August 23, 2022 – Just as cryptocurrency markets are attempting to thaw out from a “crypto winter,” a joint committee of the Uniform Law Commission (ULC) and the American Law Institute (ALI) has finalized a significant and wide-ranging amendment to the Uniform Commercial Code (UCC) that addresses the quirks and nuances of digital asset transactions and crypto-as-collateral secured financings.
At its annual meeting in July, the ULC approved a final draft of the joint ULC-ALI Emerging Technologies Committee’s (ETC) amendments to the UCC, which includes a completely new Article 12 that is devoted to defining various digital asset classes and setting ground rules for crypto-backed secured financings. New Article 12 will dovetail with a series of amendments to existing Article 9 (secured transactions) and Article 3 (negotiable instruments).
The ETC was formed in 2019 to address a growing list of legal questions stemming from the unique and intangible features of cryptocurrencies, NFTs, and other emerging digital assets, including, significantly, how security interests in digital assets can be perfected.
The new Article 12 deals with transfers of interests in a forward-looking, catch-all class of digital assets branded “controllable electronic records” (CERs), a term that was intentionally crafted to go beyond current distributed ledger and blockchain concepts in order to capture future, yet-to-be-invented intangible digital assets. Under new 12-102(a), a CER is nebulously defined as “a record stored in an electronic medium” but specifically excludes, among other things, “electronic money,” electronic records of promissory note debt (“controllable payment intangibles”), and electronic records of accounts receivable (“controllable accounts”). But per the ETC’s guidance, CERs include NFTs because NFTs do not specifically fall into any of these excluded categories of digital assets.
The proposed amendments to Article 9 are largely focused on clarifying the procedures for attachment and perfection of security interests in CERs and “electronic money,” including what constitutes “control” of intangible digital assets that cannot physically be “controlled.” Interestingly, the revised definition of “money” defines “electronic money” to mean fiat digital currencies (central bank-issued digital currencies or CBDCs), while non-fiat cryptocurrencies—like Bitcoin and Ether—are excluded (even if later adopted by a government as legal tender, virtual currencies that existed prior to official government adoption do not qualify as “money” under the revised definition, but instead are considered CERs). What this means in practical application is that perfection of a security interest in CBDC can only be achieved via the lender’s “control” of the CBDC (i.e., a UCC financing statement filing will not suffice).
Under new 9-105A, a lender will be deemed to have “control” of electronic money if “a record attached to or logically associated with the electronic money or a system in which the electronic money is recorded” gives the lender the “exclusive power” to control its transfer and the underlying blockchain—or “system in which the electronic money is recorded” —enables the lender “readily to identify itself” as the party in control (i.e., via “name, identifying number, cryptographic key, office, or account number”). New 9-107A and 12-105(a) create identical rules for establishing control of CERs, controllable accounts, and controllable payment intangibles.
In practical application, the “control” rules of new 9-107A and 12-105 mean that, in order to be first-priority perfected in (non-fiat) cryptocurrency collateral, a lender will have to acquire its borrower’s private key and transfer the crypto to a wallet the lender (or a third party trustee or custodian) solely controls. Alternatively, and more straightforwardly, control can be achieved under new 12-105(b) via a self-executing smart contract on the applicable blockchain (i.e., in which the pledged crypto is either automatically returned to the borrower at maturity or transferred to the lender’s wallet upon default).
Substantively, new Article 12 (12-104(e)) clarifies that the “take free” rule found in Article 8 (8-303) will protect “qualifying purchasers” of CERs—i.e., a purchaser who obtains control of a CER without notice of any adverse claim to or security interest in the CER will take the CER (and any controllable account receivable or promissory note debt it evidences) free and clear of any prior security interests.
These UCC amendments are being released following a handful of states’ (Wyoming, Kentucky, Idaho, and Tennessee) enactment of non-uniform statutes that attempt to define and regulate interests in digital assets. While timetables will vary from state to state, most state legislatures will likely adopt the amendments as proposed by the ETC.
The need for the amendments is readily apparent: significant and painful disputes over the relative rights of crypto lenders, borrowers, and depositors in the recent Chapter 11 bankruptcy filings of trading and lending platforms Voyager Digital and Three Arrows Capital are churning away with little or no statutory guidance in place. And the business models of existing crypto/NFT secured lending platforms like Arcade and BlockFi continue to be wholly dependent on the belief that self-executing smart contracts actually give lenders first priority security interests in crypto collateral.
As with any significant new legislation, the real-world interpretation and application of these UCC amendments by the courts will take some time to develop—time that will be tacked on to the TBA timeline for state-by-state enactment of the proposed amendments. In the meantime, digital asset secured lenders and borrowers will have to hunker down and continue to take stock of the risks inherent in this fast-evolving and technically intricate space.
The information provided in this client alert speaks only to the information and guidance we have available as of the date of publication and is subject to change. We will continue to follow further issued guidance and regulations and endeavor to post those updates via our website. Please continue to follow these updates at ulmer.com. This legal update was created by Ulmer & Berne LLP, and is not intended as a substitute for professional legal advice. Receipt of this client alert, by itself, does not create an attorney client relationship. For any questions, or for further information, please contact Stuart A. Laven, Jr. at email@example.com.