Legislators Criticize SEC Accounting Guidance on Custody of Digital Assets
Commentary by Steven Lofchie
In a letter to the Federal Reserve, the FDIC, the OCC and the NCUA (the "Agencies"), Senator Cynthia M. Lummis (R-WY) and Representative Patrick McHenry (R-NC) criticized SEC guidance on the accounting treatment of cryptocurrency assets by custodians. The legislators took aim at SEC Staff Accounting Bulletin 121 ("SAB 121") following a recent court decision classifying customers with cryptocurrency assets custodied at a now bankrupt company as unsecured creditors. SAB 121 generally provides that custodians of digital assets must treat those assets as on their balance sheet, thus materially expanding their assets (the digital assets) and liabilities (the obligation to return those assets).
Celsius Decision
In the Chapter 11 case, the U.S. Bankruptcy Court for the Southern District of New York said that the custodian's terms of use gave it the right to (i) hold digital assets under its name or in another name and (ii) exercise ownership of such digital assets by transferring or using any amount of such digital assets separately or together with other property. The Court stated that the company included a Transfer of Title clause in its terms of agreement that grants it all rights, including ownership rights, to account holders' digital assets. As a result, the Court ruled that the custodied digital assets became property of the bankruptcy estate and the clients were unsecured creditors.
SEC Staff Accounting Bulletin 121
In their letter, the legislators pointed to SAB 121 as the reason for the Court decision to treat account holders as unsecured creditors. They also expressed concern over the "massive capital charge" that has been triggered by financial institutions being required to place digital assets on their balance sheets. They stated that this dissuades financial institutions from engaging in digital asset custody. Furthermore, they stated that SAB 121 "upends decades of precedent" with regard to the accounting treatment of financial institutions' custodial assets.
The legislators asked for additional information from the Agencies in order to assess the implications of SAB 121 on financial institutions. Among other things, the Republican legislators asked the Agencies to provide the following information:
- whether they were contacted by the SEC prior to the adoption of SAB 121, and if so, detailed correspondence between SEC staff and the Agencies;
- whether the SEC has indicated that it will modify or withdraw SAB 121 "in light of widespread comments that the Bulletin is flawed";
- the legal and supervisory rationale for off-balance sheet treatment of custodial assets having historically been the norm for banks and credit unions;
- whether the Agencies have directed financial institutions within their respective jurisdictions to comply with SAB 121;
- whether the Agencies agree that SAB 121's capital charge for banks and other financial institutions is "prohibitive"; and
- whether the Agencies agree that SAB 121 "potentially weakens consumer protection by preventing well-regulated banks . . . from providing custodial services for digital assets."
The legislators requested responses from the Agencies by March 16, 2023.
Commentary
Although the Congressmembers are undoubtedly right that putting custodied digital assets on balance sheets would discourage banks from providing custody for such assets, SAB 121 was not the basis for the bankruptcy court's decision. The court reached its conclusion on the basis of the contract between the account holders and the custodian.
The accounting treatment of digital assets should follow from the terms of the custodial contract and the custodial procedures, and particularly from the treatment of the custodied assets in bankruptcy. The bankruptcy treatment does not follow from the accounting treatment, as the Congressmembers suggest; it is the other way around.
That said, it should be the case that where the custodial contract with a bank does not entitle the bank to use the custodied assets, then the assets should not go on the bank's balance sheet. It should be up to the bank regulators to make clear that digital assets truly held in custody (and not subject to rehypothecation by the bank custodian) should be returned to the beneficial owners of those assets in the event of the bank's insolvency and thus should not go on the bank's balance sheet.