In part four and part three we saw that the OSC and other provincial securities regulator regulate the raising of capital. The key learning here is that if a token is a stand-in for a thing that is regulated, then that token will be regulated just like the thing it stands in for. If I make a token that is redeemable for narcotics, that'll be unlawful, but only because the dealing in narcotics is regulated. Similarly, if a token represents a capital raise, or the token in combination with other things is sufficiently similar to a capital raise, then that's where the securities regulators will get involved.

Raising Capital Or Earning Revenue?

A product that is sold to a customer is generally booked as revenue, not as capital. Domino's doesn't consider the selling of pizzas to be raising capital, and they're right. Tokens should never be described as being for raising capital, and they shouldn't be marketed in the same way as capital raises are. Is the token project providing information similar to what an investment pitch would have?

This question is almost always just relevant to primary sales, which are the first time that the creator of the token sells the token to someone. For the secondary market, the buyer won't have the direct relationship contractually, and it probably won't have the same information. More importantly: a secondary market sale doesn't give money to the creator, so it's hard to argue that it's for raising capital. So the main way that the secondary market is engaged is either an error in the primary market sale, or that the token itself has securities-like qualities.

Securities-like Properties

Does the token have the properties of a security? For example: paying a dividend, or offering revenue or profit-sharing? Securities laws look for look-alikes, so if something is too similar to a thing that's clearly a security, then it's probably in the danger zone. Obviously this means never using securities words, but it goes beyond that to the substance of what it is.

What's A Security? Really?

Over the last 8000 words of this series I showed the genealogy of securities laws in Canada, and how the government says they apply to tokens. But what the cases really show is something different than what the government says.

In Pacific Coin (see part three), the promoters went wrong when they offered margin. There are countless dealers in silver coins today, and the OSC never tried to regulate them under the logic of this Supreme Court case. The reason why is that the case actually is about something a little bit different than how it's commonly held. The promoters took the money from customers and mixed it with their own money and efforts, which is how customers could pay 35% down for the silver. Customers were speculating on 100% of silver using 35% of the money, and the remaining amount was the efforts of the promoters. Furthermore, the only buyer of the silver was the company. You bought from them and then sold back to them. This is a closed system in which money goes in, and profits (maybe) come out, and the margin part is essential because: he has no title to any physical property but only a claim against Pacific.

If a token is sold to someone and then they receive it, the person does not have a mere claim on the creator of it. They have received an actual thing. This is different from Pacific Coin.

But what if the token still has a dependence on the creator? Because, for example, they're going to be using the money used from the purchaser to go buy oranges, sell them, and return some portion of the hoped-for profits to the token holder? That sounds like an agreement to share in the profits from the sale of oranges, which is where the discussion crosses over into securities law. But the same would be true if this was done entirely on paper.

In the bad cases there are always two things going on: the underlying thing (oranges or bags of silver) which is permitted and the investment scheme overlaid (Howey or Pacific Coin) that is not. It is not the oranges or bags of silver that are the source of the legal problem when it comes to tokens. It is almost always the overlaid investment scheme. Or, in a few cases, the creators of the tokens have deliberately constructed a system of revenue/profit-sharing that's offside because the thing itself is a security. Will management and the customers be splitting the profits on a venture together? That's probably a security.

Will management get the customers money and use it to build a business, that will then make money, and then the customers get back their money plus a profit? That's probably a security.

Turning Legal Things Into Illegal Things

Almost everything in the Canadian economy is not a security. Even things that might look like raising capital, for example, Starbucks sells gift cards that give it access to cheap capital so that it doesn't have to borrow as much money. That is a deliberate part of the strategy of gift cards, but it does not mean that the gift card is raising capital. Even the OSC isn't going to say that the gift cards are a security, no matter what the accountants at Starbucks write internally about the function of gift cards within their enterprise. And the reason is that the gift card isn't itself a security, and the customer doesn't participate in any kind of profit-making system with Starbucks. Starbucks gets all the benefit! But, if instead, Starbucks told customers that their gift card balances would earn 35% of the money that Starbucks saves on interest expenses globally and it's paid as a monthly payment? Probably they've just turned gift cards into an investment contract.

It's always easy to construct systems that are illegal under securities laws in Canada. The two best paths to doing this are to give back a portion of an investment's returns, or to raise investment capital using the thing. If Starbucks tried to raise money by telling everyone to go out and buy gift cards that Starbucks will later convert to stock, that would obviously transform the gift cards into an element of a larger capital raising scheme that's not permitted.

Conclusion

The two danger areas are:

1. Raising capital using a token, where the token is merely a stand-in for other paperwork that represents a capital raise, transforming the customer into an investor

2. Constructing a system of revenue/profit-sharing in which management and a customer share in the return of some business that was funded by the customer, transforming the customer into an investor

Tokens need to stay out of these regulated areas, and if they come close to them, the creators need to speak to a securities law expert, just like they would with raising capital. The next post in this series will explain what this means for token creators. Securities laws were not intended to cover products, only securities, which are fundamentally different from the general types of products and services that Canadians are familiar with. The difference between these two areas is the difference of opinion in what sorts of tokens are allowed to be launched in Canada.