Canada: Securities Law Considerations for Decentralized Autonomous Organizations

Published on Feb 6, 2023


Following FTX’s insolvency and its fallout throughout the cryptocurrency markets, calls for greater regulatory scrutiny have intensified. The focus of this scrutiny is primarily on the governance of centralized exchanges and risks related to custodial wallets, but will have implications for decentralized projects generally. As industry participants continue to work on these decentralized projects, including larger institutions exploring the value-add of tokenization within and among their organizations, careful consideration and attention should be given to the changing regulatory environment.

One of the central building blocks for these projects will be decentralized autonomous organizations (“DAO”). DAOs are internet-native organizations that leverage blockchain technology (including digital assets like non-fungible tokens) to facilitate the coordination of activities and allocation of resources under a decentralized governance structure. These decentralized governance structures enable DAO members to participate directly in the governance of their organization, allowing flattened organizational hierarchies and cooperation in otherwise trustless environments. For example, DAOs may be used to manage decentralized protocols for a range of Web3 projects (from finance, like Uniswap, to wireless networks like Helium), raise and invest funds, or provide governance solutions to common interest groups. Regardless of the application, DAO’s functionally require the issuance and distribution of tokens. While these tokens may in many cases resemble securities in some cases, the unique and unprecedented characteristics of DAOs require a reassessment of the assumptions underlying traditional securities analyses.

As investors and community members continue to explore the potential applications of these technologies, however, they risk coming into conflict with traditional securities laws and regulations. For example, the U.S. Securities and Exchange Commission (“SEC”) reportedly commenced a probe of Yuga Labs Inc. (“Yuga Labs”). Yuga Labs, the creator of Bored Apes Yacht Club, a popular collection of NFTs, had launched the ApeCoin DAO, which had issued ApeCoin tokens to holders of the Bored Apes NFTs. Although no charges or results have been announced in connection with its offerings, the probe highlights the increasing scrutiny that securities regulators are placing on the cryptocurrency industry and the corresponding care that participants in the space should take in ensuring their offerings comply with applicable laws in their jurisdictions.

This article provides a brief summary of a typical DAO structure, an overview of the Canadian securities law considerations for implementing DAOs in governance structures, and observations on the complications DAO governance structures introduce to the relevant securities analysis. This article will generally leave aside questions regarding the corporate law considerations of DAOs, and should be read in conjunction with our June 14, 2022 article, Class Action Lawsuit Highlights Importance of Legal Wrappers for Decentralized Autonomous Organizations.

Decentralized Autonomous Organizations Structures vs. Standard Corporation Structures

A typical DAO structure can be understood functionally as an ordinary corporation with two classes of shares:

(i) “governance tokens”, which function like common shares with typical voting rights, and

(ii) “treasury tokens”, which function like non-voting preferred shares,1 giving their holders a claim against the assets held in the DAO’s treasury.

Unlike a normal corporation, however, governance tokens allow holders more direct participation in the DAO’s governance structure than shareholders typically enjoy. This direct participation creates an opportunity for “flatter” governance hierarchies, as the functional necessities of delegation in customary corporations between shareholders, directors and management are less applicable, and comes with numerous potential benefits for stakeholders. For example, while a shareholder in a regular corporation typically has the ability to propose corporate actions, the proposal and approval thereof are subject to lengthy corporate processes and, where the proposal is contrary to the board or management’s own plans for the DAO’s operations, may be frustrated by such insiders’ informational asymmetry and proximity to the corporation’s operations. In most DAOs, any tokenholder may submit a proposal that, if approved by the requisite number of tokenholders, will automatically be implemented. Furthermore, as DAOs operate as a collection of smart contracts that should, in principle, be available to all members, the DAO platform provides members with greater transparency regarding the operations and actions of the DAO.

These features of flattened governance structures, increased transparency and direct participation will be a key differentiator in any legal analysis. For example, theories regarding shareholder liability that assumed a more passive involvement by shareholders may be challenged under certain structures. Similarly, increased participation by shareholders, together with greater transparency regarding the DAO’s operations, may mitigate the need for certain legal protections otherwise provided to shareholders.

Canadian Securities Administrators Guidance

Securities regulators in Canada have yet to issue any rules that specifically addresses the securities law implications of issuing DAO tokens, though the Canadian Securities Administrators (“CSA”) have launched the CSA Regulatory Sandbox, recognizing new financial technology businesses may not fit neatly into the existing securities law framework.

As part of the CSA Regulatory Sandbox initiative, the CSA has issued several staff notices providing guidance on their general approach to token offerings in Canada, including Staff Notice 46-30 – Cryptocurrency Offerings (“SN 46-307”) and Staff Notice 46-308 – Securities Law Implications for Offerings of Tokens (“SN 46-308”), to help financial technology businesses understand what obligations may apply under Canadian securities laws.2

SN 46-307

The CSA issued SN 46-307 on August 24, 2017, in response to the early popularity of initial coin and token offerings (“Offerings”) in Canada as well as globally. In SN 46-307, the CSA emphasized that every Offering is unique and must be assessed on its own characteristics. As a result, the analysis involved in determining whether a particular Offering involves the offer or sale of a security requires an assessment of the economic realities of the transaction and a purposive interpretation with the objective of investor protection in mind.

SN 46-307 further notes that although Offerings involve a new technology and refer to what is being sold as coins or tokens instead of a share, stock or equity, such assets may be considered “securities” as defined in Canadian securities legislation. Included in the definition of “security” is an investment contract, the test for which asks whether the Offering involves:

(i) an investment of money,

(ii) in a common enterprise,

(iii) with the expectation of profit,

(iv) derived significantly from the efforts of others.

DAOs plainly satisfy the first two prongs; however, they may not satisfy the third and fourth, depending on the nature of the DAO. As noted above, a DAO can be used for many different reasons. On one end of the spectrum are investment DAOs that explicitly pool resources for investment in various endeavours; on the other end are community-oriented DAOs like knowledge-based cooperatives. If there is an expectation of profit, the fourth prong may be further complicated by a high degree of involvement by the individuals who purchase or otherwise receive DAO tokens.

SN 46-308

In SN 46-308, the CSA specifically addresses questions it received from businesses in response to SN 46-307 regarding the securities law implications of Offerings involving “utility tokens,” being tokens that have one or more specific functions, and provides guidance on (i) when an Offering may or may not involve an offering of securities, and (ii) issues relating to Offerings that are structured in multiple steps.

At a high level, SN 46-308 reiterated two scenarios where an Offering may involve a distribution for the purposes of applicable securities laws:

(i) where the Offering involves the distribution of an investment contract, and/or

(ii) where the Offering and/or the tokens issued are securities under one or more of the other enumerated branches of the definition of security or may be a security that is not covered by the non-exclusive list of enumerated categories of securities

SN 46-308 notes that a token having a utility is not, on its own, determinative as to whether an Offering involves the distribution of a security.

Although it does not provide determinative guidance on when a utility token will constitute a security, SN 46-308 does set out a number of illustrative examples of utility token characteristics and their implications for the securities law analysis. Some DAO implementations may have characteristics similar to those listed. For example, SN 46-308 notes that if the issuer’s management represented that it has specific skills or expertise that will likely increase the token’s value, this could indicate a common enterprise because of the reliance on management and could similarly indicate an expectation of profit. On the other hand, where tokens are distributed to users for free, the distribution will likely not involve an investment of money.

SEC Guidance

Similar to the CSA, the SEC stated that whether a distribution of securities has taken place “will depend on the facts and circumstances, including the economic realities of the transaction,” regardless of the terminology or technology involved. Notably, the SEC investigated the first DAO (known as “The DAO”) that was launched on the Ethereum blockchain, which was “hacked”3 shortly thereafter, resulting in the loss of over $60 million in funds and Ethereum’s controversial “hard fork.” In its report, the SEC found that the tokens offered and sold by this virtual organization were securities and therefore subject to U.S. securities laws. The test applied by the SEC to determine if The DAO’s tokens were investment contracts (and therefore, would be treated as securities) is identical in structure to the analysis undertaken by the CSA in SN 46-307.

The DAO was launched on the Ethereum Blockchain in April of 2016. Seed investors pooled assets through the purchase of The DAO’s governance tokens and in exchange, each investor received a pro-rata ownership share of the treasury based on the amount of governance tokens each investor subscribed for. If The DAO generated revenue from successful initiatives, The DAO’s treasury fund would reward investors with proportional distributions of additional governance tokens.

In its report, the SEC noted: (i) investors in The DAO invested money, (ii) with a reasonable expectation of profits, (iii) derived from the managerial efforts of others, concluding that “issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies.” Furthermore, the SEC warned that not only is it the virtual entity itself that could be liable; retail investors participating in unregistered offerings as well as securities exchanges providing for secondary trading in these tokens (unless they are exempt) are at risk of being offside securities laws.

Available Exemptions

Notwithstanding that the tokens involved in any particular Offering closely resemble a “security,” industry participants considering implementing the technology in their organizational structure may be able to rely on certain prospectus exemptions in connection with the distribution of their tokens. Exemptions that may apply to certain DAO activities include:

(i) family, friends and business associates,

(ii) equity crowdfunding,

(iii) private issuer,

(iv) accredited investor, and

(v) offering memorandum.

While each of the foregoing has its advantages, the exemptions are by their nature restrictive, resulting in impediments to at-scale implementations.

For example, while the equity crowdfunding exemption may allow for broad participation, there are limitations on the maximum total amount an issuer can raise using this exemption during any 12 month period as well as on the maximum investment a purchaser can make in an offering. Similarly, while the private issuer exemption may allow for greater investment levels, distributions are limited to 50 people (although this limit does not apply to employees or former employees of the issuer or its affiliates) and restricts the scope of investors eligible to participate.

Notably, there have been some DAOs in the U.S. that have leveraged similar exemptions from the registration requirements under U.S. securities legislation. For example, The Flamingo DAO (“Flamingo”) is organized as a Delaware limited liability company and has limited its membership to 100 individuals, each of which must be an accredited investor in order to meet the SEC’s “Investment Club” exemption as a private investment company. Furthermore, Flamingo requires individuals who want to contribute to the DAO to complete accredited investor, anti-money laundering, know your customer, and Office of Foreign Assets Control checks, which include, among other requirements, uploading a passport or license and providing a social security number. Flamingo’s website also includes extensive disclosure regarding its governance protocols.

DAOs conducting sales of tokens in Canada should take similar steps to consider their organization’s respective aims, choose an appropriate structure and ensure compliance with securities laws.

Looking Ahead

Similar to previous periods of significant volatility in the cryptocurrency industry, while public confidence may be tested, the technology and its proponents endure. As the industry develops further, there will be continued uncertainty as regulators work to effectively address the novel risks and structural challenges posed by the technology, as recently highlighted by the collapse of FTX. As industry participants continue to try out new organizational structures, and until regulatory authorities are able to provide clearer guidance, the nature of DAO activities and the specific functions of their respective tokens will continue to drive regulatory analyses, with the securities implications for each project being addressed on their own facts.

These analyses could be complicated as industry participants implement novel DAO governance structures. Although DAO tokens mirror securities from a functional perspective – the tokens will be analogous to corporate shares in many cases – arguments could be made that the changes in how the various parties interact within a DAO should result in differing treatment from these traditional structures. In the context of securities regulations for example, the primary policy goal is to protect investors from unfair, improper or fraudulent practices. The need for this protection, however, was predicated on the informational and governance asymmetries inherent in a traditional corporate structure. While there will always be a need for protection of the public from malfeasance – which has certainly occurred in sections of the cryptocurrency industry – consideration should be given to ensure that otherwise well-intentioned and structured projects do not become victims of regulatory creep and its associated costs. Continued uncertainty on this point may result not only in participants avoiding Canada, but also increased costs for those who do attempt to launch projects here, which would only serve to undermine Canada’s competitive industry position.

The DAO community and secondary market participants exploring DAO token offerings should proceed cautiously in light of the ambiguous legislative scheme surrounding the treatment of such tokens. Nonetheless, regulators have been clear that securities laws will apply to those who offer and sell securities in Canada or the U.S., regardless whether the issuing entity is a brick and mortar company or a DAO, whether those securities are purchased using traditional or virtual currencies, and whether they are distributed in certificated form or through distributed ledger technology. The specific characteristics of these tokens that cause them to be deemed securities, however, remain unclear.

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1 The distinction here may also be viewed similarly to shareholders and creditors; however, the lack of legal protections for crypto “creditors” (absent formal legal wrappers for DAOs or more robust contractual arrangements among participants) results in a more equity-like risk than a credit risk, an issue which will need to be addressed in future DAO implementations.

2 The CSA has also published the following notices regarding cryptocurrency offerings in Canada: Joint CSA/IIROC Consultation Paper 21-402 – Proposed Framework for Crypto-Asset Trading Platforms (March 14, 2019), Staff Notice 21-327 – Guidance on the Application of Securities Legislation to Entities Facilitating the Trading of Crypto Assets (March 14, 2019), Staff Notice 51-363 – Observations on Disclosure by Crypto Assets Reporting Issuers (March 11, 2021), Joint CSA/IIROC Notice 21-329 – Guidance for Crypto Asset Trading Platforms: Compliance with Regulatory Requirements (March 29, 2021), and Joint CSA/IIROC Staff Notice 21-330 – Guidance for Crypto-Trading Platforms – Requirements relating to Advertising, Marketing and Social Media Use (September 23, 2021).

3 The “hack” that led to The DAO’s losses did not alter The DAO’s code or exploit a vulnerability to gain unauthorized access. Rather, the individual responsible for the “hack” exploited a flaw in the programming language used to code The DAO’s smart contract (Solidity) which, if used in the right way, would enable an individual to withdraw funds repeatedly at no cost. While the result represented a significant loss to The DAO’s investors, technically the underlying code operated as designed, and the flaw was even highlighted to The DAO’s founders before the project was launched. The “hacker” published an open letter to the Ethereum community in which they took the position that there was no “theft” and that instead they were fully compliant with the terms of the smart contract, noting The DAO’s terms of use, which noted that the “terms of The DAO Creation are set forth in the smart contract.