As discussed in Part I of this series, NFT-based lending is paving a new path of investment and activity on the blockchain that will enable new and innovative use cases. In this Part II, we will discuss the implications for lenders.
I. Issues for Lenders,
These on-chain loans secured by digital assets present a question for lenders: where the secured asset is digital, like an NFT, how do lenders find it easier to provide secured financing to borrowers? In traditional financing, the lender and borrower negotiate a security agreement, which controls the lender’s rights in the transaction. According to the Uniform Commercial Code (“UCC”), which governs interests in personal property as collateral for loans, a security interest in tangible collateral can be perfected against a third party by taking possession of the collateral or by filing a financing statement. Could. Additionally, a security interest in many types of intangible collateral can be perfected against third parties simply by filing a financing statement. Sometimes, best practice requires possession and filing (when both types of completion are permitted under the UCC).
Mechanically, when the lender and borrower agree to the terms of a peer-to-peer marketplace like Blurb (as discussed in Part I of this series), the NFT is held in a vault – with specific storage and security features. With a smart contract – with a lien on it; At this point, the principal amount is transferred to the borrower. As discussed below, the UCC, as currently adopted in most states, does not account for the perfection of a security interest in digital assets in any way other than filing a financing statement, so a security cannot be perfected. The Vault and Lien combination is insufficient to collateralize the interest in the NFT against third parties; However, the 2022 UCC amendments provide some clarity on perfecting a security interest in digital assets against third parties.
In general, the UCC is updated periodically to incorporate emerging technologies and trends. Among other updates, the 2022 UCC amendments address digital assets and distributed ledger technologies, providing updated default rules under the UCC to those transacting in goods and services. Thus, lenders should be aware of different new measures to ensure that their loans are adequately secured and perfected against the borrower and any third parties including customers and other creditors of the borrower. Therefore, the lender will be first in line to recover on the collateral in a fight with other creditors of the borrower.
Pre-2022 amendment arrangement:
There is uncertainty regarding the treatment of digital assets, NFTs or otherwise, under the pre-2022 amendment regime. Article 9 of the UCC regulates the attachment (creation or enforcement) and perfection (priority with respect to other creditors) of a security interest in personal property used as collateral in secured transactions.
Digital assets generally only fit into the “general intangible” category under Article 9, which can only be accomplished by filing a financing statement. Thus, if a lien is placed on the safe through a filing with the Secretary of State where the borrower is located, the lender must be secured against third party claims to the collateral, assuming that the security interest in the collateral is independent. And was made clear of any claim to any other property. Although possession of the private key to the vault may give the lender practical control of the digital asset under the UCC, possession of the private key is not sufficient to satisfy a security interest.
Parties take advantage of custody arrangements to perfect a security interest in digital assets by control, which, under Article 8 of the UCC, will give the lender priority over any other creditor or lien holder claiming an interest in the same collateral. Such an arrangement requires some resolution: control entails an interest in a “security right” over “financial assets” held with a “securities intermediary” in a “securities account”, so typically, The Parties will agree to treat the Digital Asset as a “financial asset” under Article 8, hold the Digital Asset collateral in a “securities account” with a “securities intermediary” that is in the business of holding such collateral and Enters into a control agreement. (See UCC §§8-102(a)(9)(iii), 8-106(d)). While sophisticated parties and their attorneys have used this solution to the present end, establishing this connection can be cumbersome and leave something to be desired.
A joint drafting committee of the American Law Institute and the Uniform Law Commission sought to clarify the treatment of digital assets as collateral in secured transactions by proposing 2022 amendments, which were approved and sent to states and territories for adoption. Went. To date, the amendments have been adopted in eleven states and are in effect in seven of those states (including Delaware) (see ULC enactment map). The amendments will go into effect in those additional three states on January 1. The 2022 amendments add Article 12 and make significant amendments to Article 9, among other provisions.
The 2022 amendments include several notable items: (i) Adding Article 12, governing the sale and purchase of a “controllable electronic record” (“CER”), including security interests.
- Article 12: CER and Control
Under Article 12, NFTs and other digital assets, whether currently existing or created in the future, can be classified as CERs, as long as the digital asset is susceptible to control. To have control, the holder must have (1) the power to enjoy “substantially all the profits”, (2) the exclusive power to prevent others from enjoying “substantially all the profits”, (3) exclusive power to transfer control, and (4) ability to prove control over the CER. The private key can be used to prove control. In particular, some vaults and lending platforms allow multi-sig wallets (i.e., shared control). Such arrangements will often not be a barrier to establishing controls under the 2022 amendments, nor will the fact that automated changes occur as a result of smart contracts or protocols be a barrier to establishing controls.
2. Buying CER
The “take-free” rules of the 2022 amendments apply when a purchaser of CERs, who acquires all rights in a CER held by the transferor or a security interest in the CER, becomes an “eligible purchase” that is “take-free.” “Benefits from. Free” rules. A buyer must be a “qualified buyer” to benefit from the “take-free” rule, which provides that the buyer takes an interest in such CER free from conflicting property claims when such a “qualified buyer”: (1) purchases the CER, (2) controls the CER, (3) acts in good faith, (4) and does not convey property rights under the CER.
3. Implications for secured loans
CER is included in the definition of “general intangible” in Article 9 of the UCC, meaning that security agreements granting security interests in general intangibles include NFTs, cryptocurrencies, and other digital assets. Furthermore, Article 9 allows the perfection of a security interest in the CER either by filing a financing statement or, under amendment, by control.
However, lenders should note that filing a financing statement to perfect a security interest in a CER is subject to the risk that another secured party acquires control and someone else becomes a “qualified purchaser” who acquires control of the CER. Receives and in each case is given greater rights in the CER than the secured party that merely filed the financing statement. Thus, lenders must ensure they have control of the CER under Article 12 of the UCC (which counts as control under Article 9). Furthermore, the amendment to Article 8 clarifies that CERs can be a “financial asset” where the custody arrangements described above apply, and such agreements continue to apply. Finally, these amendments should be familiar to secured lenders because, with the addition of Article 12’s definition of “control”, the application of the existing UCC framework is clarified.
As discussed in Part I of this two-part series, innovations in NFT lending are driving the industry forward and enabling new and unique business models. The law always encourages innovation, so industry participants should be aware of their rights, obligations and risk-mitigation processes to protect their investments. Fortunately, once adopted by additional states, the 2022 amendments will provide even greater clarity to secure commercial and commercial transactions, giving participants the confidence to grow and invest in the sector.