Regulatory Treatment of Initial Coin Offerings: Changing Landscape?
In November of 2017, we sent out a note on securities regulators’ approach to initial coin offerings. Since that time, there have been developments and increased scrutiny of block-chain based activities.
Facts Regarding Cryptoassets (Cryptocurrencies, Digital Tokens, and Other Blockchain Based Assets)
On June 28,2018, the Investor Office of the Ontario Securities Commission issued a report which incorporated the results of a survey of 2,500 Ontarians. The report stated the following:
- 5% of Ontarians (500,000) currently hold cryptoassets and an additional 4% did in the past
- 50% of cryptoasset owners spent under $1000 to acquire their cryptoassets and only 9% spent over $10,000
- 1.5% of Ontarians have participated in an initial coin offering
- Businesses raised an estimated US$ 5.6 billion in 2017 ($US 200 million raised by Canadian businesses)
- 531 (46%) of the 902 digital tokens launched in 2017 had failed by February 2018
- Reasons reported for owning cryptoassets:
- Interest in new technologies (46%)
- Speculation (42%)
- Use as medium of exchange
- Low trust in traditional institutions
The report concluded that most Ontarians are approaching cryptoassets cautiously and largely out of curiosity or interest in their practical use as a payment mechanism, rather than as a way to speculate. While it noted the securities regulators’ concerns about the associated risks (such as fraud, volatility, transparency, custody), it also acknowledged that there could be significant opportunities for innovative capital raising and increasing efficiencies in the capital markets.
Morgan Stanley released a report in June 2018 on cryptocurrencies and blockchain. It reported that the overall cryptocurrency market has a value of US$ 300 billion, spread across more than 1,000 coins and tokens, but 39% of total value is in Bitcoin. The report also stated that technology has been improved to enable retail use; however, volatility in pricing has made retailers wary about using it.
See the full report here: http://www.osc.gov.on.ca/documents/en/Investors/inv_research_20180628_taking-caution-report.pdf
Regulatory Treatment: Security Token vs. Utility Token
Different jurisdictions have taken different approaches to the regulation of cryptocurrencies. Switzerland, Liechtenstein, Gibraltar and Singapore are taking progressive approaches as they vie to become global hubs for offerings. The U.S., Canada and Japan are taking more cautious approaches. Securities regulators in Canada and the U.S. have focused on whether the offering involved securities tokens (which carry an expectation of profit) rather than utility tokens (which carry an expectation of use). However, the line between the two has begun to blur as many offerings contain either elements of both or are being implemented in a phased way (first as a security to raise funds which will be used to develop a platform that then uses the token as a utility).
Although securities regulators acknowledge the possibility that a securities token can change its characteristics so that it will no longer be considered a security, no specific guidance has been provided regarding when or how that happens.
While it is clear if a token issuer primes investor to expect an appreciation in the value of the tokens or promises other income streams, the tokens will likely be considered securities; it is not clear when it is definitely not a security.
On June 11, 2018 the Canadian Securities Administrators (CSA) published Staff Notice 46-308 to respond to inquiries regarding whether token offerings constituted investment contracts or are otherwise securities. In Staff Notice 46-308, Staff state that most of the offerings or tokens purporting to be utility tokens have involved the distribution of a security (because an investment contract was involved). The following types of examples were provided to be “illustrative” and would be considered in concluding whether the token is a security:
- Platform still in development: Proposed function is to use platform to purchase goods and services, but if the platform is still in development this could indicate that the purchaser is not purchasing the tokens for immediate utility but rather on expectation of profit
- Deferred delivery – Tokens are not immediately delivered – could indicate platform or goods and services are not yet available
- Purpose related to value – Stated purpose is to raise capital to support the value of token or business or platform’s usability – could indicate the existence of a common enterprise between management and purchasers and are investing in business under development; issuer indicates its team has skills that will increase the value of the token – could indicate common enterprise and expectation of profit
- Secondary market trading – Secondary market trading (“listing” on an exchange that facilitates secondary market trading)
- Advertising targets – Targeting cryptocurrency investors or purchasers who cannot use the tokens for its utility purpose (advertising on cryptocurrency boards)
- Restrictions and lifecycle of tokens – Limiting the speculative nature (tokens that are extinguished after a certain period); retaining a significant number of unsold tokens or restricting to finite number – could indicate common enterprise to increase future value of tokens
- Costs and purpose – Offering free tokens to persons who promote the offering – may create incentive to promote offering as an investment; cost of token does not align with purpose and could indicate not purchasing for personal use
- Utility of tokens beyond platform – Issuer suggests that tokens will be used as a currency or have a utility beyond the issuer’s platform, but unable to demonstrate that the tokens are widely used – could indicate a common enterprise to establish uses beyond the platform
Are We Focusing on the Right Issues?
The creation of business solutions using cryptocurrencies and other distributed ledger technology creates opportunities and efficiencies, but it also has risks. It is not surprising that the regulators are paying attention to it due to the large amounts of money involved. In fact, many interested parties would welcome some regulation which addresses transparency regarding the solutions and financings, data privacy, and security issues. However, these innovative solutions and business models do not fit into historical categories. Instead of forcing parties to satisfy requirements related to traditional models, it would be more productive to think about customized regimes that address the risks without imposing costs due to irrelevant requirements. The regulators should be encouraged to identify an appropriate regulatory framework rather than debating whether these products are like a traditional security and should be regulated as such.
 Baker & Mackenzie, Lexology (April 12,2018)
 The CSA previously set out in a notice the test for an investment contract: 1) an investment of money, 2) in a common enterprise, 3) with the expectation of profit, 4) to come significantly from the efforts of others.
 Conclusions appear tentative because of use of language “could Indicate” in the Staff Notice.