held by users, isn’t an automatic attribute; the user must evaluate the security level of the particular blockchain platform.
The increasing popularity of ICOs has caused Canadian and U.S. securities regulators to take note – and both have advised caution. Initial Coin Offerings raise a number of difficult legal issues, and regulators have warned they may pose significant risks to investors, including exploitation though unethical practices or illegal schemes. Among these risks is that ICO might be subject to applicable securities laws in Canada, the U.S., or other countries. If so, the company can’t make the ICO unless it complies with the securities laws applicable both where the Offeror and the purchasers are located. Offerors that make an ICO that doesn’t comply with applicable securities laws exposes it to enforcement by securities regulators. Regulators are generally authorized to impose a range of sanctions, including administrative monetary penalties (i.e. fines) and cease trade orders prohibiting any involvement in the securities industry (including, but extending beyond, trading) from short periods of time – to permanently; activity that amounts to fraud can also attract criminal sanctions.
United States. In July 2017, the U.S. Securities and Exchange Commission (SEC) issued an investigative report on a “virtual” organization called the “Decentralized Autonomous Organization” that offered tokens in exchange for Ether (a form of cryptocurrency). The “virtual” organization’s objective was to use Ether to fund projects in the form of an automated investment strategy; coin-holders stood to share in the expected profits from these projects in the form of “rewards” as a return on their investment in the coins. The SEC determined the transaction of coins in exchange for Ether was an “investment contract” because it was a monetary investment in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. Therefore, the coins were “securities” subject to the requirements of U.S. securities laws.
Canada. On August 24, 2017, the Canadian Security Administrators (CSA) commented, in CSA Staff Notice 46-307 Cryptocurrency Offerings, on the legal status of offerings in the form of cryptocurrencies. The CSA acknowledged that ICOs can provide new opportunities for businesses to raise capital and for investors to access a broad range of investments – but it has also warned that raising money though coins might fall within the definition of an offer of securities, and thus be subject to securities laws. Many coins issued in ICOs are tradable on cryptocurrency “exchanges”. The term “exchange” is commonly used in the cryptocurrency community but doesn’t refer to those exchanges to which National Instrument 21-101 Marketplace Operation and other Canadian securities legislation refer. Regulators in Canada and the U.S. have expressed concern surrounding “the volatility, transparency, valuation, custody and liquidity” of cryptocurrency exchanges. The CSA takes the view that ICOs are, in many cases, “securities” subject to securities law rules. The CSA has suggested fintech companies seeking to raise capital through an ICO should, as a precaution, consider whether:
Whether coins offered through an ICO are “securities” subject to securities laws, or a “service” that is not, depends on the rights and obligations associated with the coin as the Offerer described in the ICO white paper. The legal test in both Canada and the U.S. for whether an arrangement involves an investment contract, a type of security, has three independent aspects, all of which a coin must satisfy to be a security: an investment of money, in a common enterprise, with an expectation of profits predominantly from the efforts of others. A coin that meets this legal test is a “security” – and an ICO offering the coin will be subject to, and required to comply with, applicable securities laws; one that doesn’t will be a service that is not. In reality, most coins have characteristics of both securities and services, making them difficult to clearly classify – and more likely to fall under the increasing scrutiny of securities regulators. Offerors that raise capital through ICOs and aim to avoid this scrutiny will avoid marketing the coins as an investment that may increase in value, and instead market them as software products or services that serve only a particular function. The CSA will not, however, be bound to the Offeror’s marketing material, stating regulators will consider “the totality of the offering or arrangement”, including an assessment of the “economic realities of a transaction and a purposive interpretation with the objective of investor protection in mind”, to determine if the coins are securities.
Securities. Characteristics more likely to lead securities regulators to classify coins as “securities” include:
Service. Regulators may be more likely to classify coins as representing the purchase of a “service” accessed through the coin’s use if they have various rights that purchasers can use to participate in activities such as making consumer purchases, right to access or license programs and services, right to charge a toll for such access and transacting within networks. Some recent ICOs have provided purchasers with early access to the Offeror’s technology, much like a gofundme campaign.
There are two distinct approaches to an ICO: working and complying with securities regulators’ requirements; or proceeding on the basis securities laws don’t apply. Recent and contrasting ICOs by two Canadian companies, TokenFunder Inc. and Kik Interactive Inc., illustrate these two approaches:
Compliant approach. TokenFunder Inc. participated in the Canadian Securities Association’s (CSA) Regulatory Sandbox, becoming Ontario’s first ICO with a green light from the Ontario Securities Commission (a Canadian securities regulator). For its offering, TokenFunder worked hand-in-hand with securities regulators to ensure its offering was securities-law compliant: it developed a disclosure document in the form of an Offering Memorandum, referred to its coins as “securities” and generally complied with the high level of disclosure that securities regulators require. As a consequence, the CSA exempted TokenFunder from the securities laws’ dealer registration and offering memorandum prospectus requirements, and permitted it to launch its ICO by way of a private placement. The Ontario Securities Commission was also creative in addressing technology-related investor protection concerns by requiring that prospective investors complete surveys confirming their understanding of blockchain technology and coins offerings.
Non-compliant approach. In contrast, Kik Interactive Inc. raised nearly $100 million without extensive consultation with Canadian regulators, citing regulatory uncertainty as the rationale for excluding them. Offerors such as Kik Interactive assert their issue of coins are not subject to securities laws and follow certain best practice principles to inform and protect purchasers – while not submitting directly to the securities law regime – including:
Please contact your McInnes Cooper lawyer or any member of the Corporate Finance & Securities Team @ McInnes Cooper to discuss this topic or any other legal issue.
McInnes Cooper has prepared this document for information only; it is not intended to be legal advice. You should consult McInnes Cooper about your unique circumstances before acting on this information. McInnes Cooper excludes all liability for anything contained in this document and any use you make of it.
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