alerts & publications
NFTs and Secured Transactions九月 14, 2022
Just what are the “cool kids” up to these days? Creating, marketing, and selling NFTs (and if you call them “non-fungible tokens” and not NFTs, you are most definitely not cool). It has only been about 18 months since Twitter founder Jack Dorsey’s first tweet sold as an NFT for $2.9 million. And the total value of NFTs sold in 2021 was more than $17 billion. So NFTs are clearly valuable and marketable treasures, but how might parties attempt to securitize and perfect their interests in these digital assets? In our previous client alerts in our series about NFTs, we looked at what NFTs are and their tax considerations. In this, the latest edition, we explore NFTs and secured transactions.
Remind Me: What Is an NFT?
An NFT is a unique blockchain token. It is non-fungible, which means that it is not replaceable or interchangeable. NFTs were designed to prove ownership of unique digital or physical assets, and they are ideal for managing digital versions of existing physical assets (art, trading cards, other collectibles, etc.). The fact that NFTs are “stored” on a blockchain appeals to investors and collectors; they cannot be replicated. And title to an NFT can be held anonymously.
The applications of NFTs are limitless and this emerging area of technology and law has not yet been fully explored. Even professionals have questions. Are there opportunities for lenders and financial institutions to look to NFTs as collateral for debt? Is the current framework suited to protecting security interests in NFTs? How will the financial system deal with the unique challenges of electronic records? Let’s look at some of these issues.
Perfection and Enforcement of Security Interests in NFTs Today
The Uniform Commercial Code (UCC) is a set of laws that governs commercial transactions across the U.S., and Article 9 of the UCC lays out the framework for creating and perfecting security interests in personal property. Perfection of a security interest under the UCC is essentially a process for a lender or other party to claim personal property as collateral for a debt. Each state has either adopted the UCC as written or adopted the UCC with slight modifications.
Under the current framework, in every state, an NFT could be considered a “general intangible,”1 and a party may file a UCC-1 financing statement to perfect its interests. Simple, right? Not so fast. First, determining the proper location to file a UCC-1 financing statement in perfecting a security interest in an NFT may be challenging (though a lender might determine a borrower’s location through Know-Your-Customer diligence). Second, a party conducting title diligence on NFTs may encounter a problem in assembling a complete record of NFTs since they are sometimes held anonymously. Third, foreclosing on an asset that lives on a blockchain, and relying on a public ledger to confirm ownership, could be tricky.
In light of these difficulties, perfection by “control” over an NFT may be another option under the UCC (Section 9-314). This typically occurs when a secured party takes a security interest in a deposit account, using a deposit control agreement that has been established among the secured party, the financial institution holding the deposit account, and the debtor. Some secured parties might like the sound of this method, but it was designed for investment securities: It only seems viable to the extent that a particular NFT is considered to be a “financial asset,” and this includes “securities” under what is known as the Article 8 “opt in” of the UCC. If a party elects the Article 8 opt-in approach, the NFT would no longer be a general intangible, but instead a “security,” and that would subject the asset to SEC regulations. And who really wants that?
Perfection and Enforcement of Security Interests in NFTs Tomorrow
Since 2019, the sponsoring organizations of the UCC—a joint committee of the American Law Institute and the Uniform Law Commission (ULC)—have been considering amendments to the UCC regarding digital assets and other emerging technologies. The amendments, which the ULC recently adopted (but individual U.S. states have yet to), concern a category of digital assets defined as “controllable electronic records” or CERs. Article 12 and corresponding amendments to Article 9 of the UCC define a CER as (i) a record that is (ii) stored in an electronic medium and (iii) subjected to “control.”2 This includes, among other digital assets, NFTs. CERs do not include electronic chattel paper, electronic documents, investment property (including UCC Article 8 opt-in), transferable records, deposit accounts, or intangible money.
Under the proposed UCC amendments, parties will not be required to change collateral descriptions in security agreements or on financing statements. For example, CERs qualify as “general intangible(s)”; a controllable account is an “account”; and a controllable payment intangible is a “payment intangible.” As with the current UCC framework, a security interest in a CER and certain linked payment rights embodied in a CER can be perfected by filing a financing statement. The most notable changes in the proposed amendments lie in perfection. The UCC amendments detail a more accessible and better defined framework for a CER—such as an NFT—to be perfected by “control.” And a security interest perfected by “control” would have priority over an interest perfected by the filing of a financing statement.
The new Article 12 to the UCC is not a regulatory statute and it is agnostic about whether a digital asset is held directly or through an exchange or a custodian. The normal UCC rules apply for attachment—i.e., the party with control over the collateral will have priority over a party who first perfects by filing a financing statement. Also, the choice of law for perfection and priority of rights to such property is the law where the debtor is. Finally, a CER would be negotiable—able to be transferred in such a way that cuts off competing property claims to the CER, including in the sales context. It defines a “qualifying purchaser” of a CER as someone who obtains control of a CER for value, in good faith, and without notice of a property claim to the CER. And the filing of a financing statement is not, in itself, notice of a property claim to the CER. Still, a qualifying purchaser acquires all rights in the CER that the transferor had, and takes free of any property claim to the CER.3
These amendments to the UCC are expected to be submitted to U.S. states for enactment by the end of this year. Several states have already adopted language from earlier versions of the proposed amendments, including Arkansas, Nebraska, and Texas. And Wyoming has adopted rules that apply a broad stroke to digital assets, treating virtual currency as money and “control” as possession. (Wyo. Stat. § 34-29-101).
The proposed amendments to the UCC aim to lay out a more clearly defined, accessible approach to the perfection of CERs, including NFTs. The amendments should solve choice-of-law rules within enacting jurisdictions, but even with the proposed modifications, perfection of security interests in NFTs still raises several questions. For instance, how do parties address the issue of shared control over these types of assets? Is perfection by “control” still available for digital assets that fall outside the ambit of CERs?
O’Melveny will be closely monitoring the legal issues surrounding NFTs, including their involvement in secured transactions. Please contact the attorneys listed here or your O’Melveny counsel for help navigating this complex and emerging area of practice. And look for another client alert in our NFT series soon.
1 “General intangible” means “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.” UCC § 9-102(a)(42).
2 See UCC § 12-105. “Control” under the draft amendments for CERs means a person’s exclusive power to (i) avail themself of substantially all the benefit from the electronic record; and (ii) (a) prevent others from availing themselves of substantially all of the benefit from the electronic record and (b) transfer control of the electronic record to another person or cause another person to obtain control of another controllable electronic record as a result of the transfer of electronic record; and enables the person to readily identify itself in any way.
3 Generally, whatever rights are embodied in the CER and whether “take free” rules apply to those rights upon transfer of the CER are all determined by other law (e.g., an NFT where copyright law may be applicable), subject to an exception for “controllable accounts” and “controllable payment intangibles.”
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Evan Jones, an O’Melveny partner licensed to practice law in California and the District of Columbia, Will Pao, an O’Melveny partner licensed to practice law in California, Jennifer Taylor, an O’Melveny partner licensed to practice law in California, Bill Martin, an O’Melveny counsel licensed to practice law in New York, and Emma Persson, an O’Melveny associate licensed to practice law in Texas, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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