Why Crypto Needs UCC Article 12

Am I at risk of a lawsuit if I buy a token from someone who received it from a hacker?

How do I know if there’s a lien or claim on my bitcoin?

What rights do I have if I loaned out my ether and the borrower has defaulted on the loan or even filed for bankruptcy protection?

These questions have haunted the crypto industry since its beginning. Although law and regulation have been quick to embrace digital assets, many private law questions remain unanswered. These include the title to digital assets or the extent of legal rights received with the transfer of a digital asset, whether and how a security interest can be perfected in digital assets, and the priority for security interests against digital assets. For many of these issues, U.S. law looks to Article 9 of the Uniform Commercial Code (UCC).

Andrew Hinkes is a partner at K&L Gates, co-chair of its Digital Assets, Blockchain Technology and Cryptocurrencies practice, and an adjunct professor at NYU Law and the New York University Stern School of Business. Hinkes was an adviser to the Digital Assets Working Group, which drafted Article 12 and the conforming amendments.

The UCC streamlines rules for common commercial transactions like secured lending and transfers of certain assets by providing defaults and gap fillers to simplify commercial law and encourage parties to enter into agreements, and imposes certain mandatory rules. After three years of study, debate and drafting, the 2022 Amendments to the Uniform Commercial Code incorporate the newly created Article 12 of the UCC which adapts existing law to digital assets. Why does this matter for crypto? Many nagging questions will be resolved if the 2022 UCC Amendments are adopted uniformly by all 50 states. For example:

UCC Article 12 creates a new category of asset called a Controllable Electronic Record (CER), which builds on existing UCC provisions and applies that law to those in control, rather than in possession, of CERs. Existing law that addresses the perfection of security interests relies upon either the filing of financing statements or the concept of possession, which generally requires physical possession. (A perfected security interest is a secure interest in an asset that cannot be claimed by another party.)

Digital assets like ether and non-fungible tokens (NFT) are intangible and cannot be possessed as the law understands it. Rather than rely on physical possession, the CER definition uses “control.” Control is determined using a functional test that requires more than mere private key control, and focuses on the power to enjoy substantially all of the benefits of the asset and to prevent others from enjoying substantially all of the benefits of the asset, and the ability to transfer the asset to third parties.

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Most common cryptocurrencies, tokens, stablecoins and NFTs are probably CERs, given that a person can enjoy substantially all their benefits while concurrently excluding all others from interfering with their enjoyment.

“Clean” or “virgin” coins that have not circulated after being mined have been touted as more desirable than coins that have circulated; this is because the clean coins would, hypothetically, be free of regulatory or legal claims that may attach to those assets as they are transacted. As the argument goes, coins that have been taken in a hack or pledged as security but then transacted to a third party may carry a claim with them that would apply to the current holder.

Under the current state of the law, it is not clear whether (a) any digital asset has any claim associated with it or (b) whether any claim that applies to the digital asset would continue to apply to the asset after it is transferred to another person. Article 12 would clarify when a transferee takes an asset “subject to” prior claims, and under what circumstances a transferee may “take free” of claims.

A person who receives an asset in good faith, who gives value in return, and who has no notice of a competing claim would take the asset free of any other claim. Thus, Article 12 would increase the negotiability of CERs by treating them similar to other negotiable instruments like checks and promissory notes.

Although many loans are intentionally unsecured, meaning that the lender has no right to proceed against collateral in case of a default, in other cases a borrower may intend to grant to the lender a legally enforceable security interest in digital assets offered as collateral. Before Article 12 it was difficult to perfect a security interest in those digital assets and for the security interest to achieve priority over competing interests.

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By including CERs the new law would clarify that perfection may be accomplished either by filing (i.e., filing a UCC-1 financing statement in the relevant state’s filing office) or by control of the actual CER, and would give super-priority to those who perfect by control over those with earlier-filed financing statements. Until Article 12 of the UCC is enacted by all states we will have to deal with a confusing situation where different rules may apply more or less arbitrarily depending on factors such as the location of the debtor.

While the updates to the UCC address the certainty of commercial transactions involving crypto, the UCC does not address other substantive law that might affect these assets; look elsewhere for clarity as to securities and commodity regulation, intellectual property, tax, sanctions, anti-money laundering or the rights of digital exchange customers. Article 12 creates defaults and gap fillers, so parties can transact under a common set of rules without having to negotiate complex agreements in the course of their transactions.

It’s time for the crypto industry to have certainty around collateralized lending and certainty as to the legal meaning of transactions of digital assets. The crypto industry should support the adoption of Article 12 of the UCC.