Prospectus Exemption Options for Blockchain Businesses
Prospectus Exemption Options for Blockchain Businesses
Part 4 of the “Smartblock Law Guide to Security Tokens, OTC Trades, Prospectus Exemptions, and Registration”
Chetan Phull · July 17, 2018
The “Smartblock Law Guide to Security Tokens, OTC Trades, Prospectus Exemptions, and Registration” is comprised of:
- Part 1: Overview of Securities Regulation in Canada;
- Part 2: “Security Tokens” – A Developing Concept;
- Part 3: Foreign Issued Tokens Traded Over-the-Counter in Canada;
- Part 4: Prospectus Exemption Options for Blockchain Businesses; and
- Part 5: Securities Registration Requirements for Blockchain Businesses.
I. Introduction: top two ICO / ITO tips in the current regulatory climate
In the current regulatory climate, we have a couple general tips for small blockchain businesses seeking to issue and distribute security tokens through an ICO / ITO.
- restrict the jurisdictional scope of the ICO / ITO; and
- learn the prospectus exemptions.
The first tip is easy to understand. The second tip involves some additional study, which this article helps with.
A prospectus is required for any distribution of securities, pursuant to Ontario’s Securities Act (s.53(1)).
The prospectus must provide “full, true and plain disclosure of all material facts relating to the securities issued or proposed to be distributed” (OSA, s.56(1)). This is required further to the investor-protection mandate of securities law (OSA, s.1.1).
Note that a single prospectus can fulfill the prospectus requirement of every Canadian securities regulator, by leveraging the CSA’s “passport system” (NI 11-202, ss.3.1, 5.1-5.3).
Beyond Canada, a single prospectus between Canada and the U.S. could, in theory, be used for a North-America-wide public token offering, with a single Canadian regulator reviewing the prospectus. This could be done through the Multi-Jurisdictional Disclosure System (“MJDS”) (see NI 71-101).
However, a “southbound” MJDS prospectus filing is only possible if the issuer is an “eligible issuer”, the conditions of which will certainly not be met by any modestly-sized blockchain company. (For example, an “eligible issuer” of “other securities” must already be a public company with a public float of at least $75 million USD – see the SEC’s Financial Reporting Manual, s.16150.2(b) and (d).)
On the basis of the above, an ICO / ITO in the present regulatory climate raises separate, simultaneous, and onerous obligations for a prospectus (or the equivalent) in multiple jurisdictions.
In other words, as the number of jurisdictions which can access the ICO / ITO increases, a multi-jurisdictional compliance campaign stands to become increasingly complicated and expensive.
These issues may be dealt with by limiting the jurisdictional scope of the ICO / ITO, and through prospectus exemptions.
II. Value of prospectus exemptions for token issues and resales
In the ICO / ITO context, an exemption from the prospectus requirement of applicable securities law is valuable for various reasons.
- the prospectus requirement is often prohibitively expensive and time consuming for a small business seeking to raise capital (consider NI 41-101, s.3.1; Form 41-101F1);
- once a prospectus is filed, the issuer becomes subject to continuous disclosure rules and ongoing reporting requirements (see, generally, the OSC’s guide on continuous disclosure); and
- a prospectus generally does not offer the benefit of assuring investors that the distributed tokens are legal. (See Form 41-101F1, s.1.1, which indicates that the prospectus cover page must state: “No securities regulatory authority has expressed an opinion about these securities and it is an offence to claim otherwise”.)
Unfortunately, there is no prospectus exemption available for a compliant securities distribution in every jurisdiction, globally. This would require a comprehensive multi-national treaty framework for ICOs / ITOs, which presently does not exist.*
At present, therefore, available prospectus exemptions must be researched and considered for every jurisdiction of an ICO / ITO compliance campaign.
For the Canadian portion of such a campaign, it is important to understand the Canadian exemptions because they can be used multiple times, alone or in combination.
This is valuable because, until the issuer meets the difficult test of becoming a “reporting issuer” (amidst other conditions), every security token resale will require another exemption.**
In the context of exemptions in Canada, and Ontario in particular, certain prospectus exemptions exist solely for Canadian-compliant distributions into foreign jurisdictions. Other exemptions exist for domestic distributions.
In other words, there are separate exemptions for security token distributions out of Canada and within Canada.
These two categories will be discussed in turn. They should be considered with any viable options for prospectus exemptions in other concerned jurisdictions.
III. Exemptions for distributions into foreign jurisdictions
Under the recent OSC Rule 72-503, the following two Ontario prospectus exemptions are potentially viable options for a token distribution into a foreign jurisdiction:
- foreign material compliance/exemption: this exemption requires that the issuer is non-reporting in Canada, and that the distribution is qualified in the foreign jurisdiction. This exemption has common resale restrictions. However, they may be possible to avoid—including the prospectus requirement—through another exemption that requires resale outside of Canada. (See Rule 72-503, ss.2.4 and 2.7-2.8; Companion Policy 72-503 and update of same re ss.2.7-2.8; and the corresponding NI 45-102, ss.2.14 and 2.15.)
- foreign qualified public offering: this exemption requires prior qualification for a public offering in one of the following jurisdictions: United States, United Kingdom, any EU member, Switzerland, Australia, New Zealand, Hong Kong, Japan, Singapore, South Africa, and Mexico. Upon request, the OSC will also consider granting an exemption for distributions qualified in other foreign jurisdictions. A distribution under this exemption is “free trading” for resale purposes, which means no additional exemption is needed for resale. (See OSC Rule 72-503, s.2.1 and Appendix A; Companion Policy 72-503, Appendix A and generally.)
These two exemptions arguably present a simplified procedure for a Canadian-compliant ICO / ITO, where tokens are distributed from Canada into another country.
However, there are important caveats to the above two exemptions in the context of an ICO / ITO. The above two exemptions:
- do not permit flow-back of the distributed securities into Canada. The reason stems from the exemptions’ limited purpose to facilitate distributions into foreign markets—not to facilitate resale in Canada. (See OSC Rule 72-503, ss.2.5-2.6 and 2.9; Companion Policy 72-503 and update of same re ss.2.7-2.8; and March 29, 2018 CSA Notice re NI 45-102);
- should not be considered a path to global compliance for an ICO / ITO. Even if the foreign jurisdiction has a streamlined procedure to distribute securities beyond its own borders, there will still need to be local compliance for the distribution in all jurisdictions where investors reside (see Companion Policy 45-106, s.1.3); and
- rely on good faith. The OSC reserves the right to assert its jurisdiction in the presence of conduct that brings Ontario’s capital markets into disrepute (see OSA, s.127(1) para. 3; Companion Policy 72-503). This means that the OSC retains discretion to restrict or halt a distribution, if it determines that the above two exemptions are being abused.
In brief, these exemptions simply streamline Canadian compliance for token distributions into foreign jurisdictions where compliance has already been achieved.
They can be combined with additional exemptions available for distributions in Canada, discussed next.
IV. Exemptions for distributions within Canada
The CSA previously indicated its anticipation that an ICO / ITO could proceed under either the “accredited investor” or “offering memorandum” exemptions (CSA Staff Notice 46-307).
These exemptions are among six that a small- or mid-sized blockchain company’s domestic token distribution could potentially proceed under, through Ontario.
The six exemptions in Ontario are discussed below:
a. Accredited investor
There is no investment limit under this exemption. The class of investors includes certain wealthy individuals, domestic financial institutions and foreign banks, securities advisors and dealers, governments, pension funds, and charities. For the full definition, see NI 45-106, s.1.1 “accredited investor”. (See also OSA, s.73.3; NI 45-106, s.2.3; Companion Policy 45-106, s.3.5.)
b. Offering memorandum
An offering memorandum is a simplified prospectus with strict disclosure and form requirements. It must be made available to investors, and truthfully state that it “does not contain a misrepresentation”. There are no investment limits for accredited investors or FFBA investors (discussed below). However, restrictions on investment amounts are in place for other investors, and depend on whether the investor is an individual, and whether the investor is an “eligible investor”. The threshold for an “eligible investor” is lower than for an accredited investor. This exemption is not available to an investment fund. (See NI 45-106, s.2.9; OSA, s.73.6(1).)
c. Private issuer
There is no investment limit under this exemption. There is also no exempt distribution report required, and no applicable OSC fee. However, the class of investor is restricted to FFBA (discussed below) and accredited investors. The corporation must also have a maximum of 50 non-employee and non-former-employee owners. Moreover, the corporation's securities (except for non-convertible debt) must be subject to restriction on transfer. Whether this restriction applies to security tokens in any given case merits further research. This exemption is not available to reporting issuers or investment funds. Finally, private issuer status can be lost, but can be regained in certain limited circumstances—for example, after a going private transaction. (See NI 45-106, s.2.4; OSA, s.73.4; Companion Policy 45-106, s.3.6(5).)
d. Friends, family and business associates (“FFBA”)
There is no investment limit under this exemption. Investors in this case must be principals of the business, or within the close personal networks of the principals of the business. The issuer should be careful not to solicit investment from an overly broad subscription base, in order not to trigger a presumption that this exemption is not available. (See NI 45-106, ss.2.5 and 2.6.1; OSA, s.73.6(1); Companion Policy 45-106, s.3.7(1).)
e. Minimum amount investment
There is no investment limit under this exemption. However, this exemption is not available to individuals (i.e. natural persons), and there is a minimum $150,000 investment requirement. (See NI 45-106, s.2.10; OSA, s.73.6(1), s.1(1) “individual”; Companion Policy 45-106, s.3.9(2).)
f. Employee, executive officer, director and consultant
There is no investment limit under this exemption. This exemption is available where the issuer or its control person distributes securities to an insider (including a consultant). The investor may also be a “permitted assign” of an insider. Moreover, this exemption applies to distributions between a current or former insider to a current insider. With some modification to the above, it is also possible to structure the distribution through a plan. However, care should be taken with respect to whether a “marketplace” or “alternative trading system” is being created, as briefly discussed in Part 5-IV. (See NI 45-106, ss.2.24 and 2.26-2.28; OSA, s.73.6(1); Companion Policy 45-106, s.4.1.)
The distribution period is capped at 90 days, and issuers can only raise up to $1.5 million in any 12-month period. This exemption is practically possible for token distributions only if the security token is convertible into a common or preference share, or if it is a “[promissory] note or similar instrument representing indebtedness”. It is only available to Canadian companies, or companies headquartered in Canada, or companies with a majority of directors resident in Canada. Funds must be raised through a single, registered funding portal. The issuer must pass the funding portal’s mandatory background checks. Although there is no investment limit for “permitted clients”, there is an investment limit for retail investors and accredited investors. (See MI 45-108; Companion Policy 45-108; OSA, ss.1(1) “debt security”, 73.6(1).)
Prospectus exemptions require planning and consideration of applicable requirements.
If your business aims to distribute tokens under a prospectus exemption, we invite you to consider our service offering for “ICOs / ITOs and digital asset dealing / advising”.
* The implications of such a global fundraising system are presently being researched by the International Organization of Securities Commissions, the EU Blockchain Observatory and Forum, and various other international institutions. (See the IOSCO fintech report (February 2017) at 64; EU Blockchain Observatory & Forum, “Blockchain innovation in Europe” [July 27, 2018] at 15-16).
We suspect that the OSC is also considering options for a multi-jurisdictional ICO / ITO, through its participation in the Global Finance Innovation Network (“GFIN”) (see August 7, 2018 OSC news release). However, at the time of writing, no concrete plans for such a regime have been released.
** Here’s why, legally speaking:
- a previously unissued security being traded is, by statute, a “distribution” of that security (OSA, s.1(1) “distribution” (a));
- a “distribution” normally requires a prospectus for the trade to take place (OSA, s.53(1)). However, the distribution can also take place under an exemption from the prospectus requirement (see above);
- the next trade in the issued security is again, by default, a “distribution” (OSA, s.1(1) “distribution” (f); NI 45-102, ss.2.5(1) and 2.6(1));
- this trade can be taken out of the “distribution” category if certain conditions are met, including the issuer being a “reporting issuer” (NI 45-102, ss.2.5(2) item 1, 2.6(3) item 1). This could most practically occur through: the submission of a prospectus, securities being traded on an OSC-recognized exchange, or a public interest OSC declaration (OSA, s.1(1) “reporting issuer”, 1(11)(b), 21(2));
- if the issuer is not a “reporting issuer”, the trade—as a “distribution”—again requires a prospectus unless another prospectus exemption is obtained (OSA, ss.53(1); Companion Policy 45-102, s.1.2(3)).
Without a prospectus, a small blockchain business is not expected to meet the definition of “reporting issuer” after its first market-exempt ICO / ITO tranche, and must therefore rely on another prospectus exemption for issuing additional tokens.
This is why it is important to know the available prospectus exemptions for the Canadian portion of an ICO / ITO compliance campaign.
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