On July 13, 2022, the Uniform Law Commission approved the final draft of its joint proposal with the American Law Institute Emerging Technology Committee for amendments to the Uniform Commercial Code (UCC). These proposed UCC amendments aim at establishing ground rules for transferring property rights in certain digital assets — notably cryptocurrencies such as Bitcoin and Ether, stablecoins, and non-fungible tokens (NFTs) — and in particular setting up a regulatory framework to use such assets as collateral in secured transactions.
The meteoric rise of crypto-assets has been marred by regulatory uncertainty, hampering their broad adoption by traditional financial institutions and the general public. The UCC amendments look to respond to these market concerns by creating a new Article 12 governing the transfer of property rights in a new class of digital assets called controllable electronic records (CERs). The UCC amendments also modify Article 9 to clarify the procedures for attachment and perfection of security interests in CERs.
These UCC amendments must be enacted by each individual state to be effective in such state, and once completed will provide a uniform framework for dealing with security interests in crypto-assets as CERs.
UCC Article 12 and the importance of control
Article 12 defines a CER as a “record stored in an electronic medium that can be subjected to control,” which is intended to capture among other assets cryptocurrency, stablecoins, NFTs, and all crypto-assets generally. However, it specifically excludes electronic money, electronic chattel paper, electronic documents of title, and investment property. Technologically neutral language was deliberately used to ensure that this definition will encompass future digital technologies when applicable.
Under Article 12, the notion of control is the defining criterion of a CER. Control for and of a CER is established, pursuant to the new §12-105, where persons can demonstrate that they have the power to:
- Enjoy “substantially all the benefit" of the CER;
- Exclusively prevent others from enjoying “substantially all the benefit” of the CER; and
- Exclusively transfer control or cause another person to obtain control of the CER.
In determining whether a party has control over a CER, the amendments provide that fulfilling the last two conditions above creates a rebuttable presumption of control unless evidence of the contrary. In so doing, the notion of control, which somewhat parallels that of “possession” of tangible assets, is tied with the idea of exclusivity.
Interestingly, §12-105(b) contemplates that control can be achieved by using smart contracts — i.e., self-executing contracts where the terms of the agreement are set out in code — to automatically transfer the cryptocurrency between parties. The UCC amendments further provide that persons claiming control must be able to prove their control to a third party and this may be done by using cryptographic keys.
Similar to current UCC Article 2 governing sales and UCC Article 8 governing investment securities, UCC Article 12 implements the “shelter rule,” which provides that a purchaser of a CER would acquire whatever rights the transferor had or had the power to transfer. Purchasers that obtain control of a CER for value, in good faith and without notice of a property claim, would be deemed to be “qualifying purchasers” and would benefit from the take-free rule that would see them acquire the CER free from any adverse property claims.
UCC Article 9 on secured transactions
Amendments to UCC Article 9 largely focus on the new rules for the attachment of security interests in CERs. Specifically, they provide that a security interest in a CER may be perfected by control. While UCC Article 12 clarifies that the typical UCC Article 9 rules for attachment still apply and that a security interest in a CER may still be perfected by filing a financing statement, a security interest in a CER perfected by control will have priority. In other words, perfecting a security interest in a CER by control allows the secured lender to take first-rank priority. Practically, lenders to borrowers holding crypto-assets should aim to obtain control of the crypto-asset collateral by holding it in their own wallet or that of a third party for their interests such as a custodian or a trustee.
This general approach in incorporating crypto-assets under the secured transactions law framework is welcomed and aligns with our recommendation published in 20191 and reiterated in 20212. Given that control is the defining feature of a CER, it makes sense to use control as means to perfect a first-rank security interest. Indeed, perfection by control is the intangible analog to perfection by delivery, that is taking physical possession of the tangible collateral, and it confers the ability to exclude others from simultaneously benefiting from the CER. We expect these UCC amendments to reduce uncertainty between parties as to the priority of security interests in crypto-assets as well as to the valuation and realization of such security interests for lenders.
Further amendments to UCC Article 9 provide that an “account” or a “payment intangible,” as currently defined, embodied in a CER constitutes a “controllable account” or a “controllable payment intangible” respectively if the debtor has undertaken to pay the person that has control. Notably, an undertaking to pay the owner of a CER is different from an undertaking to pay the person that has control. Lenders dealing in accounts and payment intangibles that are evidenced by CERs must be careful to understand the specifics of these payment arrangements. The amendments to UCC Article 9 provide for similar security interest attachment and perfection rules for controllable accounts and controllable payment intangibles.
Finally, the amendments to UCC Article 9 provide some clarity on choice-of-law rules applicable to CERs. Applying old rules to new assets, the UCC amendments to choice-of-law provisions contemplate that the perfection, the effect of perfection and the priority of a security interest in a CER perfected by control is governed by the laws in which it is “located.” Under these amendments, a CER is located in the jurisdiction in which it is expressly stated to be located. When no jurisdiction is expressly stated, the applicable jurisdiction is that of the system in which the CER is recorded. If the system itself does not specify the jurisdiction, the CER is deemed to be located in Washington, DC, and its law applies by default. Lenders should note that when a security interest in a CER is perfected by filing instead, local law of the jurisdiction in which the debtor is located governs perfection only, but not priority.
Conclusion
In summary, UCC Article 12 establishes a new class of assets called CERs that are essentially defined by the notion of control. Under the amended UCC Article 9, a security interest in CERs can be perfected either by filing a financing statement or by control, but only the latter creates a first-rank priority. The amendments further provide that a CER will be subject to the jurisdiction in which it is located and alternatively where it is recorded.
Certainty is provided to qualifying purchasers by ensuring that they acquire CERs free from any prior security interest. There are also further minor amendments relating, among other things, to the custody and ownership rights of CERs in case of insolvency or bankruptcy at UCC Article 8, and to hybrid transactions involving both the sale/lease of goods and contracts for services at UCC Articles 2 and 2A.
To ensure a smooth transition, the UCC amendments contemplate a one-year adjustment period after going into effect, which will ensure that secured creditors can continue to hold or take steps to acquire the best priority possible in their collateral. It is important to note that the UCC amendments exclusively deal with state laws and do not address the federal regulation of digital assets, and as such will have to be enacted in every single state to take effect in all state jurisdictions.
As of this article, Iowa, Indiana, Nebraska, and New Hampshire have adopted legislation to give effect to these UCC amendments. Other states such as Idaho, Kentucky, Wyoming and Tennessee have enacted their own non-UCC amendments aimed at regulating the transfer of digital assets.
This new UCC framework will bring greater certainty to digital asset transactions. At the same time, questions remain as to how crypto-assets, either subject to a perfected security interest or benefitting from the custody protection for “financial assets” under UCC Article 8, would be handled during bankruptcy. Additionally, it remains uncertain how choice-of-law provisions will be interpreted and applied when dealing with global virtual systems. Players in the crypto space would be wise in the meantime to engage in exhaustive due diligence before entering new transactions and maintaining rigorous conventional structures that clearly specify the rights of involved parties.
The article was co-authored with Carl Farah.
