This article originally appeared in the March 2016 issue of Clarks' Secured Transactions Monthly.
With legitimate use of virtual currencies increasing rapidly, creditors may find themselves taking and seeking to perfect security interests in assets that include virtual currencies. There are hundreds of virtual currencies and cryptocurrencies in existence at the present time, with Bitcoin as the largest and most frequently mentioned. Article 9 of the UCC governs security interests in personal property, tangible and intangible. The application of Article 9 to virtual currencies, and issues related to the perfection and control of these animals, are discussed below.
What is a virtual currency? Initially, a distinction must be drawn between virtual currency and real currency. The Financial Crimes Enforcement Network (“FinCEN”), in its Guidance FIN-2013-G-0001 issued March 18, 2013, defines “real” currency as “coin and paper money of the United States or any other country that is designated as legal tender, circulates and is customarily used and accepted as a medium of exchange in the country of issuance.” By contrast, virtual currencies are electronic representations of value that may not have an equivalent value in a real government-backed currency. While virtual currencies can function like real currencies in certain transactions, and certain virtual currencies can be exchanged into real currencies, a virtual currency itself does not have legal tender status.
Users of virtual currency in commerce include owners that use virtual currency for payment; merchants that accept virtual currency; intermediaries that exchange virtual currency on behalf of merchants; exchange agents that exchange virtual currency into real currency; and electronic wallet and other non-deposit account providers who hold virtual currency for any of the above users. A virtual currency may be managed in a centralized fashion by a single administrator or in a decentralized fashion where there is no central administrator and the verification of transactions is performed by participants.
UCC security interests in virtual currency. A creditor taking a security interest in virtual currency must perfect its security interest under applicable state law. Unlike real currency, virtual currency is typically held in electronic wallets or other non-deposit accounts domiciled outside of traditional financial institutions. These electronic wallets and other nondeposit accounts are not “deposit accounts” as that term is defined in Article 9 of the UCC, because the providers thereof are not banks. Therefore, virtual currencies should be treated as general intangibles under Article 9 of the UCC.
General intangibles. Under UCC 9-102(a)(42), a “general intangible” is defined to include “any personal property, including things in action, other than accounts, chattel paper, commercial tort claims, deposit accounts, documents, goods, instruments, investment property, letter-of-credit rights, letters of credit, money, and oil, gas, or other minerals before extraction. The term includes payment intangibles and software.”
To perfect a security interest in a general intangible, a creditor must file a UCC-1 financing statement in the proper filing office, and the financing statement must include a sufficient description of the virtual currency being taken as collateral. The collateral can be described super-generically by a reference to “all assets,” more narrowly described as “general intangibles,” or specifically referenced as “all virtual currency” or “all bitcoins.”
Regardless of the collateral description, controlling an electronic wallet or other non-deposit account in which a security interest has been granted may be difficult, if not impossible. As a “general intangible,” a security interest in virtual currency cannot be perfected by use of a control agreement. As noted above, virtual currency held with a non-bank intermediary is not a “deposit account” – nor is it a securities account. Perfection issues aside, a non-bank intermediary who holds virtual currency may be unwilling to enter into a tri-party agreement whereby the debtor’s ability to transfer the virtual currency is restricted, or the intermediary agrees to remit the virtual currency to the secured party upon receiving a default notice.
Under the current system, a creditor who perfects by filing would remain susceptible to unauthorized transfers of pledged virtual currency. To compound the problem, most virtual currencies are transferred between parties in an anonymous fashion which, in all likelihood, will make it impossible for the creditor to identify the recipient or take possession of the transferred virtual currency. As a result, creditors may want to try to take possession of any virtual currency collateral at the time the security interest is granted.
Money. Under UCC 1-201(b)(24), the term “money” is defined as “a medium of exchange currently authorized or adopted by a domestic or foreign government. The term includes a monetary unit of account established by an intergovernmental organization or by agreement between two or more countries.” On its face, virtual currencies do not meet the UCC definition of money since virtual currencies are not authorized or adopted by a domestic or foreign government. Likewise, virtual currencies do not meet the FinCEN definition of “real” currency, as they are not coin and paper money of a country that is designated as legal tender.
Despite the statutory definitions, one U.S. federal district court has ruled that Bitcoin is, in an investment context, a currency or form of money. If this ruling were applied to UCC perfection issues, it could significantly impact how creditors perfect a security interest in assets that include virtual currencies.
In SEC v. Shavers, Case No. 4:13-CV-416 (E.D. Tex. 2014), the SEC accused the defendant and his company of operating a Ponzi scheme where investors used bitcoins to make their investments. In response, defendants argued for dismissal based in part on the fact that defendants’ investors used bitcoins to make their investment, that bitcoins were not currency, and that as a result there could be no investment of money in the transaction.
To provide some background, Bitcoin is an electronic, cryptocurrency which is not regulated by a central bank or governmental administrator. Instead, Bitcoin is based on a decentralized system where the participants work together to validate transactions. Transactions are recorded on a public ledger using blockchain technology. Bitcoin mining is a method of validating transactions that allows participants to obtain bitcoins as a result of their own efforts. Once mined, Bitcoin, like other virtual currencies, can be used for the purchase of goods and services from an ever- increasing number of merchants who accept Bitcoin as payment, and can be exchanged into real currencies.
The Texas federal district court’s analysis focused on the use of bitcoins in an investment context. In holding that bitcoins are currency or a form of money, the court stated that “(i)t is clear that Bitcoin can be used as money. It can be used to purchase goods or services, and as Shavers stated, used to pay for individual living expenses. The only limitation of Bitcoin is that it is limited to those places that accept it as currency. However, it can also be exchanged for conventional currencies, such as the U.S. dollar, Euro, Yen, and Yuan. Therefore, Bitcoin is a currency or form of money.…” The court ultimately entered final judgment that, among other things, required the defendants to disgorge over $40 million in profits and interest.
To the extent virtual currencies are “money” under the UCC, to perfect a security interest creditors would not file a UCC-1 financing statement, as they would for a general intangible, but instead must secure “possession” of the virtual currency.
As described above, obtaining a meaningful security interest in an electronic wallet or other non-deposit account may be difficult or impossible due to the inability of a creditor to take control of such accounts. Enforcement and taking actual possession of virtual currency post-default would likely require that the creditor be able to transfer the virtual currency – which requires access to the specific electronic wallet or other non-deposit account, many of which are access-restricted via private keys or other passwords – to an account in the creditor’s name.
Bottom line. The legal and regulatory landscape concerning virtual currencies is evolving and is likely to continue to evolve in the future as the use of virtual currencies becomes more common and expands into new areas. As the use of virtual currency expands, creditors should proceed with caution and understand the risks associated with taking and perfecting a security interest in assets that include virtual currency.