The Cryptic Case of Cryptocurrency Security Interests: Have You Properly Perfected Your Interest In Cryptocurrency And Blockchain-Based Assets?
As cryptocurrency, tokens and other blockchain-based assets, including so-called smart contracts (“Digital Assets”), begin to represent more substantial value on corporate balance sheets, lenders will inevitably begin to see these assets pledged as collateral to secure debt investments. Like other assets pledged as collateral, secured lenders will want a properly perfected security interest in any Digital Asset collateral so that (1) such Digital Asset may be foreclosed on or sold upon a default of the debtor without seeking judicial remedies and (2) the lender has priority with respect to the Digital Assets over the claims of unperfected and unsecured creditors. However, unlike other assets, the law governing secured transactions is not well-established for Digital Assets.
Perfection
Perfection of security interests in personal property is generally governed by Article 9 of the Uniform Commercial Code (“UCC”) and the particular method of perfection depends on how the asset is characterized under UCC Article 9. Article 9 does not expressly address Digital Assets given their relative nascency as an asset class and use as collateral. Limited exceptions currently exist in only Rhode Island and Wyoming.[1] As a result, lending against Digital Assets is an area rife for missteps for the unwary secured lender.
Because Digital Assets are not expressly characterized under Article 9 (at least as it exists today), one must determine which existing Article 9 category is the best fit. However, the nature of Digital Assets may vary greatly, and any Digital Asset’s characterization under UCC Article 9 will ultimately depend on the particular Digital Asset’s attributes. For example, a Bitcoin may ultimately be characterized as differently than a token issued by a start-up in its initial token offering. The below chart is a summary overview of the most likely UCC Article 9 asset characterizations for Digital Assets.
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UCC Asset Characterization
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UCC Definition or Description
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Factors or Arguments in Favor
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Factors or Arguments Against
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Method of Perfection
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“Account”
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A right to payment for services or property (UCC 9-102(a)(2))
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To the extent that a Digital Asset represents a right of the holder to payment from the issuer in some other medium, such Digital Asset could fit into this definition. An example is a claim against a digital currency exchange for an amount of digital currency maintained in a wallet on that exchange.
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Digital Assets that function as stores of value (like Bitcoin) may not be considered a right to payment but potentially payment itself.
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UCC-1 Filing
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“Deposit Account”
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An account maintained with a “bank” (UCC 9-102(a)(8) and (29))
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Certain Digital Assets could fit into definition if they are deposited with “banks”.
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At present, Digital Assets are more commonly held in a wallet on an exchange or by the issuer of such Digital Asset and unlikely to be maintained with a “bank” as defined in the UCC[2], ruling out this characterization in many instances.
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Control
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“General Intangible”
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Any personal property, including things in action, other than accounts, chattel paper, commercial tort claims, deposit accounts, documents, goods, instruments, investment property, letter-of-credit rights, letters of credit, money, and oil, gas, or other minerals before extraction. The term includes payment intangibles and software. (UCC 9-102(a)(42))
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Catch-all for any Digital Assets that may not be clearly characterized as any other type of asset under the UCC. The innovative and unique nature of many Digital Assets preclude neat characterization into an existing Article 9 asset characterization so most may end up in this catch-all category.
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This categorization does not apply where the Digital Asset at issue falls into another category. For example, a token that is a security and, therefore, investment property, is not a general intangible.
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UCC-1 Filing
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“Instrument”
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A writing evidencing a right to the payment of a monetary obligation that is transferred by delivery (UCC 9-102(a)(47))
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A classic example of an instrument outside of the fintech context is a promissory note. Certain tokens that represent a right to payment from the issuer particularly where possession of the token transfers the right to such payment may arguably be characterized similarly to notes.
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Typically instruments are tangible. Moreover, not all Digital Assets represent monetary obligations (e.g. Bitcoin or a token that may not be exchanged for money).
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UCC-1 Filing
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“Investment Property”
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A security,[3] security entitlement,[4]securities account,[5]commodity contract,[6]or commodity account[7] (UCC 9-102(a)(49))
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Under the UCC provision adopted in Rhode Island and Wyoming, cryptocurrency maintained on a licensed exchange would be a “financial asset” maintained in a “securities account”, giving the debtor a “securities entitlement”.
Digital Assets that are an obligation of an interest in an issuer (like stocks) could be characterized as “Investment Property”. According to the SEC, tokens are most likely securities.[8]
The CFTC has ruled that certain Digital Assets are commodities and can be regulated as a retail commodity.[9]
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The SEC has stated that Digital Assets like Bitcoin are not securities.[10]Moreover, Digital Assets that are decentralized and don’t have an issuer or central enterprise may not be considered “Investment Property”.
Many Digital Assets probably do not involve a commodity intermediary or commodity contract because the UCC defines “commodity contracts” as being traded on or subject to rules of board of trade, significantly narrowing the category.
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Control or UCC-1 Filing
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“Money”
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A medium of exchange currently authorized or adopted by a domestic or foreign government” (UCC 1-201(b)(24))
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FINCEN has called cryptocurrencies “currency” for purposes of anti-money laundering laws.[11]
The U.S. District Court for the Southern District of New York has held that cryptocurrency transactions can be the foundation of a money laundering charge under federal law.[12]
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While cryptocurrency has been characterized as currency or funds governing application to different laws, Digital Assets are unlikely to be characterized as “money” for purposes of Article 9 because, so far, no government has adopted cryptocurrency as its currency (although it is not out of the question that some may do so in the future).
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Possession
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While the law on perfecting security interests in Digital Assets is new and relatively untested, lenders can still utilize best practices to ensure that any Digital Asset collateral securing their investments are protected. At a minimum, lenders should file a UCC-1 financing statement with respect to any Digital Asset collateral. Filing a UCC-1 financing statement properly perfects several asset types, including accounts, instruments, certain investment property assets as well as general intangibles, including contract rights. In addition to perfection by filing, lenders should also consult with counsel to discuss other possible asset characterizations based on the attributes of the particular Digital Asset at issue to determine whether other perfection methods are necessary or desirable. Given the developing legal landscape surrounding Digital Assets, it is highly advisable to consult with counsel to assess other potential issues implicated by Digital Assets.
Diligence
A potential implication of characterizing a Digital Asset as a general intangible in which a security interest is perfected by a UCC-1 financing statement with a Secretary of State is that each subsequent transferee on a blockchain could be subject to a security interest granted by a prior owner of the Digital Asset (at least for a period of a few months)–unlike an asset characterized as money for which subsequent transferees take free and clear. However, there may be no way for a potential lender to conduct the right diligence to confirm whether this is an issue.
With other types of assets acquired by the borrower, a potential lender could simply conduct a UCC search using the name of the prior owner to confirm whether that transferor had any of its own secured creditors on record. But one of the primary characteristics of Digital Assets is their anonymity. One would not know the name of the prior Digital Asset owner to use in any UCC search–only the public key associated with the Digital Asset, which is not currently a search option. As a result, a potential lender conducting diligence of its potential collateral may not be able to ensure that it would be in a first priority position with respect to Digital Assets until the borrower has held those Digital Assets long enough for any prior liens to have lapsed.
Enforcement
Transfer of cryptocurrencies often can only be accomplished by possession of a private key associated with a particular Digital Asset. In order to foreclose on a security interest in cryptocurrency collateral, a secured creditor would need access to that private key. Such level of cooperation on the part of the debtor may not be so readily forthcoming during a foreclosure process so secured creditors should consider what steps to add to their list of conditions at the initial closing in order to facilitate the exercise of their rights and remedies in the future at any time after an event of default has occurred.
One option may be to take possession of the private key upfront. That option may not be palatable to either the borrower who may retain the right to use the asset (similar to a borrower not handing over possession of all of its cash to a lender upon a loan closing) or to a lender who does not want to bear the risk of loss of the private key.
An alternative, more feasible arrangement may look similar to deposit account control agreements, source code escrows, and collateral access agreements, whereby the exchange or other custodian that maintains “possession” of the cryptocurrency either holds a copy of the private key in escrow for the creditor or simply agrees in advance to comply with the creditor’s instructions upon notice from the creditor that the borrower has defaulted.
Accordingly, even if a UCC-1 financing statement is the appropriate method of perfecting a security interest in a cryptocurrency, secured creditors should consult with their advisors to ensure that they have a practical means of enforcing that security interest.
Jennifer Taylor is a partner in O’Melveny’s corporate finance and restructuring practice groups based in San Francisco. Herman Cheung is counsel in the firm’s corporate practice.
