When it comes to blockchain, the Canadian securities regulators aren’t sticking their heads in the sand. Except, that is, when playing in their sandbox.
The Ontario Securities Commission (OSC) created its sandbox, called LaunchPad, to encourage fintech companies to come to the OSC early with their innovations rather than build them in the shadows. The sandbox is about dealing with grey areas, which seems to be the de facto zip code of many startups these days.
And when it comes to grey zones, there’s at least 50 shades when dealing with blockchain.
So, in the hope of technicolour progress – and a little less grey in our lives – we welcome the latest OSC sandbox decision. On October 17, 2017, the OSC provided a blueprint for Token Funder Inc. on how to undertake its initial coin offering (ICO). It’s the first regulatory decision relating to an ICO to come out in Ontario. Let’s take a look at it.
Background about Token Funder:
Token Funder, an Ontario company headquartered in Toronto, wants to build a platform to:
- facilitate ICOs for third-party issuers (so, an online crowdfunding platform for token offerings);
- provide token and coin management and governance services for these token issuers (so, they’re anticipating that there will eventually be regulations governing how issuers must conduct ICOs and manage their investors, which means token issuers will need platforms like Token Funder to help support them); and
- provide for certain transferability of tokens and coins (so, a “token exchange-lite” that will address securities law requirements, such as transfer restrictions on private placement securities).
Token Funder also wants to create 1 billion of its own digital tokens through a smart contract on the Ethereum Blockchain (“FNDR Tokens”). Of the 1 billion FNDR Tokens, 200 million FNDR Tokens will be sold under Token Funder’s ICO for $10 million gross proceeds (in order to fund the build-out of if its platform), 100 million FNDR Tokens will be held back by Token Funder as payment currency for advisors and service providers, and the remaining 700 million FNDR Tokens will be held back by Token Funder for future financings.
The OSC’s Decision on Token Funder:
Token Funder came to the OSC under the Launchpad sandbox to present and analyze its business model. What resulted is the OSC’s Decision, a blueprint as to how Token Funder should structure and run its ICO, plus some foreshadowing of additional regulation to come.
Here’s how Token Funder will run its $10 million ICO:
- Treat this offering like a private placement. Token Funder must run its ICO like a private placement of securities, which means ensuring that a prospectus exemption is available. In this case, Token Funder intends to use the offering memorandum exemption, which involves a very detailed ‘white paper’ that must follow a required statutory form. Token Funder will only be able to raise a maximum of $2,500 per investor under this exemption, unless an investor is verified as “accredited”. The investment is to be made through a digital smart contract established by Token Funder using the Ethereum Blockchain, and the investor can subscribe by the payment of Ether or Canadian dollars.
- Verification of investors. Token Funder must conduct a know-your-client and suitability review for each investor in the ICO. This means a thorough onboarding, information collection and verification process, including conducting a survey to ensure that the investor has a detailed understanding of how blockchain-based tokens or coins works.
- Reporting to investors. After closing of the ICO, the Management of Token Funder must provide holders of FNDR Tokens updates regarding the milestones for development of the platform, other material events concerning the business, and annual audited financial statements.
- Limited voting rights. Holders of FNDR Tokens will not have any voting rights in respect of Token Funder’s governance or operational matters; however, holders of FNDR Tokens will have certain voting rights on the entities entitled to use the platform.
- Additional registration requirements. Once the ICO is completed, Token Funder must use the proceeds to fund the build-out and launch of the platform AND concurrently seek to become some sort of “dealer registrant” under securities laws (think licensed banker, stock broker or crowdfunding portal).
- No listing on an exchange (yet). The FNDR Tokens issued in the ICO will not be listed and traded on any exchange, cryptocurrency exchange or organized market unless such listing and trading is done in accordance with applicable securities laws and approved in advance by the OSC.
- The Decision represents a first step to a fully-licensed ICO crowdfunding and exchange platform. The Decision and the completion of the ICO are just the first step. The next step – and the real challenge – is for the OSC and Token Funder to design the rules and requirements around building and running its platform (to facilitate other ICOs for companies and provide a type of token exchange). As the Decision makes clear, in order to be a fully-regulated platform, Token Funder will have to become a “registrant” (someone who has a license to be in the business of trading or advising in securities). The OSC will likely need to provide Token Funder with further exemptive relief orders from the typical “registrant” requirements to bring such requirements into compatibility with a blockchain platform.
- Is it a security or not? They don’t even bother going into the discussion. Coins or tokens in the Token Funder context are assumed to be securities. You can call it whatever you want, but it’s still a security, so let’s move on!
- Playing in the sandbox still means following the rules. Token Funder decided to undertake its ICO, and ultimately build its platform, under the watchful eye of the securities regulators. They’ve made their bed, and now they’ve got to comply with it. Compliance in this case means: 1) treating the ICO like a private placement of securities under existing prospectus exemptions (offering memorandum exemption for retail investors, and accredited investors for wealthier “angels” or “institutional”), 2) running know-your-client and related procedures, and 3) getting registered to be in the business of trading or advising in securities.
- Liquidity of coins or tokens is still an issue to be resolved. It’s not clear yet if the OSC and Token Funder have determined how to deal with the secondary market (or transferability) of the tokens. If you treat the tokens as securities that are sold in the private market (i.e., not with a prospectus as a free trading security), then those tokens must be subject to private market resale restrictions. This means that Token Funder may have to design its platform or “token exchange” so as to facilitate secondary market trading that complies with securities laws. We will have to stay tuned to see how this plays out.