Crypto Equity Crowdfunding : magic Internet equity, app-coins, or both?

The last week of October saw the crypto-currency community seized by the dread of government crackdown as rumours spread that the US Securities and Exchange Commission (“SEC”) had turned their attention to the crypto 2.0 world. The panic was, unsurprisingly, premature. The purported SEC letters received by various crypto-currency and crypto-equity businesses merely sought further information about the business operations, fundraising activities and finances of the recipient companies. It was alleged but not confirmed and in fact later denied, that certain bitcoin based companies have been targeted by the SEC for the offering of unregistered securities. This surely won’t be the last time crypto 2.0, digital assets, and securities law appear together on the news-cycle. Questions related to new types of digital finance and securities law will surely only grow with the success and expansion of second generation services which have origins in digital currency, such as Bitcoin.

Though difficult to qualify, “crypto 2.0” generally means second generation cryptography based services that build software layers on top of existing financial systems including bitcoin and traditional fiat currency. Crypto 2.0 services include the creation of and trade in complex financial products that enable a range of different types of investment. Some crypto 2.0 services, such as Ripple, offer real time asset exchanges. Others, such as Mastercoin, allow users to trade just about anything of value online peer to peer. Another crypto 2.0 player generating a lot of buzz is Bitshares X, a distributed database and ledger that also provides for the trading of different digital math-based assets.

Most of these new financial services are built on top of ‘DAC’s. DAC stands for distributed (or decentralized) autonomous corporation. A very simplified definition of a DAC is that it is a protocol, software and network that can perform any number of functions, depending on how it is programmed. Activity on a DAC can be directed in a number of ways. For example, BitShares X is a family of distributed autonomous corporations. It describes its DAC as “as an exchange where currencies, commodities, and stock derivatives can be traded with most of the features used by professional traders including shorts and options. The bank takes a cut on every transaction and pays these transaction fees to the delegates and then shareholders…”. Shareholders are holders of BitSharesX, a digital coin or asset that can also be traded and whose value is related to the success of the BitSharesX exchange. All the transactions that go through BitSharesX charge a fee. This fee is paid to the “delegates” who support the network and verify transactions. They maintain servers, process transactions, and take a charge via the network fees. Other fees may be distributed back to holders of BitSharesX. Some compare it to owning shares in a stock exchange company, such as the Nasdaq. One key difference, however, is that Nasdaq is a legal entity, a corporation with a governance structure. BitSharesX has its own ‘governance structure’, but these “corporate by-laws” exist as a software protocol. Shares in BitSharesX are not shares in a legal entity incorporated under a statute. While these assets may not be stock in a corporation, they may, according to their characteristics, be considered an investment contract. This means that BitSharesX units may be considered securities.

Activity on a DAC can be directed in a number of ways. One such was is through the appcoins issued by the DAC. Appcoins are the tokens that users need to interact with the DAC. These tokens trade on exchanges such as BitShares, a crypto asset exchange affiliated with but distinct from BitSharesX. Other types of assets that trade on BitShares are BitUSD, BitEUR, and BitCAD – all crypto assets whose unit value is meant to track the US dollar, the Euro, and the Canadian dollar. These are stand alone assets and not based on DACs.

Applications of second-generation cryptography services that are getting the most traction are those used for financing and for asset trading. Seedcoin, for example, invests in bitcoin related start-ups through a bitcoin denominated fund. People purchase equity in ventures by sending bitcoin and can view un-registered prospectuses online. There is also Cryptostocks, a crowdfunding platform that allows users to invest in a wide range of products. Swarm is another decentralized crowdfunding start-up.

The first legal question that comes to mind is whether crypto crowdfunding involves the selling of equity, and would thus qualify as equity crowdfunding. While crowdfunding online has become a popular way to raise money for individual projects, securities regulators have not yet allowed companies to raise money by selling equity using the crowdfunding model. This is changing, slowly. Many provincial regulators, such as Saskatchewan, have put out calls for public commentary on proposed rules that would allow for equity to be sold through crowdfunding, provided certain conditions are met. One of the major questions flowing from crypto equity crowdfunding projects and DAC related fundraisers that raise money (or Bitcoin) by selling other appcoins is whether this constitutes selling equity. Alternatively, one can also speculate that these activities resemble more closely the type of crowdfunding used today on kick-starter – whereby people send money to pre-purchase a product. In this case, the product is an appcoin or token that that allows the purchaser to interact with a software program and trade for other appcoins. Some cases are clearer than others as to whether the type of asset being bought represents equity in a venture and would thus be subject the securities laws. In such a case these crypto-equities may be able to operate through crowdfunding exemptions that will eventually be implemented.

Without doubt the crypto-equity sector of the growing financial tech (fintech) industry will draw the scrutiny of securities regulators who are mandated to protect the investing public. At face value, many of the crypto 2.0 businesses appear to be involved in soliciting investments from the general public. Less certain though, is how securities law will apply to these novel virtual assets whose underlying characteristics are varied and difficult to define. Even more confusing is the fact that virtual assets are referred to by those using them with the same vocabulary as financial products traditionally treated as securities and governed by the relevant legislation. This, despite that fact that it is far from certain which types of digital assets would qualify as such. If there’s anything is be sure about it’s that this rapidly innovating technology isn’t slowing down anytime soon.

Canadian Senate hearings on digital currency

On October 2, 2014, the Bitcoin Foundation Canada, the Bitcoin Embassy and the Bitcoin Alliance of Canada were panelists for the Senate Committee on Banking, Trade, and Commerce Committee’s “Study on the Use of Digital Currency”. As chief-legal-officer of the Bitcoin Foundation Canada, I had the privilege of sharing a panel with four other top-notch digital currency industry experts. It was a truly fascinating experience and I was extremely impressed by the quality of the Committee’s questions and their interest. Their 2015 report is eagerly awaited. Re-printed below is a copy of the statement that I made and a link to the video of the testimonies.


Remarks by the Bitcoin Foundation Canada Senate Standing Committee on Banking, Trade and Commerce Study on the Use of Digital Currency

by: Jillian Friedman

Mr. Chair and honourable Senators, Mr. Babin-Tremblay and I are both here as directors of the Bitcoin Foundation Canada, the BFC. On behalf of our organization we thank you for the invitation to appear before you. The BFC is a federal not-for-profit corporation that is affiliated with the Bitcoin Foundation, a global organization headquartered in the United States. Currently there are nine affiliated Bitcoin Foundations in as many countries. The BFC is mandated to coordinate and lead efforts to protect and promote Bitcoin in Canada. This includes monitoring regulatory and legislative developments, educational campaigns, and supporting maintenance and improvement to the Bitcoin protocol.

I also speak to you as a member of the Quebec bar and my remarks today will focus on consumer protection law in Quebec and digital currency, specifically Bitcoin. We can identify the applicable legal rules by looking at the function or activity in which Bitcoin is being used. To quote American Judge Frank H. Easterbrook, “the best way to learn the law applicable to specialized endeavours is to study general rules”. Guided by that principle, it is clear that claims that Bitcoin offers consumers no consumer protection at all are simply false.

The question is not so much whether consumers need to be protected, but whether they need more than they already have. Consumer protection laws are broad and apply to consumer contracts for goods or services where Bitcoin is tendered as payment, whether the transaction is defined as barter or otherwise. Additionally, the chapter on sale in the Civil Code of Québec applies, mutatis mutandis, to contracts for exchange. A consumer’s purchase of Bitcoin from an exchange or vendor would also in principle be governed by these rules.

What does this mean? Consumers tendering payment in Bitcoin or purchasing Bitcoin enjoy implied and legal warranties under consumer protection law and the Civil Code. Additionally, Bitcoin exchange services subject to Quebec consumer law have to disclose any fees they charge to consumers, including exchange fees. It merits mention that traditional financial service providers are also subject to this rule and must disclose fees related to currency conversion services as was confirmed earlier this month by the Supreme Court.

Merchants must also provide instructions necessary for the protection of the consumer against risk or danger of which the consumer would otherwise be unaware. This obligation is relevant when dealing with a technology as novel and complex as Bitcoin especially since many users are still unaware of basic security precautions that need to be taken.

A key complaint about Bitcoin is that the irreversibility of transactions is seen to favour the merchant over the consumer. This is considered anathema to consumer protection law, which is designed to do the opposite. Recall however, that consumer protection law is not beholden to chargeback technology for the protection of consumers engaging in online commerce. In Quebec, the online merchant must perform his obligation before exacting payment unless a credit card is used. This means that if an online merchant sells goods and services for Bitcoin in Quebec to Quebec consumers, he must deliver before the consumer is required to pay. The Bitcoin sector has shown great interest in building its own solutions to the problem of trust in consumer transactions. One is the use of multi-signature addresses that require multiple permissions (or signatures) to transmit funds from a Bitcoin wallet. An escrow agent and dispute arbitrator can hold one key to a multi-signature wallet, and the consumer and seller the other two.

Securities law, which is premised on protection of the investing public, is the other major area of consumer protection law where Bitcoin and related technology is concerned. As is further set out the paper submitted by Attorney Hoegner and I, Bitcoin is likely not a security. Nevertheless, Bitcoin or other digital assets can be used as the unit of account underlying some part of a securities transaction, whether it be consideration for issuance or an investment fund denominated in Bitcoin.

It is important to examine digital currency in the context of a broader innovation known as “decentralized autonomous organization” technology, or DAOs. Decentralized autonomous organizations are software built to run on their own and mimic the operations of a corporation. The use of DAOs to raise funds, spend them, and make distributions through participation of its stakeholders is a highly anticipated use of this technology and has already been subject to experimentation. An issuance of ownership units and their trade in a secondary market may engage provincial securities rules.

We must acknowledge that digital currency technology is distinct from the programs and services that operate on it. Where possible, legal obligations should be based on the function performed rather than the technology, or medium, used to execute it. In the spirit of competition and technological neutrality – legal treatment of digital currency should avoid favouring the use of one technology over the other. Bitcoin is complicated and impressive and it requires a substantial level of technical understanding. It is encouraging that the Canadian government is indeed educating itself before making any decisions on these matters. The opportunity to share my thoughts and research with you here today has been a great honour. Thank you.


Budget implementation bill would require digital currency businesses to play by FinTRAC rules

In the 2014 federal budget, the Canadian government made unequivocal its concern that virtual currencies, specifically Bitcoin, are an emerging risk that threatens “Canada’s international leadership in the fight against money laundering and terrorist financing”. The Government promised to introduce anti-money laundering and anti-terrorist financing regulations for virtual currencies and to provide FinTRAC up to $10.5 million over five years to implement these changes.

Making good on that promise, the budget implementation bill, Bill C-31, introduced on Friday March 28, 2014, includes important amendments to the Proceeds of Crime (Money Laundering) and Terrorist Financing Act (the “Act”) that would subject digital currency to the application of the Act. Like other money service businesses and foreign exchanges, once enacted, these changes would require certain virtual currency businesses to comply with record keeping, verification of identity, reporting of suspicious transactions and registration requirements under the Act.

Other amendments to the Act attempt to deter businesses from operating outside of Canada for the purpose of avoiding the Act’s compliance regime. Under the proposed changes, reporting, KYC (“know your customer”) and licensing requirements would also apply to money service businesses that do not have a place of business in Canada but that provide services, which include dealing in virtual currencies, foreign exchange dealing, remitting or transmitting funds, and issuing or redeeming money orders, to persons or entities in Canada. A new provision would prohibit certain Canadian financial service providers, including money service businesses, businesses dealing with virtual currencies, and securities dealers, from having a banking relationship with any money service business that does not have a place of business in Canada unless those foreign entities are registered with FinTRAC. For digital currency businesses operating in Canada this means that when opening or maintaining an account or providing services to a foreign money service business such as international electronic funds transfers, and cash management they must ensure that the foreign entity with which they are dealing is registered with FinTRAC where such registration is needed.

It is important to note that the inclusion of virtual currency is merely part of a wider scale crusade to strengthen Canada’s anti money laundering and terrorist financing efforts. For example, the Act imposes additional obligations on money service businesses with respect to customer identification and record keeping specifically for dealings with certain individuals such as politically exposed foreign persons. New categories have been added to expand these obligations to dealings with politically exposed domestic persons and international organization members.

At these early stages there are still many questions as to how these changes will apply to the virtual currency industry. It is still not clear what types of virtual currency activities would be subject to the law. The proposed amendments apply to businesses in Canada that are engaged in the business of providing the service of “dealing in virtual currencies, as defined in the regulations”. While we can be somewhat confident in expecting this definition to include bitcoin and alt-coin exchanges, much needed clarification should come from corresponding amendments to the regulations.

The imminent arrival of compliance requirements to the virtual currency industry means that bitcoin businesses starting up in Canada should set up their business model and practices in ways that facilitate compliance with not only anti-money laundering laws, but privacy and consumer protection laws as well. Having these types of policies have become best practices in the virtual currency industry. Not only is it less costly to implement these policies at the early stages of a business rather than changing the status quo later on, federal and provincial regulators may not grant a grace period for digital currency-service businesses before requiring them to have a license. Moreover, having these policies and practices in place can help your business acquire consumer confidence and increase the value of your business.

Despite the initial skepticism of the federal government and FinTRAC towards the role of Bitcoin in the Canadian financial system, many continue to view the government’s regulatory stance to be investigative, rather than hostile. Anticipation is tainted however, by fears that Canada, currently a hotbed for innovation and growth for Bitcoin and distributed ledger technology, may stifle potential with onerous and misguided legislation. While it is perhaps too early to speculate on the broader effect of these proposed amendments, at the very least they suggest a desire to make virtual currency businesses play by the same rules as their fiat counterparts. The Senate Committee on Banking Trade and Commerce’s decision to study virtual currency until June 2015 also conveys an investigative approach. In light of these developments, industry players can continue to be guardedly optimistic that impending legislation regarding virtual currency can be the result of careful deliberation and thorough consultations that take into account the important views and perspectives of industry stakeholders while balancing with the need to protect the public and fight crime.

We will continue to monitor the ongoing initiatives by Canadian regulators and industry as the virtual currency landscape in Canada continues to evolve and will provide market participants with information about any new developments as they arise.

For more information on this topic please contact:

Jillian Friedman, attorney

A cautionary note:

The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.