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James Atherton, a securities lawyer, having practiced at Gowlings and then Bull Housser before going in-house with a TSX-listed mining company where I was VP of Legal and Corp Sec.

This article contains notes from a speech that Mr. Atherton gave a few years ago.

Everything in the article is in short note format and is not written for grammar.

I am now the CEO and founder of Capiche, a web-based platform for streamlining and automating the private placement process.

In this presentation, a presentation I first gave in May of 2018 at Davidson and Company, I will set out the securities laws relevant to tokens and cryptocurrencies.

I will discuss how those laws apply in this area and actions that can be taken in order to ensure compliance.

Before getting to that, it is worthwhile to spend a few minutes providing context, including key definitions.

What is blockchain technology?

Blockchain technology is a decentralized digital ledger that encrypts and records transactions.

It works as blocks of data, to the chain of transaction/data blocks that came before it.

This is sent to computers around the world and once a block of data, is validated, it cannot be altered.

3 key characteristics:

Distributed: It works as a system of record that is shared among participants of the business network, eliminating the need to reconcile disparate ledgers.

Permissioned: Each member of the network has access rights so that confidential information is shared on a need-to-know basis.

Secured: Consensus is required from all network members and all validated transactions are permanently recorded. No one, not even a system administrator, can delete it.

What is Bitcoin?

Bitcoin was the original cryptocurrency and best first application of blockchain technology (2009).

What is Ethereum?

Ethereum is a blockchain-based computing platform and operating system that allows for the development and execution of smart contracts (code) on the blockchain, which can’t be altered, tempered, or hacked.

Ethereum’s Ether was the first major utility token (which also functions as a currency) and allows users to run smart contracts and code on the Ethereum Blockchain.

“Smart contracts” are not really contracts, and they are not particularly smart either but are just code – or computer logic – that can execute a contract or certain provisions of a contract.

Smart contracts have been likened to a digital vending machine that holds assets (ie, candy bars) that are dispensed once you’ve fulfilled the terms of the agreement (ie, inserted your money).

I note that Ethereum has emerged as the standard for creating tokens, especially security tokens, which we will come to later.

What is a coin or token?

Usage of “coin” and “token” overlaps considerably and though often used interchangeably.

Notionally, there are differences between a “coin” and a “token.”

Even the use of the term “cryptocurrency” is subject to debate. Often what people are referring to should more properly be called “crypto-tokens” or, the even more all-encompassing, “crypto-assets.”

What is an ICO or ITO?

An ICO or ITO is a new way for early-stage companies to attract investment in which the issuer creates and sells a coin or token.

The tokens sold in an ICO usually do not represent an ownership stake in the organization but are most often intended to represent the right to a certain value of the future products or services the issuer plans to develop.

The biggest ICO in 2017 was Filecoin, which raised $257m (~$6b total in 2017.)

Block.one is on track to raise $4b in its ICO (over $7b total to date in 2018.)

Block. one has been somewhat opaque about what it intends to do with the funds, particularly since it claims that it will not develop or maintain the EOS software it is creating following its initial release.

However, the company has indicated that $1b is earmarked for investment into companies that develop applications on its platform. What will happen with the other $3b plus is anyone’s guess.

For the purpose of this presentation, I have broken down crypto assets into three main categories:

1. Currency

2. Utility Tokens

3. Security Tokens

The first category of a crypto asset is currency.

Disruptive Technology Examples and Unique Currency – Bitcoin, Litecoin, Monero

Digital cash that acts as a store of value and a medium of exchange.

Like Canadian dollars or any other form of fiat, they are worth whatever people choose they are worth based on supply and demand, however, unlike fiat currencies, no government backs the currency.

Since Bitcoin, many other digital currencies have entered the market including Litecoin and Monero.

Currency coins are typical of a limited supply, which explains their rise in value as demand increases (and how they may act as a store of value.)

The second category of a crypto asset is Utility Token.

Utility Token – Ethereum, Filecoin, block.one, BlockCAT, Etherparty

Utility tokens do not have the traits of a classic cryptocurrency but serve as the in-platform tokens to purchase future access to products or services (and typically are not designed as investments.)

Filecoin is developing a platform to facilitate the sharing of computer storage.

Block.one is developing the EOSIO platform, which is expected to compete with Ethereum.

BC’s BlockCAT raised tens of millions of dollars ($20m plus?) in an ICO to develop a platform that lets anyone create, manage, and deploy smart contracts on the Ethereum Blockchain.

Disruptive Technology Examples

BC’s Etherparty raised tens of millions of dollars ($30m plus?) in an ICO and aims to build easy-to-use blockchain-based applications for the creation, use, and management of smart contracts.

In this presentation, where appropriate, I have chosen to make reference to BC or Canadian companies.

This was done to show we are a player in this space (and maybe also when you hear about them in the news, for better or worse, you will have heard of them.)

The 3rd category of crypto-asset Security (Equity) Token.

Security (Equity) Token – TokenFunder, Canamex, Kabuni

Like a traditional stock, a security (equity) token buys you into some level of ownership of an organization and its success and will almost always be a security under securities laws though it might also function as a utility token.

Ontario’s TokenFunder just closed its initial security token offering of FNDR tokens, which represent a dividend-like share of TokenFunder’s future profits.

BC’s Canamex Gold (CSE: CSQ) has launched a private placement of its gold-backed GOLDUSA security tokens, which are redeemable for physical gold.

BC’s Kabuni Technologies has announced that it intends to complete a prospectus offering of security tokens, which would then be traded on the Canadian Securities Exchange.

Kabuni supplement: “The CSE has indicated it will launch a platform for trading security tokens in 2019. BC’s Finhaven has also indicated it will be launching a securities exchange for trading security tokens.

So the three main categories of crypto-asset are:

1. Currency

2. Utility Token

3. Security Token

Some crypto assets falling outside these principal categories include:

4. Reward Points (Finhaven)

5. Tokens representing collectibles (Cryptokitties)

6. Asset Tokens represent other forms of property, like real estate

The starting point for assessing whether securities laws have any application turns on whether the coin/token is security – if not, securities laws have no application and the securities regulators have no jurisdiction.

What is a security?

The securities act (or equivalent) in each province/territory provides that “security” includes, among other things, all the things you would typically regard as a security such as a share (and many more) but also an “investment contract.”

Under case law (Pacific Coin), an investment contract exists when there is: an investment of money, in a common enterprise, with the expectation of profit, that comes significantly from the efforts of others (similar to the Howey test under US securities laws.)

Armed with the definition of security and test for investment contracts and now possessing an understanding of what an ICO is, you are now in a position to form an opinion on whether any particular coin/token is a security.

Again, typically, in an ICO, coins/tokens are issued for money. The company then uses that money to develop software. The value of that coin/token depends on the company actually developing the software.

It also depends on how good a job the company did and whether the software meets a particular market needs to be determined by the company.

This pretty clearly meets the test of the investment contract under Pacific Coin and Howey.

Assuming securities laws have an application, there are 4 key requirements that need to be considered:

1. the prospectus requirement

2. the registration requirement

3. resale restrictions

4. requirement to be recognized as an exchange

The first key requirement under securities laws is the prospectus requirement

Prospectus Requirement

“prospectus requirement” has the meaning ascribed to that term in National Instrument 14-101 Definitions and, without limiting the foregoing.

For reference, it means the requirement in securities legislation that prohibits a person or company from distributing a security unless a preliminary prospectus and prospectus for the security have been filed and the regulator has issued receipts for them.

Even in traditional capital markets, securities are not typically issued pursuant to a prospectus but pursuant to one or more exemptions from the prospectus requirement.

The bulk of this exemption is in National Instrument 45-106 Prospectus Exemptions.

The second key requirement under securities laws is the registration requirement.

Registration Requirement

“Registration requirement” is defined in National Instrument 14-101 Definitions. It includes the requirement in securities legislation that prohibits a person or company from acting as a dealer.

This is true unless that person or company is registered in the appropriate category of registration under securities legislation unless a registration exemption is available.

National Instrument 31-103 Registration Requirement and its companion policy govern registration. Generally, if you are in the business of trading or advising in securities, you are going to need to be registered under securities laws.

There are some exceptions to this, including:

1. the issuer has an underlying non-securities-related business

2. venture capital

3. the activities are incidental to your main line of work (e.g. lawyers, accountants)

I note that the CSA, the umbrella organization of our provincial/territorial securities regulators, has set up the CSA Regulatory Sandbox to assist fintech companies.

Come in the front door and get comfortable with the application of securities laws to their business models.

The third key obligation under securities laws is in compliance with resale restrictions.

Resale Restrictions

National Instrument 45-102 Resale of Securities imposes an indefinite hold period on securities issued by non-reporting issuers.

Also, a restricted period of four months on securities issued by reporting issuers in a private placement. This is true unless a resale exemption may be relied upon to sell these securities.

This is a significant requirement and should be as big a “show stopper” as the prospectus requirement should be for most ICOs. Without the ability for secondary trading, the appetite for most tokens would evaporate.

I strongly suspect that no one is buying tokens in an ICO with a view to holding that token for years while the company that issued it actually develops the software they promised at the outset.

This is assuming it gets built at all. Then spending that token to gain access to whatever product or service the software provides.

“Investments” in coins/tokens are all about speculation and the sooner it trades and the more places it trades, the better. FOMO is driving this market.

The fourth and final key requirement under securities laws that I will talk about is for facilities acting as a marketplace and trading securities to apply and be recognized as an exchange or alternative trading system.

As mentioned, the CSE and Finhaven are looking to do just that.

Securities Exchange Recognition/Compliance

National Instrument 21-101 Marketplace Operation and National Instrument 23-101.

Trading Rules regulate securities “marketplaces” and require recognition as an exchange or alternative trading system by the relevant securities regulatory authority or an exemption from recognition.

They must be in compliance with the rules governing exchanges or alternative trading systems.

In summary, the four key areas requiring compliance are:

1. the prospectus requirement

2. the registration requirement

3. resale restrictions

4. recognition as a securities exchange

Understanding the test for whether something is a security, and the key requirements of securities laws for ICOs issuing securities, we are now in a position to assess the application of that test and those requirements.

Again, the starting point is to determine whether the crypto asset in question is a security.

Disruptive Technology Examples

Are companies completing ICOs/ITO’s distributing securities?

“by and large, the structures of ICOs that I have seen involve the offer and sale of securities” and “[m]erely calling a token a ‘utility token or structuring it to provide some utility does not prevent the token from being a security.” – Jay Clayton, SEC Chairman

In fact, in February 2018, Clayton testified before the U.S. Senate Banking Committee that: “I believe every ICO I’ve seen is a security.”

This is similar in Canada, although there have not been similar express statements like these.

It doesn’t stop companies from believing their token is merely a utility token and not a security, however.

Once the crypto asset has been determined to be a security for purposes of security law, we then assess which of the four key requirements under securities law have an application.

Here is the first couple.

Are such companies subject to the prospectus requirement?

If a security, yes.

Are such companies subject to the registration requirement?

If a security and in the business of trading, yes.

WRT to the registration requirement, if that company has nothing but an idea it would like to develop, it’s an open question as to whether it has an underlying non-securities-related business.

The third key requirement under securities laws is resale restrictions for securities issued under an exemption from the prospectus requirement.

Are these coins/tokens subject to restrictions on transfer?

If a security and if distributed pursuant to an exemption then yes, an indefinite hold period on securities issued by non-reporting issuers and a restricted period of four months on securities issued by reporting issuers in a private placement.

This is unless a resale exemption may be relied upon to sell these securities.

The fourth and last key requirement under securities laws I’ll mention is that platforms trading securities be recognized as an exchange or alternative trading system kicks in.

Do exchanges trading these coins/tokens need to be recognized as securities exchanges and comply with applicable requirements?

If a security, yes, and the Ontario Securities Commission recently indicated that they “are aware of several cryptocurrency trading platforms operating in Ontario and are gathering information about their activities.

To date, none have been recognized as an exchange, or exempted from recognition.”

With an understanding of how the key requirements under securities law apply, we can turn our attention to actions that can be taken to ensure compliance with them.

Disruptive Technology Examples

True currencies, such as Bitcoin, are likely not securities.

You can take steps so that your token is not deemed to be security – pretty tough unless it’s purely a currency and fewer companies now are even making this claim, at least to North American regulators.

Alternatively, you can set up operations elsewhere and don’t offer in Canada or the US.

Move to Switzerland, Gibraltar or Liechtenstein where the regimes are more accommodating. On the opposite extreme, ICOs have been banned outright in China and South Korea.

BC’s Dot Media Inc. moved its RightMesh project to Switzerland. They are now finally completing their token-generating event (read ICO/ITO.)

This all happened after having been delayed while BCSC investigated their links to BC.

Thirdly, you can see if the SAFT model will work. This is related to the first tactic of trying to get the token to fall outside the test for being a security.

Simple Agreement for Future Tokens (SAFT) Model

Under the SAFT model, investors receive the right to receive functional utility tokens.

This happens once the company has developed the platform that consumes the tokens in an attempt to mitigate the risk of utility tokens being deemed securities.

Disruptive technology examples include Filecoin.

Filecoin incorporated the SAFT model into its ICO process in raising over $257m last year.

The effectiveness of the SAFT model for its intended purpose has been called into question.

Fourthly, you can try to convince the regulators to give you an order exempting you from certain of the requirements under securities laws.

Obtain an order from the securities regulatory authorities for exemptions from certain requirements.

Disruptive Technology Examples

Quebec’s Impak Finance received exemptive relief orders from Quebec’s Autorité des marchés financiers (AMF), as the principal regulator. It also received the same from the Ontario Securities Commission.

This was for the registration requirement and prospectus requirement with respect to their offering of Impak Coins.

Ontario’s Tokenfunder received an exemption relief order from the Ontario Securities Commission for the registration requirement for its smart token asset management platform.

This was intended to, among other things, facilitate third-party issuers raising capital through the offering of tokens and coins.

These are usually time-limited and the exemption, if granted, is often very narrow.

It gives the regulators the opportunity to “horse trade” and get the issuer to satisfy additional requirements that it would not have otherwise had to satisfy if they had just followed existing law – be careful here.

Disruptive Technology Examples

And now, in 2018, we are seeing a greater appreciation that most coins/tokens are securities, that securities laws have application and that compliance with those laws may be the best way to move forward.

Distribute tokens under an exemption from the prospectus requirement, avoid the requirement to register, restrict trading and allow to trade only on a recognized securities exchange.

Capiche ensures offerings of securities are completed pursuant to applicable exemptions from the prospectus requirement.

Exempt market offerings of securities are what we have created with the Capiche platform.

In the future, we will accommodate security tokens but our current focus is on TSXV and CSE issuers completing private placements of traditional securities.

In a nutshell, Capiche takes the relevant corporate details and offers terms.

It then automatically prepares all documentation. It also acts as a platform for pushing out and managing subscriptions electronically through to closing. All of this is done while ensuring compliance.

So, hopefully, you now have a better appreciation for relevant securities laws, how they apply and what can be done to comply.

I’d like to finish off my presentation with a few thoughts. I want to talk about where things are going with blockchain technology and tokens in the area of capital markets.

The rights attached to a share typically include the right to attend and vote at general meetings.

It also includes the right to participate in the distribution of assets on the dissolution of the company. And finally, the right to receive dividends, if and when declared.

These rights can all be programmed into a smart security token.

Smart security tokens and blockchain platforms can be designed and programmed to comply with resale restrictions.

Disruptive Technology Examples

Electronically connecting issuers with not only subscribers but with all others involved in the process is important. This includes transfer agents, SEDAR, SEDI, and news wire dissemination services.

It also includes legal counsel, auditors, investment dealers, stock exchanges, and securities commissions.)

It has the potential to add momentous efficiencies to the capital markets.

Would you like to know more about Capiche? How about how you can complete your next private placement quicker, cheaper and in a more compliant manner? Then please reach out to me or go to our website where you can arrange a demo.

If you are looking for other disruptive technology examples, reach out to ClearWay Law to talk about innovation.

Make sure you hire a security lawyer when dealing with raising money. You don’t have to spend much money. It will save you a lot of stress and money in the long term. Spend $2000 now, and save $200,000 later.

The speech was given by: James Atherton, LLB, CEO of Capiche Capital Technologies Corporation

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