In the financial sector, there are three main types of cryptoassets.3 The first is the payment token (»cryptocurrency»), which serves as a means of payment for the acquisition of goods or services. The second type is the utility token, which provides access to a specific application, product or service via the blockchain. Finally, the asset token entitles the holder to a stake in a company’s financial flows, or even to voting rights, as is the case with a share or bond. Both tokens can be used to raise funds for the token-issuing company.
In August 2017, the Canadian Securities Administrators (CSA) published Staff Notice 46-307 in which they noted the proliferation of ICOs.4 In the notice, the CSA Staff remarked that ICOs could be used to finance start-ups. Without questioning this form of financing, the CSA pointed out that ICOs raised investor protection concerns, due to issues surrounding volatility, transparency, valuation, custody and liquidity, as well as the use of unregulated exchanges. In addition, investors could be harmed by unethical practices or illegal schemes, and they may not understand the properties of the investment products that they are purchasing.
One issue raised by ICOs in Canada is the legal qualification of the token. In the absence of a definition, we must rely on general principles to determine whether this cryptoasset is subject to the rules governing public offerings. The analysis requires an assessment of the economic realities of a transaction and a purposive interpretation with the objective of investor protection in mind”.5
Inspired by the U.S. Securities Act of 1933, Canadian laws set the scope of application of securities legislation using an approach that combines an enumeration of securities with an open-textured notion, namely the investment contract.6 The notion of investment contract is defined by s. 1 of the Quebec Securities Act, which has sought to codify Anglo-Canadian and American case law:7 «An investment contract is a contract whereby a person, having been led to expect profits, undertakes to participate in the risk of a venture by a contribution of capital or loan, without having the required knowledge to carry on the venture or without obtaining the right to participate directly in decisions concerning the carrying on of the venture.»
Case law interpretation highlights the influence of investor protection in judicial analysis.
More specifically, case law highlights the need to ensure that the law applies to situations where investors are vulnerable and in need of special protection. This vulnerability arises when informational asymmetries are significant. It is also present when investors do not have the power of control over the project to protect their interests. The relevance of investor protection in the analysis has frequently been emphasized in case law, which insists on the importance of looking beyond the legal form to examine the transaction in the context of the related activity and its real economic purpose.8
CSA Staff Notice 46-307 emphasizes that the qualification of a token as an investment contract requires the application of criteria developed by jurisprudence and codified in Quebec.9 While emphasizing that each security must be evaluated on its own merits, the CSA pointed out that in many of the issuances examined, cybercurrencies or tokens have been securities for the purposes of securities legislation, notably because they constitute investment contracts.
In Quebec, the application of the fundamental principles of securities law to ICOs was the subject of first decision by the Tribunal des marchés financiers (TMF) in 2017 in PlexCorps.10 In this case, the companies in question grouped together some forty engineers, programmers and cryptocurrency specialists spread across the world, all independent and oriented towards the same objective, namely to improve accessibility to cryptoservices. The website associated with these companies was designed to offer the public the opportunity to invest in «Plexcoin», a virtual currency offering returns of up to 1,354%.
Asked to determine whether the Plexcoin offering constituted a public offering, the TMF made the following observations. Firstly, it noted that there was a contract by which a person committed himself: «the mere eventual acquisition by an individual of a PlexCoin will constitute a commitment within the meaning of the definition of investment contract» [translation].11 Secondly, there was an expectation of profit since the expectation of profit was at the heart of the PlexCoin marketing scheme. Thirdly, the public shared in the risk of a deal through a contribution or loan of some kind as the investor may make less profit than expected, which constitutes a risk, or he may simply lose his investment despite having been told that his investment was guaranteed. Finally, the public solicited did not have the knowledge required to participate in the running of the business, since «buyers of PlexCoin rely entirely on the expertise and specialization of the creators of the virtual currency and the set-up of the proposed product» [translation]. Furthermore, the public had no right to participate directly in the running of the business. In fact, for the tribunal, the only decision a potential buyer of PlexCoin can make is whether or not to invest, so at no time does the potential buyer participate in any decision surrounding the running of the business.
Without analyzing the technical details, the TMF found that the characteristics of the product offered to the public in the Plexcorps case met the criteria of the definition of investment contract, making it subject to the Securities Act. This approach, which stresses the importance of examining the economic reality behind the offer made to the public, where substance overrides form, was adopted in the same case in the United States by the Securities and Exchange Commission.12 In a way, the Plexcorps decision set a precedent, as several subsequent rulings have qualified tokens as investment contracts.13
The application of the Securities Act leads to the application of the regulatory regimes designed to ensure investor protection and the efficient operation of the market. Unless this form of investment benefits from an exemption, vigilance is required for any transaction involving it, to avoid contravening these regimes, which are themselves far-reaching.
Where the Securities Act applies, the activities and transactions involving the investment contract must be carried out in accordance with the initial public offering (IPO) regime, or benefit from a private placement exemption. It should be remembered that the scope of the IPO regime is very broad. In principle, any issuer «making a distribution» of securities must carry out the operation in accordance with the regime.14
The notion of investment encompasses a wide range of activities. First and foremost, it covers financing activities. Thus, making a distribution includes the endeavour to obtain, or the obtaining, by an issuer, of subscribers or acquirers of his securities. Note that the expression “endeavour to obtain» indicates that it is not necessary for the issuer to actually carry out a transaction with the investor.15
The application of the IPO regime has two consequences. First, the issuer is required to prepare a prospectus for the distribution of its securities. Secondly, the issuer’s distribution of securities constitutes a securities brokerage activity that can only be carried out by a person registered as a dealer. The application of the registration system entails fundamental obligations towards investors, such as the obligation to know the client and the suitability obligation. Accordingly, “[b]usinesses conducting ICOs/ITOs that meet the business trigger must verify investors’ identities and collect sufficient information to ensure that purchases of coins/tokens are suitable, including on investment needs and objectives, financial circumstances and risk tolerance.”16
Given the complexity of the obligations, the law provides for prospectus and registration exemption regimes that make it legal to issue securities under a lighter regime, without a prospectus nor the need to register as a dealer. In this regard, the CSA Staff Notice notes that ICOs could be issued under the prospectus exemption for distribution to accredited investors, or under the offering memorandum exemption. In this case, such offerings must meet all the conditions of the exemptions, unless proceeding under the regulatory sandbox discussed below.
In the absence of an exemption, any activity or transaction that fails to comply with prospectus and registration requirements constitutes an offence punishable by fines or even imprisonment.17 These breaches may also give rise to bans on trading, as well as administrative penalties in addition to criminal sanctions.18 Lastly, a transaction carried out without a prospectus gives rise to a civil claim for nullity and damages, as provided for by law.19
In Quebec, case law has clearly highlighted the consequences of the legal characterization of tokens as investment contracts and, as a corollary, the failure to comply with prospectus and registration requirements. In a number of rulings, the TMF found that investment contracts had been placed without a prospectus.20 To protect investors, the court issued cease trade orders against the individuals acting as founders of the websites. Furthermore, adapting to the digital environment, the court ordered the founders to remove any advertisements or solicitations made on social media or websites.
Traditional ways of regulating the securities industry are being challenged by financial innovations. The wave of ICOs has raised tensions between the objectives of investor protection and promoting the efficient operation of the market that underpin Canadian securities regulation. In Canada, this tension has been a priori resolved in favor of the overriding objective of securities law, namely investor protection, as evidenced by the tendency to characterize tokens offered in an ICO as an investment contract.
In this context, the CSA have experimented with a regulatory sandbox model, and more recently an financial innovation hub model (FinHub) to modulate the rules applicable to ICOs, in the interests of supporting innovation and ensuring the smooth functioning of the market. While attractive, the regulatory sandbox model is likely to be transitory. As innovations crystallize, regulators should develop generally applicable regulatory regimes whose requirements are transparent and uniform ex ante for market participants. n
