Cryptocurrencies

How Secured Lenders Can Protect Their Interests When Dealing With Non-Fungible Tokens and Cryptocurrencies – Technology

How Secured Lenders Can Protect Their Interests When Dealing With Non-Fungible Tokens and Cryptocurrencies - Technology

As 2022 dawns, lenders should take the time to learn about digital assets, especially non-fungible tokens (“NFTs”) and cryptocurrency. To date, more than 30 public companies hold cryptocurrencies on their balance sheets, and major brands such as Visa and Adidas have each purchased NFTs worth over $100,000. 1 With the rise in value of digital assets, borrowers may seek to pledge NFTs and cryptocurrencies. In this alert, we explore how secured lenders can protect their security interests in this new form of ownership. 2

What are non-fungible cryptocurrency and tokens?

Generally, a cryptocurrency is a digital medium of exchange that operates on blockchain technology. A blockchain is essentially a distributed database that allows transactions to be permanently recorded without the need for a central authority or trusted third party to erase or verify the transaction, and provides digitally authenticated record keeping. . 3 Essentially, cryptocurrency is decentralized digital money whose transaction history is recorded on a publicly accessible ledger. The two largest cryptocurrencies, Bitcoin and Ethereum, currently have market capitalizations of around $800 billion and $380 billion, respectively, although both are considered highly volatile.

NFTs use blockchain to record and authenticate ownership of unique tangible and intangible assets such as digital collectibles.
4 Unlike cryptocurrency, every NFT is meant to be unique and no two are the same, hence the name “not fungible“token. 5 The most common NFTs authenticate ownership of digital art. 6 In some cases, NFTs are used to identify the location of a file such as a digital work of art or an audio clip. In other cases, NFTs have been used to sell parcels of virtual real estate in the metaverse – interactive virtual environments that many, like Mark Zuckerberg, believe are the successor to today’s internet.

Cryptocurrency and non-fungible tokens are generally categorized as digital assets, which is a broad but informal category of assets issued and transferred using blockchain.
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Relevant Questions for Secured Lenders

A. Perfecting security interests in cryptocurrency and non-fungible tokens

Digital assets are a form of personal property. The enforceability of movable collateral is governed by Article 9 of the Uniform Commercial Code. This is true even for NFTs marketed as “virtual real estate”. Make no mistake: virtual real estate is not real estate. Rather, it is a personal asset.
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Different categories of personal property require different perfection methods, and the perfection method can have a significant impact on the value of accepting certain assets as collateral. Section 9 saw its last major changes in 2010, when digital assets were in their infancy. The first cryptocurrency, Bitcoin, had just been created but had not yet reached a mass market. NFTs were hardly a gleam in anyone’s eye. Unsurprisingly, Article 9 does not include a separate classification for digital assets.

Rather, under Article 9, digital assets generally fall into one of two categories: general intangibles and investment properties. “General intangibles” is a catch-all category and can essentially cover anything that does not fit into one of the other categories of property recognized under Article 9. “Investment property” covers securities securities, securities rights and commodity contracts. Accordingly, digital assets qualifying as securities may constitute investment property, while all other digital assets may constitute general intangible assets.

Security interests in general intangibles and investment properties can be perfected by filing a UCC-1 financing statement against the debtor. Security interests in investment property can also be perfected by obtaining control of the investment property. Because security interests in investment property perfected by control take precedence over security interests protected simply by deposit, perfection by control is preferable.
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B. Problem of classification of cryptocurrencies as general intangibles

The classification of cryptocurrencies as general intangible assets is problematic if the objective is for cryptocurrencies to serve as a substitute for money. This is due to the way Article 9 deals with the survival of security following a sale of the security.

As a general rule, when the security is sold, the secured creditor’s security interest automatically attaches to the identifiable proceeds of the security. However, if the collateral has been sold without the authorization of the secured creditor, the secured creditor’s security interest in the collateral may survive the sale. ten Therefore, cryptocurrencies and other digital assets may remain subject to security interests granted by prior owners of the digital asset. The potential survival of these “zombie” collateral, which may take priority over the claim of a subsequent secured lender or buyer, must be considered when valuing digital assets as collateral.

To solve this problem, proponents of Bitcoin and other cryptocurrencies have been pushing for cryptocurrencies to be categorized as “money”. A security interest in money is effective only so long as the secured creditor retains possession of the money. 11 So far, one state, Wyoming, has adopted this categorization. 12

C. Best practices for protecting security interests in cryptocurrency and non-fungible tokens

While filing a UCC-1 can perfect a lender’s security interest in most digital assets, the lender must also take practical steps to ensure that they will be able to obtain possession and collateral control if the lender needs or wants to exercise its remedies against the collateral, for example by making a public or private sale of the digital assets.

Digital assets are stored electronically in what is known as a digital wallet which can only be accessed using a private key similar to a password. 13 Without the private key, lenders will not be able to access the asset following a default. To protect their interests, lenders should consider either acquiring the private key upon execution of the security agreement or entrusting the private key to a custodian to be held in escrow.

Merely having access to the borrower’s private key will not prevent a borrower from transferring the asset to another digital wallet, such as a cold wallet, beyond the reach of the lender. To mitigate this risk, borrowers have been suggested to transfer their NFTs or cryptocurrency to a digital wallet controlled solely by the lender or using digital wallets that require more than one key to authorize transactions. 14 These multi-signature wallets are similar to a three-party escrow agreement. 15Another type of secure wallet is a cold wallet, which is stored offline and not connected to the internet, making it more resistant to hacking. Both of these methods are similar to obtaining control of a securities or custodial account and serve the practical purpose of ensuring that the secured lender will have access to the collateral when it is needed.

Protecting the security of the private key/digital wallet is essential, as anyone who comes into possession of the private key can sell or transfer the digital asset. It is therefore strongly advised to ensure the security of the digital wallet. Digital assets are regularly stolen by cybercriminals who gain access to the digital wallet, transferring the cryptocurrency contained in the wallet with little hope of recovery.

Conclusion

2021 has seen the value of cryptocurrency and NFTs reach all-time highs, and it’s unclear what 2022 will bring. In the meantime, lenders should consider methods to protect their rights, including:

  • file a UCC-1 funding statement in the appropriate jurisdiction to perfect their security interest in cryptocurrency or NFTs;

  • obtain control of any securities account holding cryptocurrencies or other digital assets that have been or may be classified as securities;

  • implement a security procedure to protect the digital wallet from cybercriminals or unauthorized access;

  • at a minimum, acquire the private key providing access to the digital asset upon execution of a security agreement or deliver it to a custodian to be held in escrow; and

  • discuss with the borrower the possibility of placing the digital asset in a lender-controlled digital wallet or some form of tri-party escrow account.

Footnotes

1. Adrian Zmudzinski, Institutional Investors Now Own $70 Billion in Bitcoin: ReportYAHOO (August 30, 2021), https://www.yahoo.com/now/institutional-investors-now-hold-70b-122022840.html; Robert Farrington, Why big brands are spending millions on NFTFORBES (December 25, 2021), https://www.forbes.com/sites/robertfarrington/2021/12/25/why-big-brands-are-spending-millions-on-nfts/?sh=5827e15e6117.

2.

3. Kate Ashford and John Schmidt, What is Cryptocurrency?FORBES (January 3, 2022), https://www.forbes.com/advisor/investing/what-is-cryptocurrency/.

4. Jazmine Goodwin, What is an NFT? Non-Fungible Tokens ExplainedCNN (November 10, 2021), https://www.cnn.com/2021/03/17/business/what-is-nft-meaning-fe-series/index.html.

5. Identifier.

6. Identifier.

7. Matthew Vincent, What are digital assets and how does blockchain work?FINANCIAL TIMES (October 20, 2021), https://www.ft.com/content/2691366f-d381-40cd-a769-6559779151c2.

8. “Virtual real estate mortgages” present a number of difficult issues beyond the scope of this article.

9. UCC § 9-328(1).

ten. To see UCC § 9-315(a).

11. UCC § 9-313(d).

12. To see Senate File No. SF0125, Wyo. Leg. (February 2019) (this bill became Wyoming law effective July 1, 2019).

13. What is a private key?COINBASE, https://www.coinbase.com/learn/crypto-basics/what-is-a-private-key. Unfortunately, digital wallets will likely not qualify as deposit accounts under Section 9, as the definition of deposit account requires the account to be maintained with a bank.

14. To see Xavier Foccroulle Menard,
Cryptocurrency: Collateral for secure transactions?34 BFLR 347, 366 (2019).

15. Identifier.

Special thanks to Law Clerk Ryan Hibbard for his many contributions to this article. Ryan is not yet licensed to practice in any jurisdiction.

Originally published February 2, 2022

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.