The Law of ICOs/ITOs: Simplified
The Law of ICOs/ITOs: Simplified
Chetan Phull · Jan 25, 2018
Initial Coin Offerings, or Initial Token Offerings (“ICOs/ITOs”), have become a popular method for companies to raise capital. They also provide a means to disseminate tokens to early adopters of a blockchain, or a platform built on a blockchain.
The material legal question is whether this activity triggers securities laws.
This question is important because compliance with securities laws is costly and time consuming, particularly when the securities laws of multiple jurisdictions are engaged. Moreover, even an allegation of non-compliance with such laws—domestic or foreign—can have severe consequences. (See, for example, the SEC's recent emergency asset freeze imposed on Quebec's Dominic Lacroix, Sabrina Paradis-Royer and PlexCorps.)
A token distribution example: a company in Singapore accepts money from numerous investors/future users in Toronto, in exchange for coupons in the form of tokens. The company requires the proceeds to develop a public blockchain. The tokens are anticipated to increase in value over time, will never expire, and will be transferrable to third parties.
This common set of transactions has a high probability of triggering the securities laws of Ontario.
Why? Read on.
Tokens and Securities Laws: A Quick Primer
Let’s start with the basics of what a “token” is, and what securities laws are for.
A token is a digital object. In the blockchain context, tokens are produced and used in connection with one or more blockchains. Tokens can be a form of publicly traded cryptocurrency (e.g. Bitcoin), or can have a different use on a private blockchain (e.g. container for a hospital’s patient records). They can also be sold outright for a fixed price, or traded as part of a more complicated arrangement.
Securities laws are concerned with the informational needs of most investors in the course of making investment decisions. In the context of tokens, securities laws will generally only apply if the tokens are involved in an offering, solicitation, or transaction of some kind further to a public distribution. It is this kind of activity that tends to invoke securities laws, rather than the tokens themselves.
When Does an ICO/ITO Trigger Securities Laws?
In Ontario, the provincial Securities Act and OSC instruments, rules, and policies will apply where there is a distribution of tokens, and such tokens are securities (see Securities Act, s.53(1)).
Note that as long as there are investors in Ontario, dealer registration may be required even when the securities are “foreign securities” issued by a corporation outside Canada (see NI 31-103, s.8.18; and Companion Policy 31-103, s.1.3 "business trigger").
Tokens, when considered in the context of securities laws, fall into at least one of the following categories:
- securities tokens (investments), or
- utility tokens (goods).
The distribution of securities tokens will definitely invoke securities laws. However, the distribution of utility tokens may not necessarily invoke securities laws.
The vast majority of ICO/ITO activity involves the distribution of utility tokens. On this basis, every blockchain business seeking to raise capital through an ICO/ITO should ask whether its utility token is a security.
For the sake of simplicity, the term “token” will refer to “utility token” from here on.
When Is a Token a Security?—Legal Test
Tokens can be securities in various scenarios under Ontario’s Securities Act. The common analysis asks whether the distribution of tokens involves an “investment contract”.
- an investment of money;
- in a common enterprise;
- with profits;
- to come significantly from the efforts of others.
This test was applied by the SEC in July 2017, in relation to Ether distributions by the Ethereum DAO (see SEC Release No. 81207). One month later, the test was noted by the CSA in the general context of token distributions (see CSA Staff Notice 46-307). However, there are variations in how the test is applied in the U.S. as compared with Canada.*
Another often overlooked test is whether the token, by virtual of the required ledger entry, constitutes a document evidencing title to or interest in property. Although the only definition of “document” in Ontario's Securities Act is restricted to the Part regarding civil liability for secondary market disclosure, we note that the definition includes “a communication prepared and transmitted only in electronic form” (OSA, s.138.1 “document”). Moreover, consider that such a "document" can be one that is subject to sale and prospecting for profit (Pacific Coast v. OSC, 1975 CanLII 686 (ON SC), aff’d 1975 CanLII 44 (ON CA), aff’d 1977 CanLII 37 (SCC); OSC v. BCCO Ltd., 1979 CanLII 2000 (ON SC)).
When Is a Token a Security?—Factual Considerations
A court will generally run the "investment contract" test before asking whether there is a document evidencing title to or interest in property (see the Pacific Coast judicial history as provided in OSC v. BCCO Ltd., 1979 CanLII 2000 (ON SC)).
There are many online guides that presume to provide guaranteed methods to ensure that a token fails the Howey test. However, a recent speech given by the SEC Chairman strongly suggests that this kind of approach to ICO law is troubling and problematic (see the SEC Chairman's January 22, 2018 speech). We agree.
The question of whether a distribution of tokens will trigger securities laws will depend, in large part, on the blockchain business model, how the tokens will be used, and what the tokens’ characteristics are.
This is because tokens are not all created equal. Depending on their design, tokens can contain information, represent value, be fixed or transferrable between blockchains, be secure or insecure, etc. The variation between possible token uses is likewise vast.
The stage of development of the blockchain business will also matter. There is a strong argument that most tokens are securities prior to a network’s launch, but are probably not securities after this point.** On this basis, if the sale of tokens is primarily targeted toward funding the development of a minimum viable product, the tokens could be securities.
Another important consideration is whether the token is anticipated to be traded on a secondary market. If the token will be traded after its initial issuance—on speculation with the expectation of future profit—it could be a security.
A token’s anticipated future change in value could also bring it within the definition of “security”. For example, a token produced by CompanyX may initially be a non-security if it is designed as a non-expiring coupon for a free widget produced only by CompanyX. However, if the supply for such widgets decreases, the token could be considered more valuable. The prospect for speculation in this case could make the token a security.
We consider further legal and factual considerations, tailored specifically to your case, as part of our service offering for ICO / ITO and digital asset dealing / advising.
* Compare the cases discussed in J. Batiz-Benet, J. Clayburgh, and M. Santori, “The SAFT Project: Toward a Compliant Token Sale Framework” (Oct 2017) Protocol Labs at 6-9; Pacific Coast Coin Exchange v. O.S.C.,  2 S.C.R. 112 at 129.
** Ibid., SAFT Project at 9-11.
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