Token Offerings: Caution and Advice from Securities Regulators

Companies contemplating a token offering should consider the guidance published by Canada's securities regulators on June 11. The guidance in Staff Notice 46-308¹ sets out factors to consider in determining whether securities laws may apply to a token offering. The regulators cautioned that they are actively monitoring token offerings to identify potential violations of securities laws. The bottom line: the staff notice leaves limited scope to structure a token distribution outside the securities regulatory framework. At the same time, the regulators are seeking to encourage innovation and they recognize that fintech businesses may not fit neatly into the existing securities law framework. As such, the regulators invite inquiries from businesses about using the Regulatory Sandbox²—an initiative launched in 2017 aimed at supporting fintech businesses in the interpretation and application of securities laws to innovative products and structures.

Token Offerings and Securities Laws

A fundamental question for businesses creating tokens—whether or not they have a viable utility function—is whether the transaction involves an investment in securities, with the key elements being an investment in an enterprise and an expectation of profit. Investments in securities trigger the application of securities laws. Investors must be given a prospectus containing full, true and plain disclosure about the business; alternatively, the distribution of the tokens must qualify for an exemption from the prospectus requirement. When structured as an exempt transaction, the tokens will generally not be freely transferable. In addition, persons involved in the business of trading securities—which encompasses a broad range of conduct facilitating an initial distribution or supporting an after-market for the tokens—may be subject to registration requirements under securities laws. To help ensure compliance with these and other securities law requirements, the staff notice encourages companies to consult with legal counsel before distributing tokens.

Assessing Whether a Token Offering Constitutes an Investment in Securities

Several factors are summarized in the staff notice to help businesses assess whether their tokens may be characterized as securities. It is important to note that no single factor or absence thereof will be determinative. Instead, the regulators believe tokens must be assessed in light of all the facts and circumstances, taking into account that one of the key objectives of securities law is to protect investors. Some of the factors highlighted in the staff notice are as follows:

• The tokens are expected to be publicly transferable in a secondary market, such as through trading on a cryptoasset trading platform. This indicates that purchasers may have an expectation of profit through resale, especially when such trading is featured prominently in the marketing of the offering. (It is not relevant that a company may not have control over whether its tokens trade on a secondary market, which is the case, for example, for companies using the ERC20 token standard.)
• The proposed function of the tokens is to use software or an online platform or application, or to purchase goods and services, but these options are not yet available or are still in development. This may indicate that tokens are not being purchased for their immediate utility but because of an expectation of future profit, with a commensurate risk of loss.
• The stated purpose of the token offering is to raise capital for business activities—such as expanding the team of developers, building an application, expanding the network of users, marketing, etc.—that will support the value of the tokens or the value of the business.
• The company has set up a "bounty" or similar program offering free tokens in exchange for promoting the offering on social media or via other channels of communication.
• Management personnel pre-mine or retain a significant number of tokens for themselves as a form of compensation, or management represents that it has specific skills or expertise that will likely increase the value of the tokens.
• Management suggests, or encourages others to suggest, the tokens may in future be used as currency; or may appreciate in value; or may have some utility beyond the company's business; or management compares the tokens to other cryptocurrencies that have increased in value.
• The number of tokens is finite or access to new tokens may be limited in the future, creating an expectation of profit due to potentially increased demand and limited supply.
• The purchase price of the tokens does not align with their practical utility, which suggests that purchasers are not buying a specific product but are investing in the token itself with a view to future profit.
• The token offering is marketed at purchasers who cannot actually use the product, e.g., Canadian purchasers are targeted but the product is currently available only to U.S. customers, suggesting that the offering to Canadian purchasers is an investment.
• Tokens are distributed for free as part of the sale of an ancillary product or service. Securities laws may require "looking through" the free distribution of tokens to the overall substance of the transaction as a possible investment in securities.
• Tokens are fungible or interchangeable with each other, without unique characteristics that are personal to the customer, suggesting they may have value through resale at a potential profit.

Multiple-Step Transactions

Businesses sometimes conduct token offerings in multiple steps. The first step involves a SAFT (Simple Agreement for Future Tokens) which is akin to a warrant and entitles the investor to a token to be delivered at a future date. The second step is the actual delivery of the token. The regulators stated in the notice that they will consider the factors described above in assessing the application of securities laws to both single-step and multiple-step transactions. The staff notice cautions businesses and their professional advisors that a multiple-step transaction should not be employed to avoid securities laws; the economic realities of a token offering must be assessed with a focus on substance over form.

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¹ See https://www.bcsc.bc.ca/Securities_Law/Policies/Policy4/PDF/46-308__CSA_Staff_Notice___June_11__2018/.

² See https://securities-administrators.ca/industry_resources.aspx?id=1588.