The impact of the Uniform Commercial Code 2022 Amendments on lenders
From the Altair 8800 produced by Micro Instrumentation and Telemetry Systems in 1975, widely regarded as the first personal computer, technological advances over the past half-century have occurred rapidly. From supercomputers to smartphones, and from combustion engines to electric, self-driving vehicles, each technological advance has affected our global population immeasurably. Digital assets are presenting a similar impact globally, both with respect to the potential wealth such assets can afford its owners, and also the opportunity the digital assets may provide for purposes of a new “asset class” under the Uniform Commercial Code (the UCC), which this article surveys.
Developing technologies in the digital asset space, including, but not limited to, cryptocurrency, non-fungible tokens, artificial intelligence, and other forms of blockchain-based assets, have resulted in the creation of a new asset class for individual and business investors. Although the value of such assets fluctuates rapidly based on market conditions, their creation have made clear that a void existed under the UCC with respect to transference and perfection. With the introduction of newly-adopted UCC Article 12 and requisite amendments to UCC Article 9 and others Articles (the 2022 Amendments), the Uniform Law Commission and the American Law Institute presented a structure for which such assets can be transferred free and clear, and in which a party can properly perfect its security interest in the assets. This newly adopted framework accommodates the unique characteristics of these assets, which did not fit neatly within the existing categories of property under the previous UCC. To date, the 2022 Amendments have been adopted by 25 states.
Among other things, the 2022 Amendments provide rules for transfers of “Controllable Electronic Records” (as defined below), or “CERs” in short-form parlance, to buyers and secured parties. Pursuant to the 2022 Amendments, a secured party that obtains “control” of a CER has priority over another secured party that does not have control.
CERs are “record(s) stored in an electronic medium that can be subjected to control under Section 12-105.” UCC § 12-102(a)(1)). Therefore, to qualify as a CER, the following must be present: (1) a CER must be a “record”; (2) the record must be electronic; and (3) the electronic record must be “controllable.” The UCC defines a “record” as information stored in some manner and retrievable in perceivable form. UCC § 1‑201(b)(31). “Electronic” is defined as “relating to technology having electrical, digital, magnetic, wireless, optical, electromagnetic, or similar capabilities.” UCC § 1-201(b)(16A). Examples of assets constituting CERs are virtual currency, such as Bitcoin, in addition to non-fungible tokens, or NFTs, and other digital assets with embedded payment rights, assuming such assets are “controllable.” Further, the 2022 Amendments, and specifically the definition of a CER, considers the likelihood that there is presently undeveloped technology that would be considered a CER in the future. Conversely, certain assets, while electronic records, would not constitute CERs, including, for instance, “transferable records” under the Electronic Signatures in Global and National Commerce Act (E-SIGN) or the Uniform Electronic Transaction Act (UETA).
In order to assert control of a CER, one must have the power to obtain “substantially all the benefit” of the CER. UCC § 9-105(A). Additionally, one must have the exclusive power to prevent others from enjoying “substantially all the benefit of the CER”, in addition to the exclusive power to transfer control of, or to cause another party to obtain control of, the CER. UCC § 9-105(B)(i) and (ii). The 2022 Amendments presume that a party that has such dominion possesses “control” exclusively.
One who asserts control of a CER pursuant to the above-described steps, possesses a security interest in the asset superior to others’ interests. With respect to the corresponding amendments to Article 9, specifically the attachment of a security interest in a CER, “control” is the overarching concern. Although it is still possible for a party, including a secured lender, to perfect a security interest in a CER through the filing of a financing statement, if another party maintains “control,” such party will possess a security interest superior to that of the party filing the financing statement. UCC § 9‑326A. In that respect, one of the primary goals for secured lenders is to ensure “control” of the virtual assets is taken. One manner for obtaining control is a secured lender holding the virtual assets in the lender’s own digital “wallet” (generally, a system or application that stores payment information) in which access is limited to the lender. If the secured lender does not have the requisite technology in place, the secured lender could seek to outsource to a third-party custodian to hold the digital assets; however, the secured lender is necessarily limited to the services provided, and capabilities of, the outsourced third-party.
A party who purchases a CER acquires all rights in the CER that the transferor has, or had, the power to transfer. UCC § 12‑104(d). Further, a “qualifying purchaser” takes its interest in a CER “free” of any property claim. UCC § 12‑104(e). A “qualifying purchaser” is a party who: (1) acquires a CER in a transaction that constitutes a “purchase”; (2) maintains control of the CER; (3) gives value; (4) acts in good faith, and (5) does not have notice of a claim of a property right in the CER. UCC § 12-102(a)(2).
In the context of restructuring, the concept of claim priority refers to the legal hierarchy that determines the order in which creditors are paid from the assets of a debtor, especially in bankruptcy or insolvency proceedings. This order is crucial because, typically, there are not enough assets to fully satisfy all creditors, resulting in some receiving payment before others based on their priority status. Under UCC Article 12, a lender who has established control over cryptocurrency generally has priority over other parties who have not established control, including parties that have earlier perfected their security interest only by filing a financing statement. To determine priority, one must look to the applicable law governing the CER because the law of the jurisdiction that governs a CER generally also governs the perfection, effect of perfection (or lack thereof), and priority of a security interest in a CER. Because CERs have no physical location, the 2022 Amendments allow parties to a CER transaction to choose the governing law that applies to their transaction and incorporate the choice of law into their CER or the system in which the CER is recorded. UCC § 12‑107(c). If the CER’s jurisdiction is not specified in the CER, the system in which the CER is recorded, or a record logically associated with the CER, the CER’s jurisdiction will be deemed to be the District of Columbia. UCC § 12 107(c). However, when determining which jurisdiction’s law applies when a CER has been perfected by the filing of a financing statement, one must look to the law of the location of the debtor, pursuant to UCC Article 9. UCC § 9 306B(b). With that said, in such situation, the effect of perfection (and nonperfection) and the priority of the security interest still is governed by the CER’s jurisdiction. UCC § 9 306B.
Disputes may arise over which party's interest is superior if multiple creditors claim control. Therefore, lenders must be prepared to defend their claims in court, which requires thorough documentation and a clear understanding of how control was established and maintained.
To protect its priority interests, a lender or other interested party should ensure that the virtual assets in which they claim an interest are properly safeguarded. As noted above, this might include holding the virtual asset in the lender’s own digital wallet or by engaging third-party custodians who specialize in digital assets to hold and manage the private keys securely. (A party may have control through another party if the other party acknowledges that it has control on behalf of the first party. UCC § 12‑105(e). Therefore, the custodians should provide contractual assurances that the lender maintains exclusive control over the virtual currency.)
In addition, lenders should regularly monitor their virtual currency possession by establishing mechanisms such as periodic audits or technologic checks to confirm that the private keys have not been compromised or transferred. Maintaining thorough documentation to demonstrate how control was established and is being maintained is also important. Such documentation may include agreements with third-party custodians, evidence of possession, and activity logs and records of any access or transaction involving the currency. Lenders should also ensure that loan agreements include specific provisions outlining how such control over virtual currencies will be maintained, transferred, and verified. Further, loan agreements should establish clear remedies for default, including defining what constitutes a default relative to virtual currency control and outline the lender’s rights and remedies, including the right to immediately seize or liquidate the virtual currency.
Going forward, litigation may arise regarding parties’ assertion of “control” over the CER, including disagreements with respect to parties’ assertion of power and exclusivity. Litigation also may arise involving the determination of which jurisdiction’s law applies, the general priority of competing parties’ interests in CERs, and relatedly whether security interests were properly and timely attached and perfected, among other issues.
McDonald Hopkins is continually following and synthesizing the latest UCC issues, and we possess the expertise to guide our clients through the unique operational issues our clients may face. For guidance on managing and protecting your enterprise’s emerging technology assets, please contact one of the McDonald Hopkins attorneys with whom you have a relationship or reach out to John Polinko or Jory Berg.
