Technically speaking, digital assets exist in a world of certainty. Once a transaction is confirmed and the data is broadcast to the network, it cannot be reversed without violating the code—that is, the law—of the blockchain. What the blockchain records is fact, as a matter of the code.
Legally speaking, though, digital assets exist in an environment of doubt. Questions abound: Are they a security, a commodity, or something else altogether? (Answers vary depending on which representative, regulator, or U.S. Securities and Exchange Commission commissioner you ask.) Since digital assets have real-world value, can someone lend against and take a security interest in them? If so, how does that party perfect that security? And how can someone buy or take an assignment of a digital asset without worrying about whether another party will claim priority over the asset?
Newly proposed amendments to the Uniform Commercial Code (UCC)—in particular, through an entirely new Article 12—seek to provide a bit of legal certainty to these questions. Introduced last summer, the amendments aspire to create a “legal regime” not only for electronic assets that exist on distributed ledgers—i.e., blockchains—but also for those “that may be created using technologies that have yet to be developed, or even imagined.” Proposed U.C.C. art. 12, prefatory n. Already, nearly half of the states have taken up the future-focused amendments, with dozens more likely to follow. For any practitioner dealing in digital assets, secured transactions, and priority of liens, the new provisions are a must-know update to the familiar Article 9 perfection and priority scheme. This article highlights the most notable of the UCC’s new provisions.
Every day, lenders and other secured parties protect themselves and perfect their liens on debtors’ assets through the timeworn process, under UCC Article 9, of taking possession or control of the asset or—perhaps much more commonly—filing an appropriate UCC-1 financing statement.
One problem with this scheme, though, is that digital assets, practically speaking, cannot really be “possessed.” They live on the particular blockchain housing them, which, ideally, is designed to be distributed to and stored in multiple locations. And the current Article 9, while robust in its scope, simply does not contemplate digital assets like cryptocurrencies, NFTs (non-fungible tokens), and crypto tokens. Arguably, then, a creditor’s interest in them cannot be secured and perfected through a financing statement.
Article 12 addresses these issues and the priority of liens through a completely new system of perfecting security in nearly all digital assets, to which it refers as “controllable electronic records” or “CERs.” Proposed U.C.C. § 12-102(a)(1). Article 12 defines CER as “a record stored in an electronic medium that can be subjected to control” under the article. Id. “Control” exists under Article 12 when a holder is able to derive “substantially all the benefit” from the CER; has “exclusive power” to “prevent others from availing themselves of substantially all the benefit” from the CER; and the CER allows the holder “readily to identify itself in any way, including by . . . cryptographic key,” as having these powers. Proposed U.C.C. § 12-105(a).
As the provisions suggest, control is paramount. In practice, and as applied to familiar digital assets like bitcoin and other cryptocurrencies, this suggests that a party would have to have the assets assigned to a digital wallet it controls and for which it has exclusive knowledge of the cryptographic key, or “seed phrase,” that enables a party to access and transfer a particular digital asset.
You might ask: Why couldn’t the drafters have updated Article 9 to make clear that a secured party can file a UCC-1 statement for the particular digital asset in which it wants to perfect a lien? They did, but it comes at a risk. Under Article 12, a party that takes “control” of a CER “for value, in good faith, and without notice of a claim of a property right in the controllable electronic record” is considered a “qualifying purchaser” whose rights trump any other security interests in the asset, even if perfected to the extent allowable under the UCC. Proposed U.C.C. § 12-102(2). In other words, a qualifying purchaser gets super-priority status over even prior-perfected UCC-1 filers that lack control of the CER. Proposed U.C.C. § 9-107A, official cmt. 1 (“Perfection by filing and perfection by control are alternative methods of perfection for a controllable electronic record. . . . Under [proposed] Section 9-326A, a security interest in a controllable electronic record that is perfected by control has priority over a security interest perfected by another method.”); Proposed U.C.C. § 12-104(e) & official cmt. Secured lenders that take an “all assets” security interest in a debtor’s property in a jurisdiction that enacts the amendments should therefore be sure that they also obtain control of any CER—be it an NFT, a crypto token, or other digital asset—in order to obtain a first-priority lien.
While the new Article 12’s definition of controllable electronic record is broad, it comes with a bit of a wrinkle. A CER does not include, among other things, “electronic money.” Proposed U.C.C. § 12-102(a)(1). Under the proposed amendments, that means “money in electronic form.” Proposed U.C.C. § 9-102(a)(31A).
Somewhat counterintuitively, that definition does not necessarily capture the cryptocurrencies we all know: The amendments note that “money” is a medium of exchange that is currently authorized or adopted by a domestic or foreign government. . . . The term does not include an electronic record that is a medium of exchange recorded and transferable in a system that existed and operated for the medium of exchange before the medium of exchange was authorized or adopted by the government.
Proposed U.C.C. § 1-201(b)(24). Under this definition, as the commentators make clear, “cryptocurrencies, such as bitcoin, [] are not ‘money’ as defined in Section 1-201 because they were in existence and used before adoption by a government.” Proposed U.C.C. § 9-102, official cmt. 12A. Thus, for example, if the United States ever adopts an official Central Bank Digital Currency like the one the Federal Reserve is exploring, it would likely fall under the purview of the new Article 9, which provides that perfection of an interest in such “electronic money may be perfected only by control,” which the amendments define similarly to having control of a CER. Proposed U.C.C. §§ 9-105A(1), 9-312(b)(4).
