UCC Article 12: How States are Regulating Digital Asset Transactions

It’s a new year, and state legislatures around the country are beginning new legislative sessions. We expect to see more of them enacting Article 12 of the Uniform Commercial Code (UCC), which is designed to facilitate transactions in cryptocurrencies, NFTs and other types of digital assets.

What is UCC?

The UCC is a model piece of legislation produced jointly by two of the nation’s premier legal institutions: the American Law Institute and the Uniform Law Commission. Enacted in whole or in part by every U.S. state and territory, the UCC provides rules that govern many commercial transactions (e.g., sales of goods, the use of personal property as security for a debt) and many devices regularly used in commerce (e.g., negotiable instruments, letters of credit and the indirect holding system for stocks, bonds and other types of investment property). It is probably fair to say the majority of the U.S. economy operates on a foundation of law established by the UCC.

What is UCC Article 12?

The UCC was first drafted in the 1950s and has been revised numerous times since. In 2019, the sponsoring organizations decided it was necessary to consider revising the entire UCC to address emerging technologies, and they formed a committee for that purpose. In 2022, the committee finished its work and the sponsors approved amendments to the entire UCC, including a new Article 12 to deal with electronic assets. Several states were so eager to address the underlying concerns that they took the unusual step of enacting a draft version of Article 12 before the final version was completed. Currently, the final version of Article 12 has been enacted in 24 states plus the District of Columbia, and a preliminary version is in effect in six additional states (see map below).

Article 12 solves an important problem that existed under prior law. For most types of personal property, the UCC had what is known as a “take-free” rule: a rule that allows a person who purchases an asset in good faith, for value, and without notice of a claim on the asset, to acquire the asset free of the claim. These rules are vital to commerce because they allow property to be transferred freely, without necessitating expensive and time-consuming searches for potential claims to the property (e.g., a title search when purchasing real estate). But prior to Article 12, there was no such take-free rule for digital assets (e.g., cryptocurrencies, NFTs). What is worse, it was often nearly impossible to check for pre-existing claims.

For example, consider a situation in which a Borrower owned several bitcoin, and used the bitcoin as collateral for a loan. The Lender perfected its security interest in the bitcoin by filing what is known as a “financing statement” – a one page notice, filed in a public office where the Borrower is located, identifying the Borrower as the debtor, the Lender as the secured party and indicating the collateral in general terms. An indication such as “bitcoin,” “cryptocurrency” or “general intangibles” would be effective.

If the Borrower later transferred the bitcoin to a Purchaser in return for property or services, the Lender’s security interest in the bitcoin would survive. That is, the Purchaser would take the bitcoin subject to the Lender’s security interest. If the Purchaser then transferred the bitcoin to a Subsequent Purchaser, again the Lender’s security interest would remain attached to the bitcoin. The Subsequent Purchaser might not have been aware of the Lender’s security interest and, if not, is unlikely to have had a good way to protect itself from the risk that such a security exists. 

If the Subsequent Purchaser were savvy, it might search for filed financing statements identifying the Purchaser as the debtor. But the Subsequent Purchaser would likely have little or no way to identify the Borrower as the prior owner of the bitcoin, and thus no real ability to discover the Lender’s security interest. Financing statements are indexed by debtor name; blockchains are not. Moreover, financing statements are filed in a particular state, typically the state where the identified debtor is located, and thus the Subsequent Purchaser would also need to have some knowledge of the Borrower's location to know in which state to search. But just as the names of prior owners do not appear anywhere in the blockchain, neither do their locations. Blockchain addresses are not associated with particular geographic locations. 

Critically – and in spite of all this – if the Lender later tracked the bitcoin to the Subsequent Purchaser, the Lender could potentially get the bitcoin from the Subsequent Purchaser.

Some financial institutions lending against digital assets addressed these problems by obtaining functional control over the assets, such as by getting and retaining the public and private keys to the blockchain wallet holding the assets. If the debtor did not retain a copy of the keys, this action effectively prevented anyone from transferring the assets without the financial institution’s cooperation and consent. However, this action did not:

• remove the risk that someone might already have a perfected security interest in the assets – either because the debtor granted the interest or because a prior owner did so, and the debtor acquired the assets subject to that perfected security interest;
• prevent someone else that later obtained a security interest in the assets from acquiring priority by filing a financing statement; or
• perfect the institution’s security interest, so that the institution would be protected in the debtor’s bankruptcy.

UCC Article 12 seeks to address these problems.

How UCC Article 12 Works

UCC Article 12 creates a new term of art: controllable electronic record (CER). Cryptocurrencies and NFTs are CERs, as might be other types of digital assets created in the future. Article 12 then provides rules for what rights a transferee of a CER acquires. In particular, a “qualifying purchaser” – defined as a purchaser that obtains control of a CER for value, in good faith and without notice of a claim of a property right in the CER – takes free of other property rights in the CER. This rule solves the problem of whether a security interest travels with a digital asset and allows those who acquire such assets to rest assured that no one will come knocking on their door claiming to have an earlier-created property right in the digital assets acquired.

The key term on which all of Article 12 rests is “control.” To have control, a person must have:

• The power to avail itself of substantially all the benefit from the CER;
• The exclusive power to prevent others from availing themselves of substantially all the benefit of the CER;
• The exclusive power to transfer control of the CER; and
• The ability readily to identify itself (by name, number, cryptographic key, account number or otherwise) as the person having these powers.

Despite the requirement of exclusivity, these rights can be shared without losing control (subject to some exceptions) and control can be obtained through an agent or other representative. 

For example, if the owner of bitcoin shares the public and private keys with a lender, the lender will have control. This is so even though the owner retains a copy of the keys, and therefore retains the practical ability to transfer the bitcoin if the owner acts before the lender does. What is more, if the owner shares the public and private keys with multiple lenders, then each of them would have control.

It is worth noting that prior to the adoption of Article 12, some lenders taking a security interest in digital assets insisted that the assets be intermediated with a reputable custodian that agrees to treat the assets as investment property under UCC Article 8. Article 12 does nothing to undermine the efficacy of that process. Instead, it provides an alternative structure that does not require that the assets be intermediated.

Another Potential Use of UCC Article 12

In addition to creating rules that facilitate trading in CERs, Article 12 also establishes rules for another new type of property: controllable payment intangibles (CPIs). A CPI is a right to payment that is represented by a CER and with respect to which the obligor promises to pay the person in control. A U.S.-dollar-backed stablecoin, which the issuer promises to redeem for dollars, would likely be a CPI.

The new rules for CPIs are very similar to the rules for CERs. They should therefore facilitate the development and commercial use of U.S.-dollar-backed stablecoins. This is because anyone who acquires control of the stablecoin would, thereby, acquire the redemption right associated with it, and in most cases would take free of other claims to the stablecoin.

The Future

Although UCC Article 12 might be somewhat complicated, we expect many of the remaining states to enact it this year. If they do, that will help avoid the extremely complicated conflict-of-laws problems that can arises under the current situation, in which UCC Article 12 is effective in only about half of the country.

Paul Hastings Fintech lawyers are available to assist clients in understanding new UCC Article 12 and in structuring transactions to take advantages of it.