Beware the use of crypto-currencies

Crypto-currencies are the newest and biggest trend in the financial industry. Fuelled by millennials who have grown up in the digital age, their popularity is reaching new heights.

Crypto-currencies are the newest and biggest trend in the financial industry. Fuelled by millennials who have grown up in the digital age, their popularity is reaching new heights. Retailers, educational institutions and even some law firms are now accepting Bitcoin or digital tokens as a form of payment.

Crypto-currencies — such as Bitcoin, Ethereum, Litecoin and others — have two things in common. Firstly, they use blockchain technology. Secondly, they face an uncertain but evolving regulatory future. No one knows how big the crypto-currency market is, who is involved (due to the often anonymous or encrypted nature of crypto-currency trading), how crypto­currencies are valued or whether crypto-currencies are a commodity, a currency or a security. 

It is inevitable that as crypto-currency and its uses continue to evolve, new legal issues will emerge that both lawyers and the courts in Ontario will have to address. 

These issues will include the expansion and application of existing legal remedies to fit the unique features of crypto-currency trading and overcoming challenges that exist in enforcing rights and seeking redress against wrongdoers. The fact that crypto-currencies exist as strings of code stored on a network of computers around the world where every transaction is encrypted is meant to make crypto-currency transactions more secure. However, the use of “hot wallets” and other measures designed to enhance security can make it extremely difficult for investors who have suffered losses to trace funds or seek redress. 

Clients need to be aware of the risks around crypto-currencies.

The Canadian Securities Administrators has issued warnings to investors about the risk of trading in crypto-currencies, alerting the public to the fact that the crypto-currency market is unregulated and may be subject to significant price volatility. Similarly, the Ontario Securities Commission has expressed serious concerns about crypto-currencies and digital tokens.

Notwithstanding this, many investors are eschewing the warnings and ignoring the traditional cornerstones of investing, namely security, transparency and profitability, in pursuit of achieving significantly higher investment returns in the crypto-currency markets. But with higher returns comes greater risk, and in the unregulated world of crypto-currencies, the risks are considerable.

There is great potential for fraud, misrepresentation and, quite simply, theft. These issues can arise for individual investors, but they have also plagued exchanges and trading platforms, which are largely unregulated and often operate offshore.  

Securities regulators have grappled with the question of whether trading in crypto-currencies engages securities laws. Last year, in the face of a boom in initial coin offerings, the CSA and OSC made it clear that many of the digital tokens offered for sale in ICOs and later listed on exchanges fall within the definition of a “security.” Digital tokens may, therefore, be subject to securities laws, including, among other things, requirements for filing of a prospectus with the OSC, dealer registration and ongoing compliance with the securities regulatory regime. 

Similarly, the Securities Exchange Commission and the United Kingdom’s Financial Conduct Authority are on high alert and investing significant resources to protect investors, as demonstrated by their investigation and prosecution of a Quebec-based company, PlexCorps, allegedly involved in a fraudulent ICO. Investors in PlexCoin, a digital coin distributed by PlexCorps, were told through social media that they would “take control of their money” on the promise of delivering substantial returns (1,354-per-cent return) based on the appreciation in value of the PlexCoin. The SEC, and eventually Quebec’s Autorité des marchés financiers, issued orders against PlexCorps and its directors and officers to prevent them from continuing to engage in unregistered offerings and the distribution of PlexCoin tokens. 

But is this enough? Likely not. The line between what regulators will consider a security and not a security is blurry at best. This issue brings into focus the ultimate question — whether regulators have the authority and jurisdiction to regulate the crypto-currency markets. Although regulators have provided some guidance, it is far from obvious which crypto-currencies will catch their attention. There is confusion and uncertainty in the marketplace, not only as to whether any given crypto-currency is subject to regulatory oversight but also as to which regulator is responsible for that oversight, depending on whether a crypto-currency should be classified as currency, a commodity or a security. 

The result is that the courts are being asked to intervene and decide questions of regulatory authority and jurisdiction. For example, federal judges in a New York case brought by the SEC against Maksim Zaslavskiy and his companies are scheduled to rule on the question of whether digital currencies backed by investments in real estate and diamonds (which did not exist) are securities that can be regulated like stocks and bonds. In Canada, although there are no reported court decisions addressing these complex issues to date, there has been a surge in regulatory activities over the last six to eight months.

At present, while interlocutory injunctive relief, including Norwich and Mareva orders, may offer some initial relief, recovering the losses suffered in a world without boundaries and in respect of digital tokens that are not backed by any tangible assets may prove to be a challenging task. Ultimately, it is up to the lawyers to help guide their clients through this increasingly complex digital world and to fill the legal and regulatory gaps that currently exist in the crypto-currency markets.

Nadia Campion is a complex commercial litigator at Polley Faith LLP.

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