Securities Registration Requirements for Blockchain Businesses

Securities Registration Requirements for Blockchain Businesses

Part 5 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.

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I. Registration required upon “business trigger”

In Ontario, for blockchain companies engaged in the business of security tokens, registration is required for persons and companies acting in various capacities.

This is known as the “business trigger”.

The registration categories include “dealer” and “adviser” (see OSA, s.25(1) and (3); NI 31-103, ss.2.1(3), 7.1(4), 7.2(3)).

Other registration categories, such as underwriters, investment fund managers, ultimate designated person, and chief compliance officer also exist (OSA, ss.25(2) and (4)-(6)), but are not discussed in this article.

It is important to note at the outset that registration carries obligations regarding compliance, books and records, solvency, insurance, audits, financial reporting, KYC, conflicts, complaints, cybersecurity policies/procedures, etc. (see NI 31-103, Parts 11-14; CSA Staff Notice 46-307).

It may therefore be an advantage for a start-up blockchain business to ensure, as long as possible, that its operations do not invoke the “business trigger”.

Numerous factors must be considered to determine whether the “business trigger” is invoked (see Companion Policy 31-103, s.1.3).

With respect to an ICO / ITO involving a securities distribution, such activity has a high probability of invoking the “business trigger”. This conclusion follows from marketing efforts involving advertisements through a website or public events, and the intent to raise “a significant amount of capital from a large number of investors”. (See Companion Policy 45-106, s.1.6 and CSA Staff Notice 46-307.)

Moreover, an employee primarily tasked with active solicitation of the public to sell security tokens also engages the “business trigger” (Companion Policy 45-106, s.3.2).

The business trigger is generally not invoked by issuers who infrequently sell their securities, and whose officers, directors and employees only solicit investors incidentally to their primary role (see NI 31-103, s.1.2 “Business trigger examples” “(a) Securities issuers”).

II. Dealer registration

Within the “dealer” category of registration in Ontario, a blockchain businesses could fall into “investment dealer” and “exempt market dealer” categories.

It could potentially also fall into “mutual fund dealer” or “restricted dealer”.

We anticipate that the CSA will create an additional category of dealer—specific to blockchain businesses—within the next few years. (See OSA, s.26(2) para 1.)

In the context of an ICO / ITO (i.e. a “distribution”), a dealer must provide the purchaser with a prospectus if there is no prospectus exemption (OSA, s.71(1)).

If there is a prospectus exemption, registration is required as an “exempt market dealer” (see OSA, s.26(2) para. 1(iv); NI 31-103, s.7.1(1)(d)).

Registration as an “investment dealer” will also require registration with the Investment Industry Regulatory Organization of Canada (“IIROC”) (see NI 31-103, s.9.1; NI 21-101, s.6.1(b)).

Exempt market dealers that facilitate token trades are probably also required to register with IIROC (see CSA Staff Notice 31-333).

In the present regulatory climate, it would appear that cryptocurrency exchanges should not be registered under the “exempt market dealer” category.

This is because “exempt market dealers” cannot facilitate the trading of securities on a public market, because such trades occur outside the exempt market (see NI 31-103, s.7.1(2)(d)(ii)(C); Companion Policy 31-103, s.7.1 “Exempt market dealer”).

Instead, cryptocurrency exchanges should generally register as an “investment dealer” to act with respect to “any security” (see NI 31-103, s.7.1(2)(a)).

This view assumes that most cryptocurrency exchanges dealing in securities are probably a:

1. “marketplace” (OSA, s.1(1) “marketplace”; NI 21-101, ss.1.2); and/or
   

2. “alternative trading system” (OSA, ss.1(1) “alternative trading system”, 21.0.1, and 143(1) para. 12; NI 21-101, ss.1.1(b), 6.1).

Support for this view has been provided by the CSA (CSA Staff Notice 46-307), and has been endorsed by the SEC (SEC statement dated March 7, 2018).

On the basis of the foregoing, dealer exemptions should be explored inclusive of the following:

• general exemption (OSA, s.74(1) item 1);
  

• “distributions into foreign jurisdictions” (OSC Rule 72-503, ss.3.1 and 3.2);
  

• “international dealer” (OSA, s.35.2; NI 31-103, s.8.18); and
  

• other enumerated exemptions (NI 31-103, Part 8, Div 1; Companion Policy 31-103, Part 8).

III. Advisor registration

Blockchain companies should also consider whether consultants on their team invoke the “business trigger” for an advisor, through the provision of “specific advice” (OSA, s.34(1) para. 1; NI 31-103, s.8.25(5); Companion Policy 31-103, s.7.2).

Certain professionals, including accountants and lawyers, do not invoke the business trigger (see NI 31-103, s.1.2 “Business trigger examples” “(d) Incidental activities”).

However, many other advisers do.

If the “business trigger” is invoked, the following exemptions should be considered:

• general exemption (OSA, s.74(1) item 1);
  

• “international advisor” or “international sub-advisor” (NI 31-103, ss.8.26 and 8.26.1); and
  

• other enumerated exemptions (see NI 31-103, Part 8, Div 2).

Note that a disclaimer that the purported adviser is not “advising” will not, on its own, be legally effective to avoid the registration requirement (see D. Johnston et. al., Canadian Securities Regulation, 5th ed. [Markham, Ontario: LexisNexis, 2014] at ¶13.11).

IV. “Exchange” application

Both the CSA and SEC have indicated that, in the name of a blockchain business, use of the term “exchange” often misrepresents compliance with securities regulations. (See OSA, ss.1(1) “recognized exchange”, 21(1); NI 21-101, ss.1.1 “recognized exchange”, 5.4(a); CSA Staff Notice 46-307 at fn3; SEC statement dated March 7, 2018.)

In fact, cryptocurrency exchanges should apply for permission to operate as an “exchange”, even if this term does not appear in the business name (OSA, s.21(1)).

In its application to become an exchange, the business should be able to demonstrate:

• registration as a dealer (NI 21-101, s.6.1(a));
  

• compliance with applicable trading rules (NI 21-101, s.6.1(c));
  

• tailored platform rules/policies and appropriate sanctions for violations (NI 21-101, ss.5.4-5.5); and
  

• registration with IIROC (see CSA Staff Notice 31-333; NI 21-101, s.6.1(b)).

IIROC rules are not considered in this article.

V. Conclusion

Registration should occur with the assistance of legal counsel to minimize the risk of non-compliant operations.

Further to this end, we invite you to consider our service offering for “ICOs / ITOs and digital asset dealing / advising”.

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