A great deal has been written recently about the possible regulatory uncertainty surrounding Initial Coin Offerings (ICOs) in Canada. In an ICO, a newly issued cryptocurrency is sold to purchasers, who acquire a right of ownership symbolized by a “coin” or token, which may appreciate in value. Depending upon the characteristics of the ownership interest that is acquired, the “coin” may constitute a security. Once issued, the way a coin may be traded is a product of its design; some coins may be freely traded on exchanges as if they were traditional securities, while others may only be traded within specific markets at established prices.
ICOs may provide a legitimate, cost-effective source of capital for start-up enterprises with significant potential upside for investors. Alternatively, they may also be a vehicle for fraud.
As bodies like the Ontario Securities Commission (OSC) and the Canadian Securities Administrators have made clear, ICOs may involve the sale of securities and could be subject to securities laws. There is a risk that an ICO could be perceived by securities regulators as improperly sidestepping securities law requirements for raising capital.
This resource addresses some of the possible regulatory and civil consequences that an issuer may encounter if it proceeds with an ICO in Ontario without either complying with securities laws or securing an exemption, in circumstances where it is arguable that the offering is a security. As set out below, failure to comply with applicable securities laws may, at minimum, defeat any economic benefit an issuer might enjoy from the offering and result in costly litigation.
Possible regulatory compliance issues
In Ontario, the distribution of coins or tokens considered to be securities requires that a prospectus be filed with the OSC and a final receipt be obtained unless an exemption from the prospectus requirement is available under the legislation, or an order exempting the offering from the need to qualify a prospectus is obtained. The sale of the coins or tokens may also require registration as a dealer or the availability of an exemption from registration.
If a coin issuance is determined by regulators to constitute the distribution of a security, regulatory compliance does not end with the filing of a prospectus and meeting other requirements at the time of issuance. Going forward, the coins will be subject to the comprehensive securities regulation regime, as set out in Ontario’s Securities Act and the various national and multilateral instruments that govern the trading of securities in the province, including continuous disclosure obligations, and prohibitions on insider trading and tipping. It may also expose the issuer to potential civil and regulatory liability for misrepresentations made in connection with or after the ICO.
Consequences of failure to comply with regulatory requirements
The Securities Act grants the OSC broad remedial powers to address non-compliance with securities laws and regulations, including breach of the requirement in s. 53 of the Act to obtain a prospectus for a distribution of securities, and the need to be registered under s. 25 in order to trade securities. These remedial powers include the following.
Orders in the public interest
Section 127 of the Securities Act gives the OSC jurisdiction to make a wide range of orders if in its opinion it is in the public interest to do so. The courts have recognized that the Commission has jurisdiction to make an order under s. 127 even in the absence of a breach of securities law where the conduct is abusive of the capital markets.
The Supreme Court of Canada has described the purpose of the OSC’s public interest jurisdiction as “neither remedial nor punitive; it is protective and preventative, intended to be exercised to prevent likely future harm to Ontario’s capital markets.” Orders made under section 127 are designed in part to act as a deterrent:
It may well be that the regulation of market behaviour only works effectively when securities commissions impose ex post sanctions that deter forward-looking market participants from engaging in similar wrongdoing. That is a matter that falls squarely within the expertise of securities commissions, which have a special responsibility in protecting the public from being defrauded and preserving confidence in our capital markets.
The range of sanctions that can be ordered under section 127 include:
- an order temporarily or permanently suspending or restricting registration of a person or company.
- a temporary or permanent order that trading in any securities of or by a person or company cease.
- The making of a temporary cease trade order against an issuer shutting down all trades in its securities can have potentially devastating effects, both for it and for other innocent holders of its securities.
- The result in Borealis International Inc. (Re), provides a good example. In November 2007, as a result of Commission staff’s allegations that Borealis Guaranteed Return Investment Certificates (GRICs) were securities that were being sold in breach of the prospectus and registration requirements In Ontario securities law, the OSC made a temporary cease trade order, halting all trading in the Certificates and all trading in securities by certain respondents, and requiring one of the respondents to submit to monthly supervision and reporting requirements. Ultimately that order remained in effect until the conclusion of the hearing on the merits and sanctions hearing, almost 4 years later, in early 2011.
- At that time, the OSC determined that the GRICs were securities that had been distributed in breach of sections 25 and 53 of the Securities Act, and that certain of the officers and directors of Borealis had participated in those breaches and acted fraudulently. Borealis was prohibited from trading securities for a period of 5 years and lost its exemptions under securities law for the same period. Notwithstanding that prior to the hearing investors in the GRICs had been made whole, three of the officers or directors of Borealis were permanently prohibited from trading or acquiring securities, required to resign positions that they held as directors or officers of any issuer, and, in addition to other sanctions, ordered to pay administrative fines of $550,000 each, plus costs. Other individual respondents were subject to temporary bans on trading in securities and/or lesser administrative penalties.
- an order that acquisition of securities by a person or company is prohibited, either temporarily or permanently.
- an order that exemptions available under securities law do not apply to a person or company.
- an order that a market participant submit to a review of its practices and procedures and institute changes as required by the OSC.
- where the OSC is satisfied that Ontario securities law has not been complied with, an order that a document required by securities law be amended or provided. For example, if a party issuing a security has failed to provide a prospectus to a person or company, the OSC may order it to do so.
- To require an entity fundraising through an ICO to provide a prospectus may be perceived by it as negating the efficiencies of undertaking an ICO, rather than an initial public offering of securities (an IPO).
- administrative penalties of up to $1 million for each breach of securities law.
- an order disgorging any amounts obtained by non-compliance with securities laws.
Failure to heed a suggestion by Staff of the regulator that the investment product that is being sold is likely a security will be an aggravating factor when it comes to the imposition of sanctions under s. 127.
Accordingly, enterprises that engage with the OSC’s Regulatory Sandbox for assistance in navigating issues such as the need to qualify a prospectus should proceed with caution.
Applications to court for declarations of non-compliance
In addition to the broad discretion conferred by s. 127, pursuant to s. 128 of the Act, the OSC can apply to the Superior Court for a declaration that a person or company has not complied with or is not complying with securities laws. The OSC is not required to hold its own hearing on the merits before proceeding with a s. 128 application.
If the Court agrees that securities laws have been breached, the Securities Act confers on the Court extensive powers to craft orders even broader than those available to the Commission under s. 127. This includes ordering rescission of transactions or requiring the issuance, cancellation, purchase, exchange or disposition of securities; prohibitions on voting of securities; and awards of restitution or general or punitive damages, among other things.
Accordingly, the OSC could resort to s. 128 to obtain an order that would have the effect of requiring that the issuance of coins to purchasers in an ICO be rescinded and the subscription funds be repaid to investors.
Section 122 Prosecutions
The Commission also has the ability to lay charges in the Ontario Court of Justice in respect of any breach of Ontario securities law. Section 122 makes it an offence punishable by up to a fine of not more than $5 million per breach and/or imprisonment of not more than 5 years less a day to contravene Ontario securities law.
The Commission typically resorts to laying charges under s. 122 where the conduct involves dishonesty. This has included situations involving the illegal distribution of securities, contrary to s. 53 of the Act.
Section 126(1) of the Securities Act grants the OSC broad discretion to issue freeze directions ex parte, without notice to or submissions from the affected party, requiring that a person or company retain “on deposit or under its control or for safekeeping”, or refrain from withdrawing, any funds, securities or property. The OSC may make a freeze direction where it considers it expedient to do so, for the due administration of Ontario securities law or the regulation of the capital markets in Ontario.
A direction may issue at any stage of an investigation or enforcement proceeding, even prior to the issuance of a Notice of Hearing or after a hearing on the merits. It is a protective measure used to prevent parties from distributing, withdrawing, transferring, dissipating or otherwise dealing with or diminishing the value of the funds, securities or property. Its primary purpose is to preserve assets for potential recovery by investors.
The direction continues to operate until revoked by the OSC, or the Ontario Superior Court of Justice orders otherwise. As soon as practicable but no later than 10 days of the making of the direction, the Commission must apply to the Superior Court for an order to continue the direction.
In Ontario (Securities Commission) v. Future Solar Developments Inc., Justice Pattillo determined that in order to persuade the court to make an order continuing a freeze direction, the Commission must establish that:
- there is a serious issue to be tried in respect of the respondent’s alleged breaches of securities laws;
- there is a basis to suspect, suggest or prove a connection between the frozen assets and the conduct at issue; and
- the freeze order is necessary for the due administration of securities laws or the regulation of capital markets, in Ontario or elsewhere.
Accordingly, in circumstances where there is a serious issue concerning whether an ICO constitutes an illegal distribution of securities contrary to s. 53 of the Act, it is possible that the OSC could make a freeze direction over the proceeds of the offering, particularly if it is concerned that the funds could be dissipated or transferred out of the jurisdiction. In addition, as the power to make a freeze direction also extends to securities, a freeze direction could extend to the tokens or coins issued pursuant to the ICO.
Liability of Directors and Officers
Directors and officers of a company pursuing an ICO in circumstances where it is arguable that it amounts to a distribution of securities without complying with securities law requirements should not assume that enforcement activity will be restricted to the corporate entity.
By virtue of s. 129.2 of the Securities Act, directors and officers of a company that has not complied with Ontario securities law who authorized, permitted or acquiesced in the non-compliance shall be deemed to have not complied with securities law. The threshold for a finding of liability against a director or officer under section 129.2 of the Securities Act has been described by the OSC as “low”.
Further, in a prosecution under section 122 of the Act, directors and officers of a company that has breached securities laws face the same potential penalties as the company.
Civil consequences of non-compliance
ICO issuers also face the threat of potential civil action, including a class action, in respect of coin offerings that constitute the distribution of a security.
Coin/token purchasers in an ICO who lose money may resort to the courts to seek compensation for their losses.
While the statutory cause of action for misrepresentation in a prospectus or offering memorandum in section 130 of the Securities Act would not be available, a common law claim for negligent misrepresentation may be available where the legal nature of the coin offering was mischaracterized in information available to investors.
As well, attempts could be made to assert a statutory cause of action under Part XXIII.1 of the Securities Act for misrepresentations made after the offering. Under the cause of action in section 138.3 Securities Act, a “responsible issuer” may be found liable to a person who acquired or disposed of the issuer’s securities following a misrepresentation in any communication the content of which would reasonably be expected to affect the market price or value of the security. A “responsible issuer” includes any issuer with a real and substantial connection to Ontario, any securities of which are “publicly traded”. This cause of action does not require evidence that the investor relied upon the misrepresentation, and thus is frequently asserted in investor class actions.
While blockchain technology should significantly diminish the risk of major cybersecurity issues, the possibility of a hack has not been eliminated. ICO issuers, as entities amassing both funds in exchange from the sale of coins and some personal information from coin purchasers (for example, where coins are purchased using credit cards or Paypal accounts), may be possible targets for cybersecurity attacks, with the risk of civil liability flowing from any potential breaches that affect purchasers.
Technological challenges For Regulators
Just as blockchain innovations present opportunities for firms to raise capital and do business in new ways, it may create new challenges for regulators seeking to protect the capital markets.
At a minimum, investigators, prosecutors and Commission members will need to develop some basic familiarity with coding, blockchain, and cryptocurrency.
Ontario’s regulators will also need to consider how current legislative provisions address these technological developments, and what changes may be required in order to ensure that enforcement tools like freeze directions and cease trade orders cannot be circumvented in the digital world. Query, for example, whether it may be desirable to amend the legislation to require parties subject to an enforcement order to code such orders into a blockchain to ensure dissemination to those directly affected.
Other jurisdictions have already recognized the need to adapt to these changes. For example, Delaware has created a Blockchain Initiative in order to “provide an enabling regulatory and legal environment for the development of blockchain technology. On August 1, 2017, amendments to Delaware’s General Corporation law came into effect that expressly permit Delaware corporations to use distributed ledgers or blockchain technology for the creation and maintenance of corporate records, including the company’s stock ledger.
Finally, it is almost a certainty that international cooperation among regulators will become even more important in combating the potential use of ICOs to commit fraud.
Conclusion – offer at your own risk!
The list of possible legal proceedings and regulatory and civil consequences described above is not exhaustive, but may provide issuers contemplating an ICO a useful framework for the types of risks that failing to comply with securities law entails. Presumably not all ICOs will be considered by regulators to be sales of securities. However, companies considering raising capital through an ICO should be alert to the potential consequences of non-compliance that may undo the efficiencies enabled by technology.
 For example, Impak Finance Inc. was recently granted an exemption by the OSC and the Autorité des marches financiers from prospectus filing requirements in respect of its ICO of its MPK coin. That exemption was sought and obtained following Impak’s participation in the CSA Sandbox programme.
 Re Canadian Tire Corp (1987), 10 OSCB 857;  O.J. No. 221 (Div. Ct.)
 Committee for the Equal Treatment of Asbestos Minority Shareholders v Ontario (Securities Commission),  2 SCR 132,  SCJ No 38, 2001 SCC 37 at para 42.
 Cartaway Resources Corp. (Re),  1 SCR 672,  SCJ No 22, 2004 SCC 26 at para 62.
 2007 LNONOSC 866.
 2011 LNONOSC 344.
 Furtak (Re), 2017 LNONOSC 241 at para 63.
 See, for example, Maitland Capital Ltd. (Re), 2012 LNONOSC 95; or Zeitsoff (Re), 2014 LNONOSC 11.
 2015 ONSC 2334.
 Future Solar Developments Inc. at para 31.
 Rezwealth Financial Services Inc. (Re), 2013 LNONOSC 567 at para 272.
 PlexCoin’s recent ICO will be an interesting case study on the efficacy of current enforcement tools. On July 20, 2017, the Autorité des marches financiers (AMF) issued ex parte orders barring PlexCorps, a company promoting the pre-sale of an ICO for a cryptocurrency called PlexCoin, along with other companies and individuals from engaging in activities for the purpose of directly or indirectly trading in any form of investment described in section 1 of Quebec’s Securities Act, including soliciting investors inside and outside Quebec. The AMF also ordered those parties to withdraw all advertisements or solicitations, online or otherwise, for PlexCoin. On August 3, 2017, the AMF issued a press release observing that the respondents had apparently failed to comply with the AMF’s July 20, 2017 orders, and strongly cautioned investors of the major risks that could stem from responding to PlexCoin’s invitation to invest. Media outlets later reported that on August 10, 2017, the AMF conducted a raid of the Quebec City offices of one of the individual respondents. As of the date of writing, PlexCoin’s website appears to be up and running and continuing to solicit pre-sale investment.