On March 11, 2021, the Canadian Securities Administrators (CSA) published CSA Staff Notice 51-363 (Staff Notice) outlining several disclosure observations based on the first annual filings by reporting issuers (other than investment funds) that engage materially with crypto assets via mining and/or the holding of those assets. In addition to clarifying the application of continuous disclosure obligations to issuers that engage with crypto assets, the CSA provided guidance relating to (i) the safeguarding of crypto assets, (ii) issuers whose business is investing in crypto assets, and (iii) certain complex financial statement and accounting issues facing participants in the crypto asset industry.
For the purposes of this Insight, the term “crypto assets” refers to digital assets such as cryptocurrencies, tokens, stablecoins and similar digital assets relying on blockchain technology.
Safeguarding of crypto assets
Issuers who own or hold crypto assets should ensure that they have adopted adequate protections to safeguard their assets and are able to articulate and defend any such controls. The CSA clarified the controls adopted by issuers to guard against the risk of loss and/or theft associated with holding crypto assets is a material risk that is important for investors and further noted that the failure to adopt adequate protections may give rise to public interest concerns about the issuer.
Generally, any issuer that owns or holds crypto assets must determine whether it will engage a third-party for safekeeping purposes or hold such assets directly. For issuers that engage a third-party custodian to safeguard crypto assets on their behalf, consideration should be given to whether the custodial agreement constitutes a material contract and/or whether execution of such agreement constitutes a material change for the issuer requiring timely disclosure and reporting under Canadian securities laws. Notably, the CSA indicated that if an issuer does not retain a third-party custodian, the reasons for not doing so would probably be material information for investors. For clarity, the CSA indicated that not all issuers are expected to retain a third-party custodian. Regardless of whether a custodian is engaged for the safeguarding of crypto assets, crypto issuers must be able to explain the reasons behind their decision.
For issuers that act as their own custodian (“self-custody”) of crypto assets, the CSA noted the controls appropriate for a given issuer may vary depending on its size and the type and quality of crypto assets held, as well as the frequency by which they move to and from “hot wallets” or liquidate crypto assets. Other options for self-custody of crypto assets include the use of “cold wallets”, the use of multi-signature wallets, the safeguarding of private keys, and the frequent monetization of crypto assets into fiat currency.
Examples of material information
The CSA also identified several examples of potentially material information to investors for issuers who engage third-party custodians and those who self-custody their crypto assets.
For issuers that engage a third-party custodian, the CSA indicated that the following information would be material to investors:
- the identity and location of the third-party custodian and any sub-custodians;
- a general discussion of the services provided by the custodian;
- whether the custodian is a Canadian financial institution as defined by National Instrument 45-106 – Prospectus Exemptions or a foreign equivalent (and if so, by whom the custodian is regulated);
- whether the issuer is aware of anything with regards to the custodian’s operations that would adversely affect the issuer’s ability to obtain an unqualified opinion on its audited financial statements;
- whether the custodian is a related party of the issuer;
- the quantity and percentage of the issuer’s crypto assets held by the custodian as at each reporting period end date;
- whether the crypto assets held by the custodian are insured and any limitations on the custodian’s liability in the event of the loss or theft of the issuer’s crypto assets;
- any known security breaches or similar incidents involving the custodian as a result of which crypto assets have been lost or stolen;
- the treatment of the crypto assets in the event of an insolvency or bankruptcy of the custodian; and
- if the custodian operates in a foreign jurisdiction, what due diligence the issuer has performed on the custodian, including the issuer’s ability to effectively monitor the custodian and execute contingency plans and exit strategies with minimal impact on the issuer’s operations.
Conversely, for issuers that self-custody their crypto assets, the CSA indicated that the following information would be material to investors:
- a description of the controls implemented to protect the crypto assets against the risk of loss and/or theft associated with holding crypto assets;
- whether the issuer employees multi-signature wallets;
- the manner in which private keys are safeguarded, include the nature and extent of the use of “cold wallets”;
- whether the issuer’s crypto assets are insured, and any exclusions contained in the insurance policy that would prevent the issuer from making a successful claim in the event that crypto assets are lost or stolen;
- measures taken to mitigate cyber security risks; and
- the frequency of monetization of crypto assets into fiat currency.
Issuers whose business is investing in crypto assets
Following the Staff Notice, issuers in the business of investing in crypto assets without other substantial operations should be mindful of how the investment fund regime may be applicable to their disclosure obligations when preparing a prospectus or other disclosure document.
The CSA indicated that, even if an issuer does not meet the definition of an “investment fund” (as defined by National Instrument 81-106 – Investment Fund Continuous Disclosure), many of the investor protection considerations applicable to investment funds may be relevant where a material aspect of an issuer’s business is investing in crypto assets and the issuer does not have other substantial operations. In such situations, the CSA indicated that it might take the view that it would not be in the public interest to recommend issuing a receipt for a prospectus in the absence of the issuer taking relevant mitigation efforts comparable to those that apply under the investment fund regime.
Examples of investor protection considerations that have been required before the issuance of a prospectus receipt include: (i) investment concentration restrictions, (ii) an undertaking to provide continuous disclosure for underlying investee companies if they represent a substantial amount of the issuer’s business, and (iii) requirements to use a custodian qualified in accordance with Part 6 of National Instrument 81-102 – Investment Funds.
In addition, the CSA noted that specific information about an issuer’s crypto assets and other portfolio holdings is required in an issuer’s MD&A to provide a meaningful discussion of an issuer’s performance that meets the requirements of National Instrument 51-102F1 – Management’s Discussion and Analysis. Issuers with significant non-monetary transactions settled with cryptocurrencies should also ensure that its MD&A includes a robust discussion of such non-monetary transactions if they are material to the issuer’s business.
Financial statement and accounting policy considerations
The CSA noted the presence of unique aspects of the crypto asset industry that raise novel accounting issues and urged issuers to monitor and carefully consider any guidance published by accounting standard setters and regulatory boards. Discussion under the heading “Financial Statement and Accounting Policy Considerations” is limited to cryptocurrencies only and not other crypto assets.
Nature of the assets held
The CSA highlighted the publication of the Holdings of Cryptocurrencies in June 2019 by the IFRS Interpretations Committee (the Committee) and noted the conclusion of the Committee that IAS 2 Inventories applies to cryptocurrencies when they are held for sale in the ordinary course of business. Otherwise, an entity should apply IAS 38 Intangible Assets to holdings of cryptocurrencies.
Fair value measurements
If cryptocurrencies have been measured at fair value, the CSA expects the notes to the financial statements to include appropriate disclosures in accordance with IFRS 13 Fair Value Measurement for a reader to understand (i) the valuation techniques used, particularly for holdings of decentralized cryptocurrencies where fair value may be more difficult to establish and (ii) whether the fair value measurement has been categorized within level 1, 2, or 3 of the fair value hierarchy. Further, where the fair value re-measurement of an issuer’s cryptocurrencies has a significant impact on its financial results in a reporting period, the realized and unrealized components of this gain or loss should be separately disclosed in the financial statements, including any reversal of previously unrealized fair value gains or losses.
Considerations for cryptocurrency miners
The CSA also addressed complexities in determining the appropriate accounting policy for issuers that mine cryptocurrency and noted its expectation that financial statement notes contain robust disclosure of a cryptocurrency miner’s accounting policies for its mining activity with applicable references to IFRS and any significant judgments that have been made therein. In determining appropriate accounting policies, issuers should give consideration, where applicable, to (i) the structure and arrangement of any mining pools in which the issuer participants (including the payout formula and timing, any fees payable, and whether the pool differentiates between the cryptocurrency mined and the block reward), (ii) whether issuers that receive a block reward and transaction fee when completing a mining activity should separately record and disclose the transaction fees, particularly if these fees are significant, and (iii) whether a separate accounting policy must be determined by issuers who sell or “rent” hash power to other entities and whether revenue from such sources should be separately disclosed from the revenue earned from traditional mining activity.
In addition, the CSA noted that it expects financial statements to disclose the disaggregation of equipment used for crypto mining activities by the type of crypto asset such equipment is capable of mining. Furthermore, given the rate of technology obsolescence and other volatility present in the crypto industry, careful consideration should be given to whether an indicator of impairment exists in accordance with IAS 36 Impairment of Assets at each reporting date and whether a reassessment of the useful life of the asset is necessary based on the results of the impairment test.
Non-monetary transactions settled in cryptocurrencies
To address the increased risk of manipulation where assets or services received are settled in cryptocurrencies, issuers should ensure they have robust controls in place regarding the initiation and approval of such transactions, including appropriate segregation of duties and minimization of the time period between transaction inception and settlement. Issuers with significant non-monetary transactions should also ensure their financial statements disclose the accounting policies for these transactions and incorporate such transactions into their continuity schedule for each type of crypto asset. MD&A of such issuers should also include a robust discussion of non-monetary transactions if they are material to the issuer’s business.
Other notable disclosure guidance
In addition to the above-noted guidance related to the safeguarding of crypto assets, issuers whose business is investing in crypto assets, and the unique accounting considerations applicable to the crypto industry, the CSA offered the following guidance applicable to a variety of crypto issuers:
- to the extent an issuer relies on a crypto asset trading platform, which generally means an issuer will not have a private key or control over the relevant assets, the CSA expects an issuer to disclose, at a minimum, the items discussed under the heading “Safeguarding of Crypto Assets” where custodians are engaged;
- examples of potentially material changes that would require reporting include entering into a custodial agreement with a third-party, changing custodians, the loss or theft of crypto assets, an acquisition or sale of crypto asset mining equipment, entering into a mining pool arrangement or an electricity supply agreement if the arrangement is significant in relation to the issuer’s existing operations;
- risk factor disclosure that is specific and sufficiently tailored to an issuer in the crypto industry may include, among other things, disclosure of risks pertaining to the availability and/or cost of electricity, potential declines in the price of crypto assets, decreased rewards for mining a particular crypto asset, access to crypto assets held at third-party custodians and crypto asset trading platforms;
- risks related to different forms of crypto assets differ and the risks of holding more established cryptocurrencies, such as Bitcoin or Ether, may be significantly different from investments in other digital assets;
- given the relative novelty of the crypto industry, the following information will likely be material information: disclosure regarding the nature of the issuer’s operations, how the business intends to generate revenue, the specialized skill and knowledge possessed by the issuer, the competitive conditions faced by the issuer, the sources, pricing, and availability of equipment used by the issuer, and any reliance on third-party service providers;
- issuers should not engage in promotional activities that provide unbalance or unsubstantiated material claims about the issuer’s business and the corresponding opportunity for profit by investing in the issuer; and
- The CSA continues to monitor developments related to the mining of cryptocurrencies and holding of crypto assets in Canada and may raise comments in the context of prospectus or continuous disclosure reviews where it appears novel auditing issues may exist.
As the crypto industry continues to evolve in Canada and around the world, Canadian securities regulators will actively monitor and evaluate the disclosure of reporting issuers that engage in activities related to crypto assets. Although reporting issuers in the crypto asset industry are subject to the same disclosure obligations as other reporting issuers, crypto issuers should carefully consider what disclosure to provide about their business models, operations and performance.