Possessing the Unpossessable – Holding Digital Assets in Your UCC Hands

Non-fungible tokens, crypto tokens, cryptocurrencies, and other digital assets generally cannot be held in your physical hands, but they may now be legally possessed, under the Uniform Commercial Code in Delaware and other states that have newly adopted identical provisions of the Uniform Commercial Code or similar legislation.

Delaware recently joined other states that are adding to the uniform basket of regulations governing transactions with “digital assets” through amendments to the Uniform Commercial Code (the “UCC Amendments”)—as of today, 28 states have introduced the UCC Amendments, and 10 states, including Delaware, Washington, New Hampshire, Alabama, Colorado, Hawaii, Nevada, New Mexico, North Dakota, and Indiana, have enacted the UCC Amendments.[1]

The UCC Amendments clarify when a digital asset is subject to a perfected security interest and when a digital asset is considered for purposes of commercial transactions to be controlled (similar to the possession of tangible assets) and transferred to a qualifying purchaser who takes the digital asset free of competing claims, including security interests perfected by filing financing statements. This clarification in law facilitates the negotiation, transferability, and collateralization of digital assets by creating stability with respect to when a digital asset is transferred in a “take-free” manner without the concern of undisclosed claims and what it takes to perfect a security interest in a digital asset.

As an example of how the UCC Amendments work—Alex takes a Token from Pat without Pat’s knowledge and sells the taken Token to Kris. If Kris purchases the Token from Alex in (1) good faith, (2) for value, and (3) without notice of Pat’s ownership claim over the Token, and Alex can satisfy all four prongs of the Article 12 control test (described below), Kris is a qualifying purchaser and takes the Token free of Pat’s property claim. This differs significantly from the rules utilized prior to the enactment of Article 12. Under the common law rules, Kris would only have been able to take the Token subject to the property claim by Pat because Alex would not have been considered to have a clean title to convey. Because Alex had control over the Token, Article 12 says that this is enough to properly convey the digital asset to Kris without Pat’s property claim.[2]

What is the Baseline behind the UCC Amendments?

The Uniform Commercial Code (the “UCC”) has been called the “backbone of American commerce” because it provides a comprehensive set of laws governing commercial transactions adopted at the state level. The uniform adoption of the UCC by states provides a framework for businesses to enter into contracts with an understanding that the terms will be enforced in the same way by courts across state lines. Among other areas, the UCC governs the sale of goods, the leasing of personal property, negotiable instruments (e.g., checks and promissory notes), bank deposits and collections, fund transfers, letters of credit, documents for the title of personal property (e.g., warehouse receipts), and secured transactions (e.g., transactions involving the grant of credit secured by personal property).

Previously, the UCC did not have a well-defined framework to address the transfer of ownership – or use as collateral – of digital assets. States were forced to rely on common law rules or Articles 8 and 9 of the UCC when transferring ownership of digital assets. Both Article 8 and the previous version of Article 9 did not adequately capture the nuances of purely intangible digital assets and their uses in the market. As a result, the overarching aim of the UCC Amendments is to provide legal certainty for market participants dealing with digital assets and establish the necessary framework for their effective use in commercial transactions. American Law Institute and Uniform Law Commission have developed and approved the UCC Amendments, which include significant changes to the existing Article 9 and the introduction of a new Article 12 titled “Controllable Electronic Records” and many states have been moving forward with reviewing and approving the UCC Amendments so as to continue with the uniform set of laws governing cross-border commercial transactions.

What Type of Digital Assets do the UCC Amendments Apply to?

The UCC Amendments regulate a range of specified digital assets, including “controllable accounts” and “controllable payment intangibles,” although the focus is on “Controllable Electronic Records” (“CERs”), defined as (1) a “record,”[3] (2) in “electronic”[4] form, (3) that is “controllable.” Examples of CERs include Bitcoin (or other cryptocurrencies), tokenized equity, and non-fungible tokens (NFTs). Certain digital assets that may be considered CERs that are already governed by their own commercial laws are excluded from the definition of CERs (e.g., electronic documents of title, deposit accounts, electronic money, and investment property).

How does Possession Occur for Digital Assets Free of Property Interest Claims?

A key concept introduced by Article 12 is digital asset “control,” providing for the equivalent of possession of a tangible asset. In order to establish control over CERs, the person must establish (1) the power to avail themselves of “substantially all” of the benefits of the CER, (2) the “exclusive”[5] power to prevent others from enjoying “substantially all” of the benefits of the CER, (3) the “exclusive” power to transfer control, or cause another person to obtain control of the CER, and (4) the ability to identify itself as having these powers. In other words, control is based on a person’s ability to prove that they have the exclusive power to enjoy, and transfer the enjoyment, of substantially all of the benefits of the CER.

A person who has control of CERs may also be a qualifying purchaser and can then take the CERs free of property interest claims pursuant to the take-free rules established in Article 12. Specifically, if a purchaser obtains control over a digital asset, in:

• “good faith,”[6]
• for “value,”[7] and
• without “notice”[8] of any competing claim over the digital asset, the purchaser is considered a qualifying purchaser, thereby acquiring all rights over the digital asset previously held by the transferor.

Article 12 specifies that a qualifying purchaser takes the digital asset free of any property claims and obtains control of the digital asset.

With respect to controllable accounts and controllable payment intangibles, generally meaning an account or payment intangible that is evidenced by CERs that provides that the account debtor undertakes to pay the person that has control, these digital assets are treated in the same manner as CERs with respect to the qualified purchaser treatment.[9] To determine whether the qualified purchaser has control of a controllable account or controllable payment intangible, the purchaser must look to whether the purchaser has control of the CER which evidences it.[10]

How does a Perfected Security Interest Occur for a Digital Asset?

The UCC Amendments include an updated Article 9 that provides two methods to perfection for digital assets, (1) filing a financing statement and (2) taking “control” of the security interest. The first method takes a typical approach to perfection, i.e., secured party can file a financing statement to perfect a security interest in the digital asset. However, because a qualified purchaser may take a digital asset pursuant to the take-free rules established in Article 12, this method suffers from significant deficiencies. Therefore, the second method of obtaining control may prove to be more useful when dealing with digital assets. Furthermore, the UCC Amendments state that a security interest perfected by control has priority over a security interest perfected by filing.[11] For example, if a borrower is pledging a token and transfers that token to a custodian, the appropriate method of perfection in this instance would be to execute a control agreement between the lender, the borrower, and the custodian where the lender will have the sole right to control the token that is held by the custodian.

This differs significantly from the previous version of Article 9 where if there was no UCC-1 filing and no agreement to treat the digital asset as a financial instrument, there would be no perfection of the secured interest regardless of the persons control over the digital asset.

What is the Upshot? 

• The new Article 12 and amendments to Article 9 establish new digital asset categories and rules for perfection and priority, which means that this should be considered in mergers and acquisitions involving digital assets, loans secured by digital assets, other financing arrangements, bankruptcies, and other commercial transactions involving digital assets.
• The UCC Amendments are broad and will impact not only current digital assets, but future digital assets.
• Although the UCC Amendments provide some clarity regarding the use of digital assets as collateral, there is a distinct void in terms of regulation and case law.

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[1] Many other states including, Nebraska, Iowa, and California, have enacted legislation reflecting earlier versions of the UCC Amendments. Many of these states with previously enacted legislation have introduced new bills to bring the early version of the enacted UCC Amendments into conformity with the official text.

[2] Please note, that any issues outside of control, i.e., IP rights or contract rights, are purposefully not addressed by the UCC Amendments. These are considered separate issues and governed by their respective regimes.

[3] A “record” is “information stored in some manner and retrievable in perceivable form.” UCC § 1-201(b)(31).

[4] “Electronic” is defined as “relating to technology having electrical, digital, magnetic, wireless, optical, electromagnetic, or similar capabilities.” UCC Amendments 2022 § 1-201(b)(16A).

[5] A presumption of exclusivity is established if a person can demonstrate they have the power to prevent others from the enjoyment of “substantially all” of the benefits of the CER and the power to transfer that benefit to others. UCC Amendments 2022 § 12-105(b)(2).

[6] “Good faith” means honesty in fact and the observance of reasonable commercial standards of fair dealing. UCC § 1-201(b)(20).

[7] “Value” has the meaning provided in Section 3-303(a), as if references in that subsection to an “instrument” were references to a controllable account, controllable electronic record, or controllable payment intangible. UCC Amendments 2022§ 12-102(a)(4).

[8] A person has “notice” of a fact if the person: (1) has actual knowledge of it; (2) has received a notice or notification of it; or (3) from all the facts and circumstances known to the person at the time in question, has reason to know that it exists. UCC § 1-202.

[9] UCC Amendments 2022 § 9-102(a)(27A).

[10] UCC Amendments 2022 § 12-104(b).

[11] UCC § 9-326A.