Cryptocurrency financing: perfection issues

Cryptocurrency is becoming a widely accepted form of exchange after initially being deemed destined to fail. With the increase in popularity, value and investment opportunities, lenders are experiencing a demand for cryptocurrency-backed loans. Lenders providing such financing must take the appropriate actions to ensure their loans are legally compliant, properly structured and secured.

Cryptocurrencies are digital assets exchanged over the internet from individual to individual. While there are multiple cryptocurrency types, Bitcoin is the most publically recognized. Bitcoin is essentially a chain of digital signatures, referred to as “keys.” The holder of the “private key” is able to spend or transfer the cryptocurrency. The transactions are then recorded on ledgers known as “blockchains.” 

While there are numerous unanswered questions and conflicting opinions surrounding the legality, regulation, and value of cryptocurrencies, courts, regulatory bodies and professionals have provided some guidance. Lenders providing loans secured by Bitcoin should review Article 9 of the Uniform Commercial Code (UCC).

The following governmental agencies have provided their respective classification for Bitcoin.

• The Commodity Futures Trading Commission has determined that Bitcoin is a “commodity,” which requires compliance with the Commodities Exchange Act.
• The Internal Revenue Service has classified Bitcoin as “property.”
• The UCC classification is not yet definitive. At first glance it appears that Bitcoin could fall into numerous UCC categories of collateral, including “money,” “investment property” or “security.” The popular opinion is that Bitcoin is a “general intangible” pursuant to Article 9 of the UCC.  

To create a security interest in a general intangible, the lender and borrower must enter a security agreement describing the security interest. To perfect the security interest, the lender must file a UCC-1 Financing Statement in the jurisdiction in which the debtor is located. Once perfected, the security interest continues notwithstanding sale, lease, license, exchange or other disposition unless the secured party authorized the disposition free of the security interest.

A significant issue for lenders is continuing perfection. A lender possessing the private key described above is not sufficient to ensure the Bitcoin will remain with the borrower. While the blockchain shows ownership of the Bitcoin and records all Bitcoin transactions to prevent someone from repeatedly spending the same Bitcoin, it does not show liens on Bitcoin. Since the lender and the borrower would both have the private key, the borrower could transfer the Bitcoin to another address controlled by another key, misplace the private key, or hackers could copy the private key, send the Bitcoin to themselves or others, and thus, dilute the value of the lender’s collateral pool.

Lenders must accept the possibility of the borrower transferring the Bitcoin in violation of the security agreement until an alternative solution arises such as the idea of “dual private keys,” where the Bitcoin is unable to be transferred without the borrower’s and lender’s private keys, or a private lien registration system on the blockchain. Unfortunately, neither solution is available at this time.

Lenders have also explored the idea of having the Bitcoin sent to a trusted third-party, but these scenarios have resulted in violations of the Commodities Exchange Act. An additional idea is for the lender to obtain the private key or take physical possession of the cryptocurrency on a USB drive or other form of media holding the actual cryptocurrency. However, rather than being considered a secured transaction, this could be found to be an outright transfer, bringing regulatory issues for the lender. Because possession is not the method to perfect a security interest in a general intangible, this would create both perfection and priority issues for the lender.

With the uncertainties surrounding cryptocurrency as a source of collateral, lenders should be cautious when underwriting, conducting diligence and documenting cryptocurrency-secured loans. They should be fully informed and current on new laws, regulations and classifications of cryptocurrency to be as protected as possible.

If you have questions about cryptocurrency-backed loans, contact a Chuhak & Tecson Banking Law attorney.

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

Client alert authored by: Adam R. Moreland, Principal and Margaret M. Walsh, Associate

This alert originally appeared in the Fall 2018 Banking Focus newsletter.