The NFTs Market
Imagine a firm that is in the business of “minting” and selling non-fungible tokens (NFTs), such as Dapper Labs or Yuga Labs. Though there is no universally accepted definition of NFTs, they can be broadly described as digital assets that are uniquely identifiable and one of a kind within a specific system. NFTs are widespread in distributed ledger technology (DLT) networks, such as Ethereum, Solana, Avalanche, and many others.
NFTs have found broad adoption in a variety of business endeavors. The prevailing use case for NFTs is associated with the concept of tokenization. This is the process whereby a person creates an NFT and asserts that it represents specific tangible or intangible property, such as a painting, a rare car, a digital image, or an ownership interest in a company. Alternatively, the NFT can be presented as entitling its holder with the right to receive a service, such as access to a concert or other event. In principle, the innovative commercial proposition is that the NFT acts as unique digital indicator and identifier for property or services to which it is purportedly linked.
There are presently two primary models for tokenizations: intermediated and disintermediated.
Intermediated tokenization is prevalent in the high-volume, low-value NFT market. Under this model, individuals create and sell NFTs relying on online platforms such as Rarible, SuperRare, Foundation, or Mintable. It’s a process that involves several steps, which can be delineated as described below.
First, an individual establishes an account on a minting platform and links it to the individual’s digital wallet, enabling the transmission and receipt of funds for NFT minting and subsequent sales. Leveraging the interface of the minting platform, the individual uploads a digital image, text, or musical composition that purportedly will be linked to the individual’s soon-to-be-minted NFT. At this stage, the individual also selects a preferred method of monetizing the NFT, typically via a direct sale or an auction.
Second, the platform executes two core functions: minting the NFT and generating a dedicated web page devoted to this token. To accomplish the former, the minting platform typically relies on a smart contract executed on a DLT network of choice. The web page showcases the uploaded content—i.e., the digital image, text, or music—alongside any other information provided by the individual creating the NFT.
Third, both the minting platform and the NFT originator actively endeavor to attract prospective purchasers through various means, including targeted advertising via social media and other relevant channels. Once a buyer emerges, the minting platform assumes the role of an intermediary, facilitating payment processing and effectuating the transfer of the NFT. The material execution of this final step might differ depending on the technological structure adopted by the platform.
In most cases, the NFT will be transferred to a wallet cryptographically controlled by the buyer. Alternatively, the NFT might remain in an omnibus wallet controlled by the platform if both the creator and buyer of the NFT have accounts on the platform itself. This is not dissimilar to how banks manage fund transfers when counterparties both have accounts at that institution.
The other tokenization model is disintermediated. This approach has been utilized by notable artists and corporate issuers—including Pak (Merger NFT), Beeple (Everydays: the First 5000 days), Yuga Labs (Bored Apes), and Dapper Labs (Top Shot)—particularly in high-value NFT transactions. Under this model, the issuer directly mints the NFT by executing a smart contract either on a major public DLT system, such as Ethereum, or a private one under its control, such as Dapper Labs’ Flow Blockchain. Subsequently, each NFT is associated with a specific asset, typically a creative work in digital format such as an image, video, or music file. The connection between each NFT and its corresponding creative work usually involves storing the relevant digital content on internet-connected servers and then hyperlinking each NFT to a specific creative work.
Once minted, the NFTs are offered to the buying public either by the issuer or through specialized intermediaries, including renowned auction houses such as Christie’s, Sotheby’s, and Phillips. In addition to the NFT itself, the issuer may offer supplementary services or accompanying assets. For example, regarding the Bored Apes NFT collection, Yuga Labs granted the original purchasers and subsequent buyers a worldwide license to utilize the images connected to their token. However, it is noteworthy that artists such as Beeple have successfully auctioned their NFTs while neither granting to purchasers a license to the specific creative work in question nor transferring the relevant copyrights.
With that background, let us focus on the disintermediated tokenization model. For corporate issuers utilizing this approach, NFTs may very well be the principal means by which they generate earnings. The question then becomes this: how might a lender go about obtaining a floating lien over this crypto inventory?
Crypto Inventory Financing
Assume that a corporate issuer of NFTs wishes to use these digital items as collateral. These businesses hold NFTs out for sale. In a practical sense, these assets are the issuer’s inventory. Under Article 9, however, inventory is a defined term that only encompasses “goods” and other tangible movables held out by a person for sale or to be furnished as a service. As NFTs are intangible personal property, Article 9 classifies them as general intangibles. As we explain below, the 2022 UCC Amendments reshape the regime to create a floating lien over crypto inventory.
NFTs as Controllable Electronic Records
The 2022 UCC Amendments create a new collateral subcategory under the UCC’s definition of general intangible: the controllable electronic record (CER).
A CER is “information that is stored in an electronic or other medium and is retrievable in perceivable form” and that is susceptible to control. Importantly, the definition is based on the ability to take control of the record. Control entails satisfaction of a three-part test: the person claiming control must have the power to (i) enjoy “substantially all the benefit” of the CER, (ii) prevent others from enjoying “substantially all the benefit,” and (iii) transfer control to another. Lastly, the person claiming such control must be able to demonstrate to a third person that all three parts of the test are met.
As generally implemented in prominent DLT networks, such as Ethereum, Solana, and Avalanche, NFTs meet the definition of a CER. In these systems, NFTs are data entries stored in a distributed database and, thus, constitute “information that is stored in an electronic or other medium and is retrievable in perceivable form” in the eyes of the UCC. Moreover, the cryptographic infrastructure implemented in DLT networks enables a person to have dominion over and dispose of NFTs in a manner that satisfies the “control” requirements. For example, on Ethereum, a person can control an NFT thanks to the public/private key cryptography adopted by this network. Through their private key, an individual has the power to interact with an NFT, enjoying all of its benefits (whatever those might be), and to prevent all others from interfering. This same technology also enables that individual to completely divest themselves of those powers by transferring them to someone else. Finally, public/private key cryptography also enables an individual to identify themselves as being in control of a determinate NFT through their digital signature.
Creating and Perfecting a Floating Lien over Crypto Inventory
The 2022 UCC Amendments forge a new framework for taking security in CERs, including crypto inventory. Regarding attachment, prospective secured lenders have two avenues when using crypto inventory as collateral.
First, as CERs are a subset of general intangibles, a security interest that is enforceable between the parties can be created with a “signed” agreement that adequately describes the collateral. Notably, the 2022 UCC Amendments have moved past the word authenticated. For NFTs, a clause stating that the collateral comprises “all debtor’s present and future general intangibles” or “all debtor’s present and future CERs” would be effective; there would also be no obstacle to a narrower description focused on the tokens in question, such as “all NFTs minted by the debtor,” and possibly also specifying the relevant DLT network, smart contract, and cryptographic identifiers.
The second avenue to create a security interest in crypto inventory leverages the concept of control. Dispensing with the requirement of a signed security agreement, the 2022 UCC Amendments provide that a security agreement can be created between a debtor and creditor if “the collateral is . . . controllable electronic records . . . and the secured party has control under Section . . . [12-105] . . . pursuant to the debtor’s security agreement.” Extending to CERs the rules previously available for deposit accounts, electronic chattel paper, investment property, and letter-of-credit rights, the 2022 UCC Amendments recognize that taking control of CERs adequately evidences what collateral the parties objectively intended to encumber.
The 2022 UCC Amendments also introduce a novel regime for the perfection of security interests in CERs that further cements the prominent role of control. As with all types of collateral, a creditor can perfect a security interest in crypto inventory by filing a financing statement in the relevant registry, just as it could before the new rules came into effect. However, the 2022 UCC Amendments also provide that a creditor can perfect a security interest in CERs by taking control of these assets. A creditor can also obtain control through a third party who acknowledges that it has or will obtain control on the creditor’s behalf.
For example, a creditor could perfect a security interest in an NFT by having the debtor transfer the NFT to the creditor. This can occur by associating the NFT on the relevant blockchain with the creditor’s public key, rather than the debtor’s key. Other methods are also available, such as using specific NFT metadata configurations or escrow-like software structures (often referred to as multisignature smart contracts) that require the creditor to consent using its own private cryptographic key prior to the NFT being transferred by the debtor. The broad, functional character and flexibility of the notion of control is one of the most significant value-adds of the standards-based framework erected by the 2022 UCC Amendments: it allows parties to deploy whatever technology might be available at a given point in time to achieve control. This approach reflects the explicit intent of the UCC drafters to be technologically neutral and to accommodate future types of CERs.
Lien Priority and “Take Free” Considerations
Crypto financiers will likely want to achieve perfection by control for yet two more reasons.
First, the 2022 UCC Amendments introduce a non-temporal priority rule to rank competing security interests over CERs. Specifically, a secured creditor who perfects by control “has priority over conflicting security interests held by a secured party that does not have control.” Adopting the same approach historically adopted by the UCC for the priority regime applicable to deposit accounts and investment property, the 2022 UCC Amendments recognize a preference for secured creditors who have direct dominion over the encumbered collateral.
The second reason why crypto financiers will want to take control of encumbered CERs stems from the “take free” regime introduced by the 2022 UCC Amendments for these assets. Under these rules, a person who acquires a CER for value, in good faith and without notice of any conflicting property claims, is deemed a “qualifying purchaser” and, as such, takes it free from any preexisting property claims. The 2022 UCC Amendments draw heavily from the UCC Article 3 provisions for negotiable instruments, and these provisions have the effect of making CERs negotiable. It follows that if a secured creditor obtained a security interest in CER inventory and only perfected by filing, that creditor would be at risk of the debtor disposing of the collateral and transferring control to a qualifying purchaser that would take it free from any competing claim.
The Mechanics of Controlling Crypto Inventory
With that foundation, now consider how a floating lien under Articles 9 and 12 could be achieved over all of a debtor’s crypto inventory. Recall that our debtor is a corporate issuer of NFTs who routinely creates and then sells NFTs to the public. Attachment could be achieved through a security agreement describing the collateral as either the debtor’s general intangibles (taking a broad approach) or all of the debtor’s NFTs in a determinate DLT network (being more specific). The security agreement could also include an after-acquired property clause so as to encumber preexisting NFTs and those that would be minted in the future, as well as a present and future indebtedness clause when describing the secured obligation.
As to perfection, the creditor should file in the relevant registry but also take control of the collateral. There are a few different ways control could be achieved, but here we describe the two simplest ways. The corporate issuer and the creditor would agree that all newly minted NFTs should be immediately associated with the creditor’s public cryptographic keys on the relevant blockchain—not those of the debtor. In other words, all new NFTs should be held in the creditor’s digital wallet, not the debtor’s. Alternatively, the creditor and the debtor could agree that all newly minted NFTs should be held through a multisig smart contract that would be directly or indirectly governed by the secured creditor, in a manner that satisfies the statutory requirements for control.
This transactional structure would create a floating lien over all of the debtor’s crypto inventory. Whenever the debtor desires to sell an NFT, the creditor would have to approve the transfer. In turn, the debtor would transfer to the creditor whatever portion of the funds received from the sale that the parties had agreed to. This arrangement would, of course, involve some monitoring costs, but such expenses would be significantly lower than those associated with traditional inventory financing (i.e., tangible personal property). Typically, a creditor with security in inventory has to arrange for inspectors that examine the state, quantity, and quality of the collateral; the premises where it is held; the manner in which it is offered to the public; and many other similar matters. By contrast, a creditor who has taken security in crypto inventory and perfected by control would only have to approve of any sale of the assets in question and surveil that the debtor does not secretly mint NFTs without duly transferring control. Finally, any minting of an NFT by the debtor that does not immediately appear in the creditor’s digital wallet or in the designated multisig smart contract should be deemed an event of default in the security agreement.
In constructing the transaction as we describe here, the creditor would have created a floating lien on digital assets of the debtor—specifically, crypto assets in the form of NFTs—using UCC Articles 12 and 9. The lien would both float and provide preferential priority through control. For more on this topic and the transactional structure we set forth above, see our essay Floating Liens Over Crypto-in-Commerce, forthcoming in the Indiana Law Journal.