Part two of this series dealt with federal regulators in Canada, which is a relatively simple story: they're simply not very relevant to a company launching a token (unless it's a stablecoin). This part deals with the thornier topic of securities regulators, who have been the most vocal governmental opponents of new token launches.

Understanding The Securities Regulator Dilemma

Many crypto industry people hold a negative view of securities regulators, in part because they fail to realize their role. Securities regulators exist to enforce securities laws. They do not exist to enable new models, improve the economy, or bring about a new golden age of decentralization. The mandate is to regulate securities, which is a deliberately broad term. What's a security? It's generally something that's an investment (more on this in a minute). If it's not a security, that's a different regulator's problem (or, a problem for common law courts.) This is the same pattern across most of the countries in the world. And token launches have run into very similar issues around the world. Why? To understand how this ended up roping in units of account in decentralized databases that use private/public-key cryptography and hash functions, a thing which didn't exist until the 1980s (other than in the secret math departments of intelligence agencies), we have to go back into the history archives.

When Did Everything Become A Security?

People imagine that laws today work the way they did a century ago. That's not true. Most laws, in most countries, are not written as a series of clear rules to follow. Most significant laws today involve delegating substantial authority to technical experts, who then decide what the rules should be. (They also involve vague definitions that lawyers can fight over - excellent for my profession, not so great for most other stakeholders.) The rules are not clear by design. The design is: preserve maximum flexibility for the government to act when something looks like the sort of thing they're supposed to be doing something about. This is a very modern idea, and it only came about within the last century or so.

Originally, the English Companies Acts were about regulation of stocks in companies (today, this is corporate law, not securities law). Stocks emerged in various ways, in various cultures, over many centuries. But the modern corporation as we know it today really emerged in the 1800s, and the English Companies Acts are written in language that's very understandable to today's businessperson. But regulation of stock issuance by companies is not the starting place for our current law, but rather an evolutionary step towards greater legislative control over what was previously a private matter.

With widespread companies and stocks came stock markets. Although an invention of the 1600s in the Netherlands, stock exchanges really took off in America in the latter part of the 1800s. Stock markets democratized access to company shares, and when society at large gets involved in any activity regulation often follows. Statutory (as opposed to self-imposed) rules for stock markets emerged in the early 1900s. But still, the laws were about things that no one disputed: stocks or stock markets. It's obvious what a stock market is, and it's obvious what a company is. This is still not the origin of modern securities laws, because at this point in time the laws were still quite clear about the subject matter, and there was little doubt about whether stock regulation applied.

American stock market regulation continually expanded until the 1940s, when the modern statutes for the SEC and stock regulation emerged. This led to pressure in Ontario to conform, in part because American regulators were fed up with Canadians soliciting Americans with scammy investments into mining ventures. This followed decades of experience at the state level in the US, following the first blue sky law in Kansas in 1911. These laws were novel, and triggered a US Supreme Court case in 1917, which notes that the subject matter was:

any stock, stock certificates, bonds, debentures, collateral trust certificates or other similar instruments (all hereinafter termed 'securities')

Here we have the origin of the modern Ontario rules about securities. Over the years, they've added more definitions, but it's still the basic idea of "similar instruments", which is what makes these laws have an uncertain scope. What's similar? It is at this point that securities laws cross over into regulating an uncertain field of things, because what is similar to a stock is in the eye of the beholder. In practice, that means the eyes of the courts.

The current Ontario definition of security is so long that I've included it as an appendix at the bottom of this article, but it's clearly drawing on the same concept as the Ohio law that was made based on the Kansas law, with the concept ultimately blessed by the US Supreme Court in 1917. This ushered in the modern world of vagueness. The law moved from regulating shares in companies, or shares on stock exchanges, to regulating things similar to shares, which becomes an open-ended concept. This has led to no end of frustration by people who want to know: what is a security?. Is a token a security? Well, is it similar to a share? How similar does it have to be? Is it about the underlying business, how the thing is sold, expected returns, or maybe how likely someone is to lose money? Everything in the world has some similarities to other things, and how regulators are to think about similarity comes from the courts.

Security Is A Catch-All Term: The Supreme Court of Canada Decides

The Canadian Supreme Court noted in 1977 that the definition of security is really a catch all, of overlapping definitions that aren't clearly defined. Even more than half a century ago, promoters were hard at work coming up with new ideas that tested the limits of what a security is. In the 1977 case, which is the cornerstone of Canadian law about what a security is, the promoters were selling bags of silver coins. That doesn't sound like a security (and isn't: selling silver coins is not a securities business), but they offered margin loans to buy silver, and that's where they ran into the law. The promoters called the silver bags an investment and most people bought on margin (i.e. 35% down payment, which is effectively leveraged speculation on the price of silver). Is that a security?

Supreme Court Defines Securities As Things Like Securities: Pacific Coin

The famous (among securities lawyers) case of Pacific Coast Coin Exchange v. Ontario Securities Commission was the first real test of the idea that the government could regulate so broadly. Bags of silver were not historically considered securities, and if the company had confined itself to just selling silver coins, there never would have been a case. The Ontario Securities Commission (provincial regulator) only disputed the part about allowing people to speculate by paying part of the price of the bags of silver coins. And even then, they weren't actually sure why that was illegal.

The OSC argued that the silver bag deals were either investment contracts or evidence of title to or interest in the capital, assets, property, profits, earnings or royalties. And today, they still argue cases like this, arguing that maybe it's one thing, maybe it's another, but it's definitely a security. The Ontario Court of Appeal said they're investment contracts, so there's no need to figure out if they're also the other thing, and then when it went to the Supreme Court only the category of investment contracts was in question. This category is the main category the OSC relies on today to try to capture digital assets within the definition of security.

The Chief Justice of the Supreme Court was not keen on the OSC's interpretation. If he'd had his way, the term investment contract would have a far narrower definition in Canada:

The term 'investment contract' applies to one of the many kinds of security included within The Securities Act [of Ontario]. It was conceded that the term could not be given a literal meaning as to do so would bring innumerable transactions which have no public aspect within the scope of the Act; and it was common ground that commodity futures contracts were not per se under the Act. It is easy when faced with a widely approved statute for the protection of the investing public to give broad undefined terms a broad meaning so as to bring doubtful schemes under the authority of the statute. However where the Legislature has deliberately chosen not to define such a term which embraces various transactions, of which some are innocent, there is no reason for Courts to be oversolicitous in resolving doubt in the enlargement of the scope of statutory control.

Justice Laskin recognized that vague terms shouldn't be interpreted widely, and that the goodness of the cause (fighting fraudsters) doesn't mean we should throw good legal principles out the window. (His actual words are slightly different than the headnote quoted above, but it's more concise and has exactly the same meaning.) What he went on to say was that the case should be decided based on whether or not the financial outcome depends on a market vs. a system controlled by the promoters (Pacific Coin was the only purchaser of the bags of silver). He sought to distinguish that from the American case that the majority of the court relied on to conclude that yes, the law in Canada is the same as that in the United States when it comes to the meaning of security. The court ruled that it should be decided in the same way as the 1946 US Supreme Court case of Howey. They distilled the rule down to this key inquiry: Is there a common enterprise? Are the profits to come solely from the efforts of others?. This is still the rule today in Ontario, and the rest of Canada.

The Howey Test Of 1946

It is at this point that the story shifts back to America, which was in any event the origin of the rules in Ontario (this interplay is a key part of the Canadian regulator system, since American investors are a major force in Ontario business). Today, the Howey Test is still cited in virtually any discussion of whether a digital asset is a security, even though the case was actually about renting orange grove production. Yes, that's right, the regulation of blockchain tokens and renting Florida orange grove production in the 1940s still controls our lives. In law, history is always with us.

What was Howey up to? Starting in 1932, Howey's company offered people sales of orange grove land. The land cost more if it had more mature orange trees. Once purchased, Howey's company would service the fields and sell the oranges. People could choose not to use Howey's company, and do it themselves, but only 15% of buyers did and Howey said he was the best at it (which was probably true - they had massive orange grove plantations.) The federal US securities regulator (analogous to the OSC in Ontario) said this was illegal because it was an investment contract. The Florida court said it was fine because they weren't selling investments, they were selling land, orange tree services, and marketing services. The US Supreme Court said it's completely unlawful. How did they get to that conclusion?

The Supreme Court Defines Investment Contracts Using The Howey Test

The Supreme Court pointed out that most of the buyers of these odd orange grove deals were non-residents who didn't know anything about citrus growing. Although true, how is that relevant? Because it goes to the idea that the law is for investor protection, and that the less knowledgeable the buyer, the more they need protecting. This is not officially a part of the so-called Howey Test but it is a key part of securities regulation across North America, even today. Regulators regard themselves as standing up for the little guy, and they'll apply the test flexibly to achieve that. And in this, we see the beginnings of modern law, in which rules aren't rules, but are actually guidelines, to be enforced selectively against the people they ought to be enforced against. (This is very popular amongst lawyers, and considered the right and proper way to do things, but the public generally doesn't know that this is how many regulatory schemes work.) As the Supreme Court put it: Form [is to be] disregarded for substance and emphasis ... placed upon economic reality.

The first part of Howey notes that the buyers were buying more than fee simple interests in land (i.e. more than property), and by going beyond the normal bounds of property and management services, Howey and his company were stepping into the world of investment contracts.

The Supreme Court then goes on to note that the returns from citrus growing depend on the large scale that Howey's company provides, since only with their very large farming operation can the individually owned plots make the 10% returns they advertised. Even though the owners could have cultivated the oranges themselves (and some did), the buyers were depending on Howey's larger scale operation, which was labelled the common enterprise. The fact that some people didn't use the services of Howey's company is immaterial, because what is illegal is offering the possibility, even if it's not actually taken up. So long as the orange grove land owners were offered the services that Howey offered, it's the offering that's wrong, not the land sales, orange grove cultivation services, or sales agent services. The test becomes:

Thus all the elements of a profit-seeking business venture are present here. The investors provide the and share in the earnings and profits; the promoters manage, control and operate the enterprise. It follows that the arrangements whereby, the investors' interests are made manifest involve investment contracts, regardless of the legal terminology in which such contracts are clothed.

We reject the suggestion of the Circuit Court of Appeals that an investment contract is necessarily missing where the enterprise is not speculative or promotional in character and where the tangible interest which is sold has intrinsic value independent of the success of the enterprise as a whole. The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others. If that test be satisfied, it is immaterial whether the enterprise is speculative or non-speculative or whether there is a sale of property with or without intrinsic value.

If that's hard to follow, consider reading the 2019 paper by the SEC explaining how they believe this test applies to digital assets. The second paragraph refers the reader back to 1930s orange groves in Florida.

Back To Ontario: Investment Contracts

The Ontario Securities Commission released some of their first guidace about cryptocurrencies in 2017 amidst a boom of ICOs. This guidance was not a new law, but rather the OSC's interpretation of the existing, wide-ranging, catch-all: the investment contract.

Side note: the term ICO was a very unfortunate term that was meant to sound like IPO. Since IPOs are the main route for companies to list on stock markets, this obviously attracted regulatory attention. Hardly anyone uses this term anymore.

The language the OSC used in its 2017 guidance has clear parallels to the historical source of securities laws, the guiding motivation of supreme courts to protect people, and a clear set up for further moves by the regulator:

ICOs/ITOs are generally used by start-up businesses to raise capital from investors through the internet. These investors are often retail investors. An ICO/ITO is typically open for a set period, during which investors can visit a website to purchase coins/tokens in exchange for fiat currency or a cryptocurrency such as bitcoin or ether. The structures of ICOs/ITOs will vary, and they may be used to raise capital for a variety of projects, including the development of a new cryptocurrency, distributed ledger technology, service or platform. Anyone with internet access can create or invest in an ICO/ITO; in many cases, they can do so anonymously. In many ways, an ICO/ITO can be very similar to an initial public offering (IPO).

It is absolutely true that many people were illegally raising money using tokens when the OSC issued their guidance. It's also absolutely true that people were treating token exchanges as something analogous to stock markets. But what is much less obvious is how far this view goes, and what exactly it covers.

At this point it is worth stopping to point out that in the Canadian and American high court cases, the claim was not that oranges, land, or bags of silver are securities. There must be additional elements on top of these things, because the underlying things are simply property. Had Howey just sold his orange grove land, the US Supreme Court would not have said that is the sale of securities. A recent Ontario Court of Appeal case confirms this idea, by explaining that the sale of condos isn't the sale of securities, but it can certainly be so if it's a part of a larger system. If Howey had just sold orange grove services to owners of land, that would also not be a securities transaction. And if Pacific Coin had just sold bags of silver they'd be merely a dealer in precious metals. Property is not a security, but it can become a part of a security if there's more that happens as part of a larger system. Securities laws create a new regulatory layer over top of assets, whether shares, orange groves, or bags of coins.

Coming Up Next: OSC/CSA Opinions On The Law

The next part of this series examines whether the public's take on the OSC's 2017 view has been accurate, and how the OSC's guidance stands up today, 9 years after issuance. Keep in mind that the laws are the same today as they were decades ago, and what's changed is how they are interpeted to fit the facts. Or, how they're enforced. Because modern law is not about clear rules set down by the legislature, and especially not when it comes to securities. Securities law is up for debate, and recently that debate has shifted in the United States towards an understanding that far more is permitted within the realm of tokens than the regulators previosuly telegraphed.

Appendix A: Definition Of Security Under the Ontario Securities Act

Read the statute here.

“security” includes,

(a) any document, instrument or writing commonly known as a security,

(b) any document constituting evidence of title to or interest in the capital, assets, property, profits, earnings or royalties of any person or company,

(c) any document constituting evidence of an interest in an association of legatees or heirs,

(d) any document constituting evidence of an option, subscription or other interest in or to a security,

(e) a bond, debenture, note or other evidence of indebtedness or a share, stock, unit, unit certificate, participation certificate, certificate of share or interest, preorganization certificate or subscription other than,

(i) a contract of insurance issued by an insurance company licensed under the Insurance Act, and

(ii) evidence of a deposit issued by a bank listed in Schedule I, II or III to the Bank Act (Canada), by a credit union or central to which the Credit Unions and Caisses Populaires Act, 2020 applies, by a loan corporation or trust corporation registered under the Loan and Trust Corporations Act or by an association to which the Cooperative Credit Associations Act (Canada) applies,

(f) any agreement under which the interest of the purchaser is valued for purposes of conversion or surrender by reference to the value of a proportionate interest in a specified portfolio of assets, except a contract issued by an insurance company licensed under the Insurance Act which provides for payment at maturity of an amount not less than three quarters of the premiums paid by the purchaser for a benefit payable at maturity,

(g) any agreement providing that money received will be repaid or treated as a subscription to shares, stock, units or interests at the option of the recipient or of any person or company,

(h) any certificate of share or interest in a trust, estate or association,

(i) any profit-sharing agreement or certificate,

(j) any certificate of interest in an oil, natural gas or mining lease, claim or royalty voting trust certificate,

(k) any oil or natural gas royalties or leases or fractional or other interest therein,

(l) any collateral trust certificate,

(m) any income or annuity contract not issued by an insurance company,

(n) any investment contract,

(o) any document constituting evidence of an interest in a scholarship or educational plan or trust, and

(p) any commodity futures contract or any commodity futures option that is not traded on a commodity futures exchange registered with or recognized by the Commission under the Commodity Futures Act or the form of which is not accepted by the Director under that Act, whether any of the foregoing relate to an issuer or proposed issuer