On June 11, 2018, the Canadian Securities Administrators (CSA) released CSA Staff Notice 46-308 – Securities Law Implications for Offerings of Tokens (Notice) providing guidance on the applicability of securities laws to offerings of coins or tokens, including those commonly referred to as “utility tokens”.1
While the tone of the Notice suggests that the CSA considers most crypto-coins and tokens to be securities, it includes guidance as to when they might constitute mere utility tokens not subject to securities laws. This note discusses and provides context on the key points in the Notice, including:
- The existing “investment contract” analysis will often guide regulators in determining whether an offering involves a security, i.e., they will ask whether it entails an investment of money in a common enterprise, with profits significantly attributable to the efforts of others.
- The Notice provides a list of circumstances that are likely to cause regulatory staff to view a product as a security, which is the result of specific previous business ideas that have been vetted or otherwise reviewed by the regulators.
- An offering that is structured to occur in multiple steps could be deemed an offering of securities at each step.
- Those seeking a “flexible approach” to compliance can contact their local regulator to discuss their business plan, but should obtain securities law advice in advance of doing so.
Follow-up on previous guidance on crypto-offerings
The Notice follows the initial guidance document from the securities administrators’ staff on cryptocurrency matters in 2017 (see our client bulletin Securities Regulators Provide Guidance on Cryptocurrency Offerings) where they clarified that many such offering will be considered securities. Since that time, regulators have seen many business plans involving “utility tokens”, from which they have produced a list of criteria set out and considered in the Notice. A utility token is described as a token with “specific functions, such as allowing its holder to access or purchase services or assets based on blockchain technology”. The fact that a token has utility is not, on its own, enough to render a token a “utility token”.
Examples of securities-like features
The Notice lists potential features associated with a token offering that could cause regulators to view it as an offering of securities. In making such an assessment, they will consider (among other things) the criteria set out in the “investment contract” test described above, with a specific focus on whether there is an expectation of profit and a common enterprise. A few examples are:
- The token can’t be used until sometime in the future when the product or service for which it is to be used does not yet exist.
- There is a time lag between purchase and delivery of the token.
- The number of tokens issuable is finite, or there is an expectation that “access to new tokens” will be limited in the future.
- The issuer allows purchasers to buy tokens in an amount that “does not align with the purported utility of the token”, such as a $100,000 purchase of tokens that can be used for personal music downloads.
Either of the first two examples could connote both a common enterprise and an expectation of profit, while each of the last two could lead to the inference that a purchaser of the token has an expectation of profit.
The expectation of profit generally arises, of course, from a prospect of reselling the token at a higher value than the purchase price. The Notice clarifies that whether the issuer has any control over resales – i.e., over “secondary trading” – is generally not relevant in considering whether purchases are made with a view to a profit. That is, an issuer won’t avoid the conclusion that purchasers have an expectation of profit by claiming that the issuer has no say over whether a purchaser resells a token, for example on a trading platform.
“Non-securities” features
The Notice also sets out some features that could cause regulators to view a token as a true utility and not a security, again with reference to whether there is an expectation of profit and a common enterprise, including:
- Tokens have a fixed value that does not change over time, and are available continually.
- Tokens are distributed to users for free, and not “as part of an overall sale of an ancillary or secondary product or service”.
- Each token has unique characteristics.
The first two criteria could reduce a purchaser’s expectation of profit, while the last may mean there is no common enterprise.
A more extensive list of indications that a token does or does not constitute an “investment contract”, as set forth in the Notice, is appended to the end of this bulletin.
Offerings structured in multiple steps
The Notice also sets out guidance for issuers that sell tokens in multiple stages. This is often done via what is known as a simple agreement for future tokens (SAFT). The first step is the sale of a right to receive a token, which right in itself is typically a security. The second is the delivery of the token. Whether or not the token is a security will depend on its characteristics – per the criteria noted above, among others – and will often involve an analysis of whether there is an expectation of profit and a common enterprise.
Any issuance of a security must either be qualified by a prospectus or be exempt from the prospectus requirement. The process of preparing and clearing a prospectus is very expensive and time consuming, so practically every issuer will seek to use an exemption. As discussed in the Notice, a frequently-used exemption is available for sales to “accredited investors”, being purchasers who have a significant level of financial means or sophistication.
One matter not discussed in the Notice is that, in a two-part issuance as described above, the issuance of the token could qualify for the less well-known “conversion, exchange or exercise” prospectus exemption. This is the exemption typically used, for example, when a company issues shares to an employee upon exercise of a stock option by the employee. That exemption has several specific conditions and, as with all exemptions, should only be used following appropriate advice from a securities lawyer.
The Notice also restates the securities law requirement that any person who is in the business of trading in or selling securities must be registered as a dealer. Just as “security” is defined broadly, so is the term “trade”, which includes the issuance or sale of a security, and “any act in furtherance” of such things. Some companies that are looking to issue securities tokens may be able to show that they are not, in fact, in the business of selling securities, but rather in the business of selling whatever the token might be redeemable for. Other companies have sought out specific “exemptive relief” from securities regulators, which can allow a company to avoid registering as a dealer even though it may appear to be in the business of selling securities.
Other matters highlighted in the Notice include the resale restrictions associated with securities sold under prospectus exemptions, and the fact that regulators will focus on the substance of a transaction rather than its form in determining if and how securities laws will apply.
Seeking advice and obtaining regulatory guidance
The Notice encourages any would-be issuers of tokens to consult with legal counsel and discuss their project with regulatory staff to avoid “costly regulatory surprises”. Some regulators, including those in British Columbia, Ontario and Québec, have teams dedicated to “fintech” initiatives, such as token offerings. With extensive experience in dealing with securities regulators in Canada, our team would be happy to assist with your token or coin offering concerns.
For assistance with token and coin offerings, please contact partners Scott Rozansky or Adam Allouba of our Securities and Corporate Finance group.
Indications of an investment contract
Situational examples | Possible implications | Resulting indication | |
1. | Proposed token function is for an unavailable platform still in developmental stages; developmental stages are a question of fact | Purchasing tokens or investing in a business under development due to an expectation of profit Reliance on management’s efforts indicating a common enterprise between management and purchasers | More likely to be an investment contract |
2. | Tokens are not immediately delivered to purchaser, indicating platform is not available | Purchasing tokens or investing in a business under development due to an expectation of profit Reliance on management’s efforts indicating a common enterprise between management and purchasers | More likely to be an investment contract |
3. | Management’s skills have been represented to increase token value | Purchasing tokens or investing in a business under development due to an expectation of profit Reliance on management’s efforts indicating a common enterprise between management and purchasers | More likely to be an investment contract |
4. | Purpose of the offering is to raise capital to increase token or business value | Purchasing tokens or investing in a business under development due to an expectation of profit Reliance on management’s efforts indicating a common enterprise between management and purchasers | More likely to be an investment contract |
5. | Free tokens provided to those who promote the offering | Promoters incentivized to characterize offering as an investment creating an expectation of profit | More likely to be an investment contract |
6. | Management personally retains unsold tokens | Reliance on management to establish use beyond the platform and future increases in value financially benefit management and purchasers creating a common enterprise | More likely to be an investment contract |
7. | Tokens are not widely used or accepted | Reliance on management to establish use beyond the platform and future increases in value financially benefit management and purchasers creating a common enterprise | More likely to be an investment contract |
8. | Issuable token number is fixed | Increased demand should lead to an increase in price leading to an expectation of profit from initial purchasers | More likely to be an investment contract |
9. | Exorbitant token price relative to purported utility | Marketed and sold as an investment and not for purported utility creating an expectation of profit | More likely to be an investment contract |
10. | Targeted marketing to persons who would not reasonably be expected to use platform | Marketed and sold as an investment and not for purported utility creating an expectation of profit | More likely to be an investment contract |
11. | Statements by management or others suggesting token value will appreciate | Marketed and sold as an investment and not for purported utility creating an expectation of profit | More likely to be an investment contract |
12. | Tokens are distributed for free as part of an overall sale of an ancillary or secondary product or service | Appropriate to “look through” the token distribution to the investment of money in overall offering | Less likely to be an investment contract, unless distributed as part of an overall sale of an ancillary or secondary product or service |
13. | Tokens have fixed value | Reduction in purchaser’s expectation of profit | Less likely to be an investment contract |
14. | Unlimited supply of tokens available | Reduction in purchaser’s expectation of profit | Less likely to be an investment contract |
15. | Tokens are reasonably expected or marketed to trade on one or more cryptoasset trading platforms, whether decentralized or “peer-to-peer”, or freely tradeable on the secondary market | Purchasing tokens to eventually resell on the secondary market with an expectation of profit | More likely to be an investment contract |
1 “Utility Token” is an industry term used to refer to a token that has one or more specific functions of utility. These functions include allowing the token holder to access software or an online platform or application, or to purchase goods and services, and are typically processed through blockchain technology.