Lenders looking to take security interests in digital assets, including cryptocurrency and non-fungible tokens (NFTs), may gain some certainty in the near future.
The Uniform Commercial Code (UCC) sponsoring organizations have proposed a new Article 12 to the UCC, which is intended to keep pace with these and other emerging types of collateral. If adopted, the new Article 12 will create an asset classification called “controllable electronic records” (CERs). To ensure the UCC remains relevant, CERs are defined to include not only assets created using extant distributed ledger or “blockchain” technology (such as cryptocurrency and NFTs), but also any assets that may function similarly using future technologies.
Under the new regimen, traditional attachment and perfection rules will apply to security interests in CERs. Accordingly, a security interest in a CER will attach by means of a security agreement and a lender may still perfect its security interest by filing a UCC-1 financing statement in the appropriate filing office.
Importantly, however, if Article 12 is adopted, a security interest in a CER perfected by control will be given priority over one perfected only by a financing statement. This elevation of perfection-by-control over perfection-by-filing is not uncommon in the UCC context. In many situations, a lender will file a UCC-1 financing statement against all, or a subset of, the debtor’s assets and take additional actions to ensure it has “control” over specific assets. This two-step process will ensure the lender has priority over a security interest perfected by the filing of a financing statement alone and is standard when establishing security interests in securities and deposit accounts, for example.
Under the new Article 12, “control” exists where a party has (1) the power to enjoy substantially all of the benefits of the CER, (2) the exclusive power to prevent others from enjoying substantially all of the benefits of the CER, (3) the exclusive power to transfer control of the CER and (4) the ability to readily identify itself as having these powers. The UCC amendments do not stipulate or recommend any particular method for attaining such control. Market practice may shift as lending against digital assets becomes more commonplace, but it is expected that establishing control will generally require a digital asset account “control agreement” (similar to that used for obtaining control of deposit and securities accounts) in which the relevant custodian will agree to comply with the secured party’s instructions following an event of default under the definitive loan documentation.
The amendments have been proposed, in part, because the existing UCC rules do not provide a clear path for secured lenders to perfect and maintain a first-position security interest in digital assets. Intangible assets of this nature are considered general intangibles and thus subject to perfection by filing a UCC-1 financing statement, but the existing framework lacks clear direction on this asset class and leaves open important questions about creditor lien priority.
As a result of the amendments, two-step perfection will be important in transactions where the lender attributes meaningful value to any digital assets included in the collateral base. Absent control, a secured lender risks losing its first-priority status to later creditors who perfect their security interests using this method.
Lenders should make clear to their legal counsel if and when digital assets form part of the collateral for a loan, as additional due diligence and legal documentation should be considered in those circumstances. This will hold particularly true if non-uniform perfection rules are adopted across different states.
While the likelihood that commercial banks will extend capital on the “strength” of digital assets seems remote at the present time given regulatory concerns about the safety and soundness of bank crypto exposure, the potential for massive swings in valuation, questions over enforcement and liquidation, and notable market failures such as the FTX collapse and the Silvergate and Signature Bank closures, digital assets seem here to stay. It is important for commercial lenders to become familiar with the proposed Article 12 because there may well come a time when digital assets are used as collateral support, and the UCC sponsoring organizations have made clear that, when that day comes, they intend for the new Article 12 to govern attachment and perfection.
New York has not yet introduced legislation to enact the proposed uniform amendments. The Harris Beach Financial Institutions and Capital Markets team is familiar with the UCC amendments and keeping track of which states adopt them and when. If you have questions about this subject or related matters, please reach out to attorney Tyler A. O’Reilly at (585) 419-8634 and firstname.lastname@example.org, attorney Mathew P. Barry at (518) 701-2768 and email@example.com, or the Harris Beach attorney with whom you most frequently work.
This alert is not a substitute for advice of counsel on specific legal issues.
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