UCC amendments embrace digital assets as collateral

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Law Firms McDermott Will & Emery Follow November 10, 2023 – States are actively developing comprehensive frameworks that more reliably enable the use of digital assets like cryptocurrencies, non-fungible tokens (“NFTs”), and other blockchain-based assets as collateral in financing transactions. The Uniform Law Commission (“ULC”) has proposed Uniform Commercial Code (“UCC”) changes to address legal challenges and uncertainties associated with digital assets within the existing framework of secured transactions. These proposed UCC changes include the addition of Article 12 and amendments to Article 9 to effectively address the evolving realm of digital assets. The goal is to provide greater clarity, predictability, and protection for lenders and creditors who accept digital asset collateral, thereby fostering trust and confidence in the expanding and volatile digital asset ecosystem. Article 12 of the UCC aims to establish a clearer framework for governing the creation, perfection, priority, and enforcement of a security interest in digital assets. Meanwhile, the proposed amendments to UCC Article 9 expand the scope of the UCC’s provisions on secured transactions to include digital assets. This article explains how these changes highlight how they facilitate financing transactions that involve digital assets as collateral. Article 12 Proposed UCC Article 12 seeks to provide a legal regime for digital assets by introducing the term “controllable electronic record” (“CER”) to describe digital assets (UCC § 12-102(a)(1)). CER is defined as a “record stored in an electronic medium that can be subjected to control.” Id. This broad definition encompasses not only blockchain technology but also future technologies; however, deposit accounts, electronic chattel paper, investment property, and electronic money are expressly excluded from its scope.Id. The concept of control plays an essential role in determining the applicability of CERs as secured interests because control establishes clear ownership, possession, and enforceability of these assets. To establish control over a CER, UCC § 12-105(a) stipulates that a party must demonstrate: 1. Power to avail themselves of “substantially all the benefit” from the CER; a. This means having the ability to fully benefit from the CER’s value and functionality. 2. Exclusive power to “prevent others from availing themselves of substantially all the benefit” from the CER; a. This requires having sole authority to restrict others from enjoying the benefits that the CER offers, including using it as collateral. and 3. Exclusive ability to transfer control or cause another person to obtain control of the CER. It’s important to note that if a party can satisfy the last two criteria, the power to control is presumed to be exclusive. Demonstrating the power and ability to establish control over a CER, as well as digital assets in general can be a complex and intentionally opaque process. Article 12 simplifies the concept of control by requiring a party be able to identify and prove their control of a CER to third parties using methods such as their name, identifying number, cryptographic key, office, or account number even if they wish to otherwise remain anonymous (UCC § 12-105(a)(2)). These identification methods serve as means to authenticate and verify control over the CER, ensuring additional transparency and trust in the transaction. UCC Article 12 also seeks to enhance the negotiability (i.e., transferability) of CERs by recognizing the use of digital assets as an instrument of payment. For example, Article 12 introduces a “shelter-rule” whereby a purchaser of a CER obtains all the rights that the transferor held (UCC § 12-104(d)). Additionally, the “take-free” rule allows a “qualifying purchaser” to acquire an interest in the CER without competing property claims if they gain control of the CER (i) for value, (ii) in good faith, and (iii) without notice of any property claim (UCC § 12-104(e)). This means that qualifying purchasers of CERs will acquire their interests free from competing claims (including security interests perfected by the filing of a financing statement) without needing to perform a UCC search before engaging in a digital asset transaction (Joseph Cioffi, Adam Levy and Christine DeVito, “Perfecting digital assets: There’s no control without power,” Reuters Legal News, May 19, 2023, https://bit.ly/3Mu48Gv). Article 9 The proposed amendments to Article 9 recognize the value and potential of digital assets as collateral in secured financing transactions. Under the Article 9 amendments, the definition of “general intangibles” formally includes CERs, which means that attaching security interests to digital assets applies the same way as attaching a security interest to general intangibles (UCC § 9-312(a)-(b)). However, the amendments expand the options for perfecting security interests in CERs. Moreover, in addition to the customary method of perfecting against a general intangible by filing a financing statement, the UCC amendments clarify that creditors can also establish perfection by demonstrating control over the CER (UCC § 9-314(a); UCC § 9-312(a)). Control is defined in Article 12 and involves the ability to exercise exclusive power and authority over the CER, as previously outlined (UCC § 12-105). Importantly, a security interest perfected by control has priority over a conflicting security interest that has been perfected through a method other than control (UCC § 9-326A). By ensuring that a creditor who can demonstrate control has a superior position in asserting their rights, the amendments emphasize clarity and enforceability in determining the strength of a creditor’s claim over a CER where multiple parties have competing interests in the same digital asset. Conclusion In summary, UCC Article 12 introduces the CER to describe digital assets, which encompasses various technologies beyond blockchain. Control is a key factor in establishing a security interest in a CER, requiring power to benefit from the asset, exclusive authority to prevent others from benefitting, and the ability to transfer control. Demonstrating control can be complex given CERs often operate on decentralized networks, but Article 12 proposes alternative identification methods, like names, identifying numbers, or cryptographic keys to authenticate control. Article 12 also enhances transferability by granting purchasers rights from the transferor and providing protection for qualifying purchasers against competing claims without the necessity for UCC searches. The proposed Article 9 amendments recognize the value of digital assets as collateral and expand options for perfecting security interests in CERs. Creditors can now establish perfection by demonstrating control over the CER, granting them flexibility in securing their right and providing priority over competing claims. Despite the emergence of digital assets, only 10 states to date have enacted the ULC’s proposal, including, most notably, Delaware and California (Legislative bill tracking for the UCC amendments is available at https://bit.ly/40nk8Ql (last accessed on Oct. 19, 2023)). Eighteen additional states, including New York and Texas, have introduced bills to adopt the UCC amendments. Id. Other states (Idaho, Iowa, Kentucky, Tennessee, and Wyoming) have passed different formulations of the proposed Article 12 and Article 9 amendments to address digital assets in security arrangements. Id. Such reforming states realize that a uniform legal regime governing digital assets is crucial in building lender trust and providing borrowers flexibility going forward as digital assets continue to grow more influential in commercial transactions. Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias. Westlaw Today is owned by Thomson Reuters and operates independently of Reuters News. Acquire Licensing Rights, opens new tab Anh B. Lee Anh B. Lee, a partner with McDermott Will & Emery, focuses her practice on corporate finance, with an emphasis on representing private equity sponsors and their portfolio companies, alternative and direct lenders, public companies, and other privately held businesses. She is based in Chicago and can be reached at anhlee@mwe.com. Sam Scaletta Sam Scaletta is a corporate finance associate at the firm. He is based in Chicago and can be reached at sscaletta@mwe.com.

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