Canada: Is The CSA Regulatory Sandbox For ICOs Filled With Quicksand?

The Canadian Securities Administrators (CSA) made a pragmatic move in establishing the CSA regulatory sandbox (Sandbox). The Sandbox's purpose is to support fintech businesses intending to offer innovative products, services and applications in Canada. Notwithstanding the establishment of the Sandbox, issuers contemplating initial coin offerings (ICOs) would be wise to consider the recent decision of impak Finance Inc. (Impak) by the Autorité des marchés financiers (AMF) and the Ontario Securities Commission (OSC). In this instance, the regulators appear to have indicated that their investor protection mandate took precedence over facilitating an ICO.


Background

Impak launched an ICO for impak Coin (MPK Tokens), which Impak describes as a cryptocurrency with a social purpose. The ICO proceeds are intended to fund the development of impak.eco, an online social network 100% dedicated to the "impact economy."

The key features of MPK Tokens are:

  • MPK Tokens will form the sole medium of exchange on Impak's future platform

  • Impak's platform will bring together "local" and "green" businesses and connect them with those who wish to buy their products

  • MPK Tokens will not be tradable on secondary markets: the sole market for MPK Tokens will be operated by Impak

  • Impak will impose fees on MPK Token holders who convert their MPK Tokens to fiat currencies (like US or Canadian dollars) and will award "bonus" MPK Tokens to holders that spend MPK Tokens on the Impak platform

  • MPK Tokens do not represent an equity or other interest in Impak: holders have no right to participate in Impak's profits or a distribution of its assets nor a right to vote on Impak matters

  • the exchange rate for MPK Tokens will be determined by an advisory board on a quarterly basis

Prior to the launch of its ICO, Impak submitted its proposed business model to the Sandbox. It is presumed that after consultation with the securities commissions in Quebec, Ontario and elsewhere, Impak decided to treat MPK Tokens as securities and offer them to the public pursuant to prospectus exemptions. The regulators stated that, in the absence of discretionary relief, the "first trade" of MPK Tokens, being the use of MPK Tokens for payment to a merchant, would be a "distribution" requiring the filing of a prospectus or reliance on an exemption. The regulators then granted discretionary relief from the dealer registration requirement and the prospectus requirement for the first trades of MPK Tokens, provided that Impak:

  • conduct know-your-client and suitability reviews and verify accredited and eligible investor status

  • not provide investment advice

  • deal fairly, honestly and in good faith

  • establish policies and procedures to manage the risks of its business, including cybersecurity and conflicts of interest

The decision to treat MPK Tokens as securities is questionable

Despite the AMF's and OSC's decision, there are strong arguments that MPK Tokens are not securities.

In Staff Notice 46-307, the CSA states it is important to look at the totality of the offering and focus on substance over form when determining if a security is being offered. Purchasing MPK Tokens is not an investment in Impak, but a means to access goods and services on the impak.eco platform. According to Impak's offering memorandum, the value of an MPK Token is not tied to and should not fluctuate based on the value of Impak itself. MPK Tokens in our view are better likened to commercial gift cards and/or customer loyalty programs than to investment contracts.

Applying the legal test endorsed by the CSA leads to a similar conclusion. The four-prong test in determining whether a product is an "investment contract" (a subcategory of security) is whether the offering involves:

  • an investment of money

  • in a common enterprise

  • with the expectation of profit

  • which profit comes significantly from the efforts of others

It is unclear that MPK Tokens meet the third and fourth elements of the test. While one can argue MPK Tokens could appreciate or depreciate like any other currency or asset class, which may result in a profit or loss when converted into a fiat currency, applying the test in this manner would result in all cryptocurrencies being treated as securities. It is not apparent that any profit would come significantly from the efforts of others. While there is a "cash-back" system whereby participants can earn additional MPK Tokens by using the Impak platform, this incentive is earned through a participant's active efforts to use the platform, rather than through passive investment.

This decision is not easily reconciled with the "substance over form" analysis set out by the CSA. Though investor protection is an important mandate when regulating new products, we believe it is important that the CSA provide clear guidance to prospective issuers, which would facilitate the development of new products in the marketplace.

Treating MPK Tokens as securities has serious implications for Impak, including the cost of preparing a form-compliant offering memorandum, filings and related fees payable to the securities commissions, conducting KYC and suitability reviews, and preparing annual audited financial statements.

Where do we go from here?

Regulating any rapidly evolving field is undeniably a daunting task. Canadian regulators should be commended for establishing forward-thinking platforms like the Sandbox and the OSC LaunchPad. The next hurdle for regulators will be how to utilize the potential of these new resources. However, the Impak decision is a confusing starting point that may cause concern among Canadian startups and result in fewer participants approaching the Sandbox for guidance, notwithstanding the regulators' statement that the decision "should not necessarily be viewed as a precedent for other filers in the jurisdictions of Canada."

The likely result of the Impak decision is participants will elect to avoid Canada when conducting ICOs rather than bear the cost, burden and delay of attempting to comply with Canadian securities law requirements. We saw this in early September, when Kik, a Waterloo-based startup, decided to exclude Canadian residents from participating in its now-completed ICO. Kik's founder explicitly cited "weak guidance" from Canadian regulators as a key reason for Kik's decision. Kik is certainly not alone in its sentiments. On August 28, the Blockchain Association of Canada, a not-for-profit blockchain advocacy group, sent a letter to Canada's finance ministers urging for a more "open-minded" regulatory policy on ICOs.

Though the task is by no means easy, Canadian securities regulators must balance their investor protection mandate with the need to respond to market innovations rapidly and creatively. Greater clarity as to what steps companies can take to comply with securities law would be helpful. Otherwise, it will be difficult for Canada to become and remain a leader, not only in terms of cryptocurrencies, but also in responding to future investment products.


About Norton Rose Fulbright Canada LLP

Norton Rose Fulbright is a global law firm. We provide the world's preeminent corporations and financial institutions with a full business law service. We have 3800 lawyers and other legal staff based in more than 50 cities across Europe, the United States, Canada, Latin America, Asia, Australia, Africa, the Middle East and Central Asia.

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