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How Secured Lenders Can Protect Their Interests When Dealing with Non-Fungible Tokens and Cryptocurr

How Secured Lenders Can Protect Their Interests When Dealing with Non-Fungible Tokens and Cryptocurrency
February 2, 2022 by Alice A. Kelly, Partner | Alyson M. Fiedler, Partner | Louis T. DeLucia, Partner | Michael Ott, Of Counsel | Phillip N. Coover, Partner | Yankun Guo, Partner
As we enter 2022, lenders should take time to familiarize themselves with digital assets—specifically, non-fungible tokens (“NFTs”) and cryptocurrency. As of today, more than 30 public companies hold cryptocurrency on their balance sheets, and big brands such as Visa and Adidas have each purchased NFTs worth more than $100,000. [1] With the value of digital assets increasing, borrowers may seek to pledge NFTs and cryptocurrency as collateral. In this alert, we explore how secured lenders may protect their security interests in this novel form of property. [2] 
 

What Are Cryptocurrency and Non-Fungible 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 clear or verify the transaction, and provides digitally authenticated recordkeeping. [3] Essentially, cryptocurrency is digital, decentralized money that has its transaction history recorded on a publicly available ledger. The two largest cryptocurrencies, Bitcoin and Ethereum, currently have market caps of around $800 billion and $380 billion, respectively, though 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, each NFT is intended to be unique and no two are alike—hence the name “non-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 piece of digital artwork or audio clip. In other cases, NFTs have been used to sell plots of virtual real estate in the metaverse—interactive virtual environments that many, like Mark Zuckerberg, believe will be the successor to the current Internet. 

Cryptocurrency and non-fungible tokens are popularly categorized as digital assets, which is an expansive but informal category of assets issued and transferred using the blockchain. [7]
 

Issues Relevant to Secured Lenders

 
A. Perfecting Security Interests in Cryptocurrency and Non-Fungible Tokens

Digital assets are a form of personal property. The perfection of security interests in personal property 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 personal property. [8]

Different categories of personal property require different methods of perfection, and the perfection method can have a material impact on the value of accepting certain assets as collateral. Article 9 had its last major amendments in 2010, when digit assets were in their infancy. The first cryptocurrency, Bitcoin, had just been created but had not yet reached a mass market. NFTs were barely even a glint in anyone’s eye. Unsurprisingly, Article 9 does not include a separate classification for digital assets. 

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

Security interests in both general intangibles and investment property may be perfected by filing a UCC-1 financing statement against the debtor. Security interests in investment property may also be perfected by obtaining control over the investment property. Because security interests in investment property perfected by control have priority over security interests protected merely by filing, perfecting by control is preferred. [9]
 
B. Problem with Classifying Cryptocurrencies as General Intangibles

Classifying cryptocurrencies as general intangibles is problematic if the goal is for cryptocurrencies to serve as a substitute for money. This is because of the way Article 9 handles the survival of security interests following a sale of the collateral. 

Generally, when collateral is sold, the secured party’s security interest automatically attaches to the identifiable proceeds of the collateral. However, if the collateral was sold without the authorization of the secured party, then the secured party’s security interest in the collateral may survive the sale. [10] As a result, cryptocurrencies and other digital assets may remain subject to security interests granted by prior owners of the digital asset. The possible survival of these “zombie” security interests, which may have priority over the claim of a subsequent secured lender or purchaser, should be considered when valuing digital assets as collateral.

To solve this problem, proponents of Bitcoin and other cryptocurrencies have been lobbying for cryptocurrencies to be categorized as “money.” A security interest in money is perfected only so long as the secured party 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 may perfect a lender’s security interest in most digital assets, the lender should also take practical steps to ensure that it will be able to obtain possession and control over the collateral if the lender should need or want to exercise its remedies against the collateral, such as by effectuating a public or private sale of the digital assets. 

Digital assets are stored electronically in what is known as a digital wallet that can only be accessed by using a private key similar to a password. [13] Without the private key, lenders will be unable 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 having the private key turned over 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, out of the lender’s reach. To mitigate this risk, it has been suggested borrowers transfer their NFTs or cryptocurrency to a digital wallet solely controlled by the lender or by using digital wallets that require more than one key to authorize transactions. [14] These multi-signature wallets are similar to a tri-party escrow agreement. [15] Another type of secured wallet is a cold wallet, which is stored offline and not connected to the Internet, making it more resistant to being hacked. Both of these methods are similar to obtaining control over a securities or deposit account and serve the practical purpose of ensuring that the secured lender will have access to the collateral when it needs it. 

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—therefore it is highly advisable to ensure the security of the digital wallet. Digital assets are routinely stolen by cybercriminals who successfully access the digital wallet—transferring the cryptocurrency contained in the wallet with little hope for recovery.
 

Conclusion 


2021 saw the value of cryptocurrency and NFTs hit historic highs, and there is no telling what 2022 will bring. In the meantime, lenders should consider methods for protecting their rights, including:
 
  • filing a UCC-1 financing statement in the appropriate jurisdiction to perfect their security interest in either cryptocurrency or NFTs;
  • obtaining control over any securities accounts holding cryptocurrencies or other digital assets that have been or may be classified as securities;
  • implementing a security procedure to protect the digital wallet from cybercriminals or unauthorized access; 
  • at the minimum, acquiring the private key granting access to the digital asset at the time a security agreement is executed or have it turned over to a custodian to be held in escrow; and
  • discussing with the borrower the possibility of placing the digital asset in a digital wallet controlled by the lender or some form of tri-party escrow account. 
Ice Miller represents financial institutions as well as borrowers in a broad range of commercial financing and real estate transactions. Ice Miller also has extensive experience in asset financing, including financing of securities, real estate, and asset-based lending. For more information, please contact Michael Ott, Louis DeLucia, Alyson Fiedler, Alice Kelly, Guillermo Christensen, Yankun Guo, or Phillip Coover.

[1] Adrian Zmudzinski, Institutional Investors Now Hold $70B of Bitcoin: Report, YAHOO (Aug. 30, 2021), https://www.yahoo.com/now/institutional-investors-now-hold-70b-122022840.html; Robert Farrington, Why Big Brands Are Spending Millions on NFTs, FORBES (Dec. 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 & John Schmidt, What Is Cryptocurrency?, FORBES (Jan. 3, 2022), https://www.forbes.com/advisor/investing/what-is-cryptocurrency/.
[4] Jazmin Goodwin, What Is an NFT? Non-Fungible Tokens Explained, CNN (Nov. 10, 2021), https://www.cnn.com/2021/03/17/business/what-is-nft-meaning-fe-series/index.html.
[5] Id.
[6] Id.
[7] Matthew Vincent, What Are Digital Assets and How Does Blockchain Work?, FINANCIAL TIMES (Oct. 20, 2021), https://www.ft.com/content/2691366f-d381-40cd-a769-6559779151c2.
[8] “Virtual real estate mortgages” present a number of difficult problems beyond the scope of this present article. 
[9] UCC § 9-328(1).
[10] See UCC § 9-315(a).
[11] UCC § 9-313(d).
[12] See Senate File No. SF0125, Wyo. Leg. (Feb. 2019) (this bill became effective Wyoming law on 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 likely will not qualify as deposit accounts under Article 9 because the definition of deposit account requires that the account be maintained with a bank.
[14] See Xavier Foccroulle Menard, Cryptocurrency: Collateral for Secured Transactions?, 34 B.F.L.R. 347, 366 (2019).
[15] Id.

Special thanks to law clerk Ryan Hibbard for his many contributions to this article. Ryan is not yet admitted to practice in any jurisdiction.

This publication is intended for general informational purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader’s specific circumstance.


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