Canada: Evolving Law: An Update On The Regulation Of ICOs And Cryptocurrencies

Last Updated: October 27 2017
Article by Joanne Luu and Sylvie J.M. Welsh

On August 31, 2017, the authors published an article A Brave New World: Regulation of Initial Coin Offerings describing the rise of initial coin offerings (ICOs) and their regulation by Canadian and US regulatory authorities. In that article, the authors wrote about the Decentralized Autonomous Organization (DAO) ICO that sold DAO tokens to create a pool of assets to fund "projects" that DAO token holders voted to fund. The DAO is a prominent ICO as a hacker used a flaw in the DAO's code to divert and steal approximately US$50 million of the funds raised. On July 25, 2017, the United States Securities Exchange Commission (the SEC)1 published an investigative report on the DAO, focused on the threshold question of whether the tokens it offered constituted a "security." The SEC broke ground by concluding that DAO tokens were securities and released its report as a warning to the industry: in certain circumstances, the offer of coins/tokens through ICOs may be caught by securities laws and participants should do their due diligence and govern themselves accordingly. Further, the Canadian Securities Administrators (the CSA) issued a Staff Notice2 on cryptocurrency offerings which is in line with the cautionary statements made by the SEC and encouraged all businesses offering coins/tokens through ICOs to carefully determine whether a security is involved and to consider seeking legal and other professional advice in making this determination.

Since that article, we have seen further reactions from regulators around the world, while Canadian regulators apply securities laws to ICOs for the first time.

Regulators Around The World Weigh In

China

China has played a key part in the ICO boom, housing one of the world's most active cryptocurrency communities by trading volume. On September 4, 2017, The People's Bank of China (PBoC) shook up the industry by announcing a ban on ICOs and an immediate halt on all ongoing ICO activity. PBoC further required all proceeds already raised by way of ICOs be refunded to investors. It has also been reported that PBoC plans to inspect domestic exchanges and consider banning these exchanges from trading cryptocurrencies.

Despite taking these drastic measures, the director general of PBoC's research institute has continued to promote the wide range applications for blockchain technology. He emphasized that although PBoC has banned ICOs, this should not prevent companies from continuing their research into blockchain technology through avenues other than ICOs.

Following China's ban on ICOs, Hong Kong's Securities and Futures Commission followed the lead of the SEC and the CSA by cautioning the market that certain coins or tokens may be securities and subject to regulation.

South Korea

South Korea has set up a digital currency task force group (the Task Force) to determine regulations for cryptocurrencies, and in particular, bitcoin. The Task Force is made up of key players such as the Bank of Korea and the Financial Services Commission. At the end of September 2017, the South Korean Financial Services Commission announced it is prohibiting domestic companies from participating in ICOs and prohibiting the trading of virtual currencies.

Europe

The Gibraltar Financial Services Commission is implementing a regulatory framework in January 2018 to oversee the cryptocurrency exchange industry. In the mean time, the Gibraltar Financial Services Commission is cautioning the market much like the regulatory bodies in Hong Kong, the US and Canada.

On September 29, 2017, the Swiss Financial Market Supervisory Authority (FINMA) provided guidance on ICOs and announced it was examining a number of ICOs to determine whether they violate anti-money laundering or securities laws. Additionally, FINMA's guidance suggested enforcement proceedings may be initiated where such legislation has been circumvented or breached.

Canadian Developments

Despite the cautionary guidance provided by securities regulators in Canada and around the world, the number of ICOs and the amount of money being invested in coins/ tokens continues to grow and regulators continue to react.

Playing Nice in the CSA Regulatory Sandbox

In our earlier article, we noted that the CSA has set up a "regulatory sandbox" (the Sandbox) to allow firms to register and/or obtain exemptive relief from securities laws requirements through a swift and flexible process. Two companies have already taken advantage of this approach:

1. Impak Finance Inc. (Impak): Québec's financial regulatory and oversight body, the Autorité des marches financiers (AMF), granted Impak exemptive relief from the dealer registration and prospectus requirements in connection with its proposed ICO of a new digital currency, known as MPK. Utilizing this token, consumers with a preference for socially-focused merchants can purchase goods and services over a platform.

The relief granted by the AMF was subject to conditions. The AMF granted the registration relief on the conditions that Impak: (i) conducts know your client (KYC) and suitability reviews for each investor; (ii) verifies that each investor that represents itself as an accredited investor actually is an accredited investor; (iii) does not provide investment advice to the investors; (iv) deals fairly, honestly and in good faith with its investors; and (v) establishes policies and procedures to manage the risks associated with its business. The prospectus relief was granted on the condition that the first trade in MPK be made between an Impak user and an impact organization

(which are required to undergo a screening process to join the Impak ecosystem). The AMF also imposed ongoing continuous disclosure requirements.

2. First Block Capital Inc. (First Block): On September 6, 2017, the British Columbia Securities Commission granted First Block Capital Inc. registration as an investment manager to operate a bitcoin investment fund. This represents the first registration of a cryptocurrency fund in Canada that provides Canadian investors with access to bitcoin investments through a regulated entity. The Commission imposed a number of conditions on First Block's registration relating to the risks inherent in investing in cryptocurrencies. Among other things, First Block must provide the Commission with reporting on its operations and on its oversight of the custodians and brokers it uses in distributing its fund.

Continued Uncertainty

Despite these cooperative examples between provincial securities regulators and industry, the regulatory regime remains uncertain. For example, this fall, a Canadian company named Kik offered an ICO for its Kin tokens. This cryptocurrency is billed as an extension to Kik's existing messaging app product with 300 million registered users, allowing creators, innovators and subject matter experts to easily monetize their content. Two days prior to the token sale, which has raised approximately $120 million to that date, Canadian investors who had already been subjected to a KYC screening, received an email indicating that they could not participate in the sale. Lack of direction from the Ontario Securities Commission was cited.

Enforcement Issues

Entities offering ICOs are not the only ones struggling to adapt in this new environment. Enforcement of these virtual enterprises is also challenging regulators, as seen by the example of PlexCoin. PlexCoin offers a new cryptocurrency that purports to allow people to undertake their everyday transactions privately anywhere in the world. It encouraged investors to take advantage of its discounted pre-sale, citing a potential 1,354% return on investment. PlexCoin's website claimed to have raised US$2.5 million during its week long pre-sale. However, before the pre-sale closed, the AMF successfully applied for orders from Québec's Financial Markets Administrative Tribunal (FMAT) to compel PlexCoin and related entities to (i) cease soliciting investors, (ii) take down their internet ads, and (iii) post the FMAT Order on the PlexCoin websites. It also ordered Facebook to close PlexCoin's accounts.

To date, while plexcoin.com is offline, a new website bearing the URL plexcoin.tech has emerged, and PlexCoin's facebook account appears active.

Conclusion

These developments underscore the constantly shifting ground on which this new industry operates. Securities regulators around the world continue to be cautious, as they shape regulations for ICOs. In Canada, regulators are applying securities laws to regulate this industry for the first time, drawing that fine line between protecting investors and encouraging innovation. While there have been positive developments that reflect a willingness of regulators to work with this new industry and facilitate ICOs and the development of cryptocurrency funds, the regulatory environment is far from clear.

Footnotes

1 Securities Exchange Commission, Report of investigation pursuant to section 21(a) of the Securities Exchange Act of 1934: The DAO dated July 25, 2017 (Release No. 81207).

2 Canadian Securities Administrators, Staff Notice 46-307 Cryptocurrency Offerings dated August 24, 2017.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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