FRACTIONALIZATION OF PROPERTY OWNERSHIP IN CANADA
At a time when entering the housing market is becoming increasingly out of reach for so many Canadians, legislation supporting fractionalization vehicles could work to address the affordability crisis plaguing the Canadian economy by placing partial ownership in property within reach of more Canadians. Marketplaces like Lofty AI in the United States allow property owners who are earning rental income from the property to sell fractional interests in their property, with the buyer earning a share of the rental income.
Fractionalization of property is achieved through a Decentralized Autonomous Organization (“DAO”), characterized by a flattened governance structure whereby members collectively make governance decisions according to a smart contract (code on the blockchain) that dictates voting mechanisms according to a member’s token holdings. Wyoming[1] and Tennessee[2] have both enacted legislation informing how the DAO structure integrates into existing legislation respecting Limited Liability Companies (“LLCs”).
The power of the DAO LLC structure is in its capacity to reduce the securitization risk of the entity. Members have a property and voting interest in the DAO LLC proportionate to their token holdings under the smart contract. If these token holdings are characterized as an “investment contract” by securities regulators in the United States and Canada, the DAO LLC has the heavy burden of filing a prospectus with these regulators.
The DAO LLC is structured to avoid this burden as it is unlikely to meet the test for an investment contract originating out of SEC v. Howey Co., 328 U.S. 293 (1946) (“Howey”).[3] The Howey decision defines an investment contract as including “a contract, transaction, or scheme” and provides a four-prong test for investment contracts: (1) an investment of money; (2) in a common enterprise; (3) with the expectation of profit; and (4) to come solely from the efforts of others. The DAO LLC structure specifically circumvents prong 4 of the Howey test, as the member-managed structure imposes a responsibility on all members to participate in the governance and day-to-day operation of the organization.
Canada does not have a business vehicle akin to the LLC. While Canadians can register an extra-provincial Wyoming or Tennessee DAO LLC, Canadian tax authorities do not recognize flow-through treatment and there is a risk of cross-border double taxation. The traditional business structures in Canada pose risks for DAOs. Private corporations provide members with liability protection, but a maximum of 50 shareholders are allowed under the “private issuer” exemption for filing a prospectus,[4] reducing the number of token holders to 50. Under a limited partnership, limited partners lose their liability protection if they take on decision-making akin to a general partner, which would be the case in a DAO.[5] Mutual fund trusts require a minimum of 150 unitholders all of whom must meet strict prospectus exemptions, generally as high net worth individuals,[6] which would be unsuitable for a DAO looking to attract membership among a more diverse and humble group of Canadians.
For a Canadian fractionalized property business to operate in Canada without facing the risk of filing a prospectus, a jurisdiction in Canada needs to pass legislation accommodating the DAO structure into an existing business model. The corporate model could, in theory, serve this purpose. Supplemental corporate legislation could provide for a model whereby all shareholders are required to participate in governance, reducing securitization risk. Ultimately, as the model is implemented, it may look increasingly like the LLC as it takes on an amalgamation of partnership and corporate features. DAOs have the power to connect everyday Canadians with accessible investment projects and the opportunity to participate in day-to-day management. It’s time that Canada has a business structure to allow this.
[1] See Wyoming Decentralized Autonomous Organization Supplement (“DAO Supplement”).
[2] See Tennessee’s Amendment No. 1 to HB2645.
[3] SEC v. Howey Co., 328 U.S. 293 (1946).
[4] See section 2.4 of the Ontario Securities Commission National Instrument 45-106 dated September 18, 2009.
[5] See for example section 13(1) of the Ontario’s Limited Partnerships Act, R.S.O. 1990, c. L.16.
[6] See July 2020 McMillan article “Thinking About Real Estate in Canada? Practical Considerations for Structuring a Private REIT”.
