New UCC Amendments Address Certain Digital Assets

The use of digital assets, such as cryptocurrencies and non-fungible tokens, in commercial transactions has been growing for years. That growth requires changes to the law to address how those assets should be characterized and how interests in them are protected. Therefore, 2019 saw the start of an effort to update the Uniform Commercial Code (“UCC”) to address those emerging issues.

In July 2022, that effort culminated in a package of extensive revisions to the UCC, including the addition of Article 12 (entitled “Controllable Electronic Records”) and significant additions and revisions to a number of other UCC articles, including Article 9 on secured transactions. The package of UCC revisions, or some version of it, has already been enacted into law in North Dakota and has been introduced in the legislatures of 23 other states, plus the District of Columbia. Virginia and the other remaining states will very likely enact it or some version of it in the coming years. Therefore, Virginia lenders should familiarize themselves with the updated rules. A thorough review of the UCC revisions is beyond the scope of a short article, but we address some of the main concepts here.

1. “Controllable Electronic Records” (and “Controllable Accounts” & “Controllable Payment Intangibles”)

Article 12 introduces the concept of the “controllable electronic record” (“CER”). As the name suggests, a CER is a record stored in an electronic medium that can be subjected to “control”. “Control” in the context of an electronic record parallels the concept of physical possession of a tangible asset and is based primarily on exclusivity. A person has “control” of an electronic record when the person receives substantially all the benefit from it and has the exclusive power to (1) prevent others from availing themselves of substantially all the benefit of it, and (2) transfer it, or control of it, to another person. The person asserting control must also be able to identify itself as the person in control by use of a specific identifying name, number, or key.

Two distinctions should be kept in mind. First, not every digital asset is a CER. For example, a digital photo could be considered a digital asset, but it could not be a CER unless it is subject to “control”.

Second, while some CERs have inherent value - insofar as they can be exchanged for money or property - not all do. For example, cryptocurrency like bitcoin has inherent value, while a CER evidencing a contract for delivery of goods might not. Under existing law, whether a person who acquires a paper evidencing a contract for the delivery of goods also necessarily acquires the right to receive the goods depends on other applicable law. In other words, the “right” might not necessarily travel with the “record” (i.e., the piece of paper on which the contract is written), depending on other applicable law. Article 12 generally applies the same rule to a contract document that qualifies as a CER.

Analogous to this distinction between a CER (the “record”) and the related “right” is a distinction that Article 12 draws between a CER and a “controllable account” (“CA”) or a “controllable payment intangible” (“CPI”). A CA is defined as “an account evidenced by a [CER] that provides that the account debtor undertakes to pay the person that has control … of the [CER].” Similarly, a CPI is defined as a “payment intangible evidenced by a [CER] that provides that the account debtor undertakes to pay the person that has control … of the [CER].”

Article 12 gives special status to CAs and CPIs insofar as the right to payment on a CA or CPI necessarily belongs to the person who controls the CER that evidences the account or payment intangible (so long as that person is a “qualifying purchaser”, a concept discussed below).

1. Negotiability of CERs, CAs, and CPIs

The drafters of Article 12 state that its principal function is “to specify certain rights of a purchaser” of a CER, which includes both buyers and secured parties. Just as existing UCC law provides protections to purchasers of negotiable instruments, money, or goods, Article 12 seeks to make CERs, CAs, and CPIs negotiable by making rules for their transfer and defining the rights of those involved in transfers. Those rules include the following:

• Shelter Principle. Under the shelter principle, a purchaser of a CER, CA, or CPI acquires all rights in the CER, CA, or CPI that the transferor had or had the power to transfer.
• Take-Free Rule. The take-free rule provides that a “qualifying purchaser” acquires rights in a CER, CA, or CPI free of third-party claims. A “qualifying purchaser” means a purchaser who obtains control of the CER, CA, or CPI for value, in good faith, and without notice of any competing property interest in the CER, CA, or CPI. For example, if a hacker takes control of a CER and sells it to a qualifying purchaser, the purchaser can obtain rights to the CER even though the hacker did not have any rights to it. The concept of a “qualifying purchaser” is similar to the concept of a “holder in due course” of a negotiable instrument under UCC Article 3.
• Tethering. The concept of tethering relates to both the take-free rule and the distinction discussed above between the “record” (e.g., a CER) and the related “right”. In sum, while the take-free rule applies to a CER, CA, or CPI (and the right to payment inherent in the CA or CPI), it does not necessarily apply to other rights that may be “tethered” to a CER. To use the example given above of a contract for the delivery of goods, under the concept of tethering, not only does the person who acquires the related CER have to look to other applicable law to determine whether he also acquired the right to receive the goods, he also needs to look to that other law to determine whether any such acquisition of the right was free and clear of third-party claims.
• Amendments to Article 9 Regarding Security Interests in CERs

Article 9 governing secured transactions has also been amended to allow lenders to perfect security interests CERs, CAs, and CPIs and extend existing rules for attachment and perfection to those assets. Specifically, a lender may perfect a security interest in a CER, CA, or CPI either by filing a financing statement or by obtaining “control” of the asset.

The amendments make clear that a security interest in a CER, CA, or CPI perfected by control has priority over a conflicting security held by a secured party that does not have control. In other words, control trumps a financing statement, even if the financing statement was filed before the control was obtained. Additionally, secured parties who are “qualifying purchasers” receive the protections of the take-free rule.

1. Takeaways

The 2022 UCC amendments build off of the UCC’s existing framework regarding tangible property to establish a similar structure for transactions involving certain digital assets and should provide greater clarity for lenders involved in those transactions. Although Virginia has not yet acted on the amendments, lenders in Virginia should familiarize themselves with the amendments to prepare for the eventual enactment of similar legislation in Virginia or other states where the lenders operate.

Neil E. McCullagh is a partner at Spotts Fain PC in the firm’s Creditor’s Rights, Bankruptcy and Insolvency practice group.

Christopher A. Hurley is an associate at Spotts Fain PC in the firm’s Creditor’s Rights, Bankruptcy and Insolvency practice group.

Spotts Fain publications are provided as an educational service and are not meant to be and should not be construed as legal advice. Readers with particular needs on specific issues should retain the services of competent counsel.