In July 2013, the market cap of Bitcoin, the largest and most widely recognized cryptocurrency, stabilized at just over $1 billion – growth in excess of 1,000% from the prior year. In July 2023, Bitcoin’s market cap oscillates around the $600 billion mark, dwarfing its market cap from a decade prior as it recovers from a precipitous fall from a peak of more than $1.2 trillion in November 2021. Digital assets such as cryptocurrencies and non-fungible tokens have, thanks to their recent and meteoric rise in value and notwithstanding their generally high volatility, become a significant source of collateral in financing transactions and a prevalent asset in purchase transactions.
Despite their digital and intangible nature, digital assets constitute “property” under the Uniform Commercial Code (UCC). As such, sellers, purchasers, borrowers and lenders have applied the existing provisions of the UCC as best they could to address transactions involving sales and transfers of, and security interests in, these digital assets. The UCC, as in effect in the majority of states in July 2023 (the current UCC), however, is inadequately suited to address certain of these transactions, resulting in inconsistency in transaction structures and questions regarding transfers of rights and whether liens in these assets are properly perfected. The increasing adoption of digital assets has also caused unforeseen complications in the already murky treatment and classification of these assets under the current UCC. El Salvador and the Central African Republic, for example, have adopted Bitcoin as official legal tender, which would cause Bitcoin to be reclassified from a general intangible to “money” under the UCC, thus rendering previously sufficient financing statements ineffective to perfect a secured party’s security interest in Bitcoin.1
Overview of UCC Article 12
In July 2022, the Uniform Law Commission (ULC) approved and recommended for enactment amendments to the current UCC to address the issues stemming from transactions that involve digital assets and electronic records, specifically those that are susceptible to control and not already adequately addressed by the current UCC. These digital assets and electronic records are referred to as controllable electronic records (CERs) under the amendments to the UCC, which are commonly and colloquially referred to as “UCC Article 12” due to the addition of a 12th article to the UCC. Still, these amendments modify nearly every other article of the UCC as well, including substantial revisions to Article 9. These amendments answer fundamental questions that arose from the recent prevalence of CERs:
- Which types of digital assets constitute CERs, and which types remain general intangibles or another class of property under the UCC?
- A CER is a record that (i) is stored in an electronic medium and (ii) can be subjected to control. A CER specifically is not a controllable account, a controllable payment intangible, a deposit account, an electronic copy of a record evidencing chattel paper, an electronic document of title, electronic money, investment property or a transferable record.
- How does a secured party perfect its security interest in CERs?
- A secured party may perfect its security interest in a CER by either filing a financing statement or obtaining control over the CER under Section 12-105 of the UCC, but it is strongly advised to obtain control, as, consistent with the UCC’s treatment of other “control vs. filing” priority constructs, a party with control over the CER has priority over a party that perfects its security interest by simply filing a financing statement.
- Control of a CER is established when the electronic record (a record attached to or logically associated with the electronic record) or a system in which the electronic record is recorded:
- (i) gives the secured party (a) power to avail itself of substantially all2 the benefit from the electronic record; (b) exclusive power to prevent others from availing themselves of substantially all the benefit from the electronic record and (c) exclusive power to transfer control of the electronic record to another person; and
- (ii) enables the secured party readily to identify itself in any way, including by name, identifying number, cryptographic key, office or account number, as having the powers specified above.
- How does a secured party enforce and protect its perfected lien against third parties, including bona fide purchasers?
- UCC Article 12 contains a “take-free rule” like those found in Articles 3 and 8 with respect to holders of negotiable instruments and purchasers of securities. UCC Article 12 provides that if a secured party or good faith purchaser of a CER obtains control without notice of a competing property right, it will acquire rights in the CER free of any competing property rights that may exist in that CER.
- Only a person3 who establishes control of a CER qualifies as a qualifying purchaser under the take-free rule discussed above. Accordingly, owners and secured parties who properly establish exclusive control of a CER minimize their risk of losing their interest in the CER under the take-free rule.
As of July 12, eight states have enacted the UCC Article 12 amendments and 20 other states and the District of Columbia have introduced bills to adopt the same.4 While many legal practitioners were optimistic about the rate at which each state would introduce and adopt UCC Article 12, certain media commentators and then lawmakers raised concerns about the treatment and definition of “money” in the amendments, which resulted in certain states making non-uniform modifications of the definition of money, following which the ULC created a “hip pocket” amendment to the originally proposed UCC Article 12 amendments to assuage these concerns.5
As more states adopt these revisions to the UCC, the reduction in legal risk stemming from the uncertainty of the treatment of digital assets under the UCC, coupled with the recent rally of the value of cryptocurrencies and other digital assets, may provide a much-needed source of collateral relief in tightening debt finance and M&A transactions.
Potential Issues and Questions for Transactions Going Forward
While a secured party’s establishment of control over deposit and securities accounts, negotiable instruments and certificates representing securities has become commonplace in the finance space, will debtors push back on a secured party establishing control of digital assets such as cryptocurrencies? One feature of these assets is the anonymity and independence that a decentralized currency stored on an electronic medium can offer. How much does an owner’s grant to a third party of access to these assets undermine the value of those assets to their owner? While several proffered methods exist for a secured party to obtain control over a CER involving third parties and control agreements, smart contracts and escrows, a secured party may also obtain control over the CER by receiving the private key to the CER. Any party with the private key to the CER has de facto ownership of that CER. Will debtors trust secured parties with the safekeeping of private keys, or will an alternate method become the preferred means of a secured party obtaining control? Additionally, what regulatory and compliance controls, particularly with respect to the safekeeping of means of control, use of proceeds and anti-money laundering regulations, must be established on the secured party’s side prior to digital assets becoming ubiquitous in financing and M&A transactions?6
An important business and valuation consideration also stems from the volatility of digital assets and assets related to or dependent on them. Common transaction features such as post-closing purchase price adjustments and earn-outs, which include the value of digital assets in the valuation formula, could significantly increase the range of a potential post-closing payment or refund. Further, the appetite for secured parties to lend against digital assets and tangible assets related to digital assets – coin mining equipment, for example – is unlikely to approach that for more established assets such as securities and traditional goods and equipment.
In conclusion, while issues will most certainly arise as states continue to adopt UCC Article 12 and digital assets become more widely adopted in the market, the proposed amendments to the UCC provide much-needed clarity, a road map to consistency and a reduction in legal documentation risk in transactions involving digital assets.
1 Under UCC §9-310, a filed UCC-1 financing statement is sufficient to perfect a security interest in general intangibles. Under UCC §9-313(b)(3), however, a security interest in money may only be perfected by the secured party’s taking possession (via actual possession) of the money. Accordingly, the reclassification of Bitcoin from a “general intangible” to “money” under the UCC changed the means by which a secured party may perfect its lien against Bitcoin.
2 The concept of “substantially all the benefit” of a CER is a somewhat sticky subject – certain rights, e.g., the ability to spend digital currency, may be limited based on how the CER is recorded. In determining whether a person has the power to avail itself of substantially all the benefits from a CER or to prevent others from availing themselves of substantially all the benefits from a CER, only the benefit that the system makes available (subject to the system’s inherent limitations) should be considered.
3 Under the UCC, a “person” means an individual, corporation, business trust, estate, trust, partnership, limited liability company, association, joint venture, government, governmental subdivision, agency or instrumentality, public corporation or any other legal or commercial entity.
4 Colorado, Indiana, Iowa, Nebraska, Nevada, New Hampshire, New Mexico, North Dakota and Washington have adopted the amendments, and Alabama, Arizona, Arkansas, California, Delaware, the District of Columbia, Hawaii, Kentucky, Louisiana, Maine, Massachusetts, Missouri, Montana, New York, Oklahoma, Rhode Island, South Dakota, Tennessee, Texas and West Virginia have introduced the amendments. Legislative bill tracking may be found at https://www.uniformlaws.org/committees/community-home?communitykey=1457c422-ddb7-40b0-8c76-39a1991651ac#LegBillTrackingAnchor.
5 While not all states adopted the precise language found in the “hip pocket” amendment, the general theme of the amendment has been to (i) exclude electronic forms of “money” from the definition of “money” under the UCC; (ii) eliminate the concept of “electronic money”; (iii) revert related means of perfecting a lien against money to actual possession and (iv) exclude central bank digital currencies of any type and issued by any government from qualifying as “money” under the UCC.
6 Privacy and control concerns have also been raised in connection with the implementation of the Corporate Transparency Act’s requirement for reporting information about the beneficial owners of all U.S. business entities following the Financial Crimes Enforcement Network’s (FinCEN) issuance of proposed regulations to implement the Corporate Transparency Act. Owners of U.S. business entities are seeking to protect identities by limiting who may access the beneficial ownership information that FinCEN will be collecting.
Meet the Author
Lisa Jacobs has extensive experience representing businesses and institutions on domestic and international transactional matters. For more than 30 years, Lisa has served as an advisor to both private and public companies in a wide variety of industries on matters related to mergers and acquisitions, corporate finance, institutional and private equity financings, securitization and structured finance and corporate governance issues.