In this article, Matthew Burgoyne, head of the Fintech group of McLeod Law, decodes new Canadian Securities Administrators guidance and the implications on token offerings.
On June 11, 2018, the Canadian Securities Administrators (the “CSA”) released a new Staff Notice1 on the securities law implications for token offerings (the “Notice”). The Notice was published by the CSA partly as a result of inquiries received from companies on the applicability of securities laws to the sale of cryptocurrency coins and so called “utility tokens”.
In my experience, many in the cryptocurrency community believe there is a distinction between a token which has the characteristics of an equity or debt investment and is thus a ‘security token’ and a token which has some utility or functionality on a constructed or to be constructed online platform, a so called ‘utility token’.
There is confusion on whether Canadian securities laws apply to the latter ‘utility tokens’. To add to the confusion, over the last few years several major law firms in the U.S. have advocated the use of the “Simple Agreement for Future Tokens” (or “SAFT”). Essentially, the SAFT is a concept that involves the sale of a security at the first stage to fund the development of an online platform. The online platform will utilize a token in some way, for example by allowing users to buy goods and services on the platform with the tokens. Once the online platform has been completed, a second stage sale will occur, which involves a sale of the tokens which can be used in some fashion on the platform. Proponents of the SAFT argue that this second stage token offering is really a sale of a consumptive good, and not a traditional investment, and therefore securities laws should not apply or do not apply.
The CSA wanted to clear the air on both issues:
- Whether there is merit to the argument that so-called ‘utility tokens’ should not be classified as securities.
- Whether the SAFT analysis holds together under Canadian securities laws.
In regards to the first issue, the CSA relies heavily on the ‘investment contract’ component of the definition of a security under Canadian securities law when analyzing whether securities law applies to token offerings. If an offering of a coin or token involves any of the following, the offering likely involves an investment contract and is therefore a security under Canadian law:
a) An investment of money
b) In a common enterprise
c) With the expectation of profit
d) To come significantly from the efforts of others
It is clear from the Notice that the CSA believes that most token offerings that they have reviewed are investment contracts. Some businesses have argued that their proposed token offerings do not involve securities because the tokens will be used in software, on an online platform or application, or to purchase goods and services. These businesses appear to miss the point that the four prongs of the above test can still exist, regardless of the fact that their tokens may have a consumptive use or utility. The CSA Notice also notes that when assessing whether a token offering involves an investment contract:
“businesses and their professional advisors should assess not only the technical characteristics of the token itself, but the economic realities of the offering as a whole, with a focus on substance over form”.
The Notice goes on to cite numerous examples of situations which the CSA has reviewed where the presence of one or more elements of an investment contract has been identified. Many of the examples cited contain common examples which our office has seen where a business is trying to structure a ‘utility’ token offering and not a securities offering. Facts which are common in many of the examples cited include:
- The fact that the online platform, software or application does not exist, is not yet available or is still in development
- The fact that there is no use at all for the tokens or they are not widely used or accepted
- The fact that the number of tokens issuable is finite or limited
- The fact that the token may one day be listed on a cryptocurrency exchange
In each of these cases, the CSA believes the facts point to possible securities law implications, i.e. the token holder is purchasing with an expectation of profit as per (c) in the above definition, or there is the existence of a common enterprise as per (b) of the above definition (where management’s efforts are still needed to develop or deliver the software, application or platform).
It is relevant to note that all prongs of the above test for an investment contract must be met before an investment contract can be said to exist. The Notice fails to address this fact and seems to highlight examples where only one or two indicia of the test would be met.
The Notice also indicates the CSA’s position that where there is an expectation that tokens will be traded some day on one or more cryptocurrency exchanges, this would be indicative of an expectation of profit on the part of a purchaser, in that there is an expectation to resell the tokens for profit at a later date. Whether businesses issuing these tokens have no control over the transferability of the token or the ability of a purchaser to resell on an exchange at a later date, is not on its own relevant in assessing whether purchasers expect a profit. The CSA notes that in general, the tokens offerings they have seen which involved securities have likely breached the resale restrictions contained in securities laws, as secondary trading of the tokens have taken place without a prospectus or an exemption from the prospectus requirement.
Finally, in regards to the second issue cited above, the CSA considers the issue of a multi-stage distribution of tokens, or the SAFT, and whether a utility token offering can be conducted in the second stage of the SAFT outside the ambit of securities law. The point the CSA makes here is not surprising; a token delivered at a second stage may still be a security, despite the fact that the token may have some utility. Most importantly, if the token still contains all of the indicia of an investment contract discussed above, it may still be a security.
The CSA takes the opportunity to remind readers that any distribution of a security in the first stage of a SAFT is subject to the prospectus requirement (or an available exemption from the prospectus requirement) and resale restrictions, and that someone in the business of trading in securities must be registered as a dealer under securities law.
The main take-away from the Notice is that just because something may be consumable or have some form ‘utility’, does not as a result mean it can’t also be a security. One has to look at the how a token is being sold and the expectation of purchasers. Is there a centralized third party involved in the sale of tokens who carries out some essential entrepreneurial effort? Are people buying the tokens, in part on the belief that they will increase in value one day? If the answer is "yes" to both questions, you’re likely dealing with a security.
For further information, please contact the author or any member of our Fintech Group.