Mapping the fault lines: SEC sample letter directs public companies to disclose effects of crypto

SEC staff likely to comment on risk factor, MD&A and business description sections

Recent news in the digital assets space has been startling, including the insolvencies of multiple, previously well-regarded and high-flying entities. As both the digital asset industry and the broader economy seek to understand exactly what contributed to such vulnerabilities, lawmakers, regulators and market participants are looking ahead to determine where follow-on risks may reside. 

Perhaps to that end, the U.S. Securities and Exchange Commission’s (the “SEC”) staff (the “Staff”) has issued a “sample letter” (the “Sample Letter”) making clear that it will require U.S. public companies to disclose the effects of recent crypto market disruptions – such as significant declines in digital asset prices and the bankruptcy filings of major digital asset players – on their businesses. 

The Staff periodically issues sample letters to alert public companies of the questions likely to be asked by the Staff when reviewing disclosures in a registration statement, annual report or other SEC filing. While a sample letter is not intended by the Staff to create any new or additional disclosure obligations, it clearly signals areas of probable Staff comment. In the event of any such comments, registrants will need to resolve them by including additional disclosure in their SEC filing or by providing supplemental explanations or information to the SEC staff. The Staff also expects public companies to consider the sample comments when preparing disclosure documents that may not be subject to Staff review prior to their release, such as prospectus supplements for takedowns from existing shelf registration statements. 

The Sample Letter directs companies to consider addressing crypto asset market developments in their filings generally, including in their business descriptions, risk factors, and management’s discussion and analysis (“MD&A”). The sample comments included in the Sample Letter request clear disclosure from companies about the material impacts of crypto asset market developments, which may include: 

  • exposure to counterparties and other market participants; 
  • risks related to liquidity and the ability to obtain financing; and 
  • risks related to legal proceedings, investigations, or regulatory impacts in the crypto asset markets.

Specifically, the sample letter directs companies to provide disclosure in the following areas: 

  • General – Companies should disclose any significant crypto asset market developments material to understanding or assessing their business, financial condition and results of operations, or share price since their last reporting period, including any material impact from the price volatility of crypto assets.
  • Description of Business – To the extent material, companies should describe:
    • The impact of the bankruptcies of various crypto asset companies and their downstream effects, including whether there are material assets that may not be recovered. 
    • Any direct or indirect exposures to other counterparties, customers, custodians, or other market participants known to have filed for bankruptcy; have experienced excessive redemptions or suspended redemptions or withdrawals of crypto assets; have the crypto assets of their customers unaccounted for; or have experienced material corporate compliance failures. 
    • Any steps taken to safeguard customers’ crypto assets, including any policies and procedures that are in place to prevent self-dealing and other potential conflicts of interest. 
  • MD&A – Companies should disclose: 
    • Whether they have experienced excessive redemptions or withdrawals, or have suspended redemptions or withdrawals, of crypto assets and explain the potential effects on their financial condition and liquidity. 
    • To the extent material, whether crypto assets they own, have issued or hold on behalf of third parties serve as collateral for any loan, margin, rehypothecation, or other similar activities to which they or their affiliates are a party. If so, identify and quantify the crypto assets used in these financing arrangements and disclose the nature of the relationship for loans with parties other than third-parties. State whether there are any encumbrances on the collateral. Discuss whether the current crypto asset market disruption has affected the value of the underlying collateral. 
    • To the extent material, and if known, explain whether crypto assets they have issued serve as collateral for any other person’s or entity’s loan, margin, rehypothecation or similar activity. If so, discuss whether the current crypto asset market disruption has impacted the value of the underlying collateral and explain any material financing and liquidity risk.
  • Risk Factors – Companies should consider the following as risk factors: 
    • Any material direct or indirect risk due to excessive redemptions, withdrawals, or a suspension of redemptions or withdrawals, of crypto assets. Any material concentrations of risk and quantify any material exposures should be quantified.
    • To the extent material, any reputational harm in light of the recent disruption in the crypto asset markets. 
    • Any material risks from unauthorized or impermissible customer access to their products and services outside of jurisdictions where they have obtained licenses or authorizations. Companies should describe any steps taken to restrict access of U.S. persons to these products and services and any related material risks.
    • Material risks from the possibility of regulatory developments related to crypto assets and crypto asset markets. 
    • Material risks related to the assertion of jurisdiction by U.S. and foreign regulators and other government entities over crypto assets and crypto asset markets.
    • Material risks related to safeguarding the company’s, its affiliates’, or its customers’ crypto assets, and material risks if the policies and procedures surrounding safeguarding, conflicts of interest, or comingling of assets are not effective.
    • To the extent material, any gaps the company’s board or management have identified with respect to risk management processes and policies in light of current crypto asset market conditions as well as any changes they have made to address those gaps.
    • Any material financing, liquidity, or other risks related to the impact that the current crypto asset market disruption has had, directly or indirectly, on the value of the crypto assets the company uses as collateral or the value of its crypto assets used by others as collateral.
    • To the extent material, the following risks due to disruptions in the crypto asset markets:
      • Risk from depreciation of the company’s stock price; 
      • Risk of loss of customer demand for products and services; 
      • Financing risk, including equity and debt financing; 
      • Risk of increased losses or impairments in the company’s investments or other assets; 
      • Risks of legal proceedings and government investigations, pending or known to be threatened, in the United States or in other jurisdictions against the company of its affiliates; and 
      • Risks from price declines or price volatility of crypto assets. 

In a digital asset market eager to find stable ground, these disclosures may help the SEC and the public understand more quickly the extent to which public companies are feeling the effects of recent crypto-related bankruptcies and other significant events. They may also expose the extent to which public companies may have been “experimenting” (or more) in digital assets, as well as which public companies themselves may have a heightened risk profile. If sunlight is the best disinfectant, mapping the fault lines from this year’s digital asset-related storms may provide the swiftest path to a more positive future, for crypto proponents and skeptics alike.

We will continue to monitor developments in this area and welcome any queries you may have.