In this article, George K Fogg at law firm Perkins Coie examines why bitcoins might be subject to security interests that reduce their value for owners, and if this can be resolved.
Would you purchase a house if you had no information on its mortgages?
That’s comparable to what buyers of bitcoin do everyday: purchase bitcoin without any information about liens on their bitcoins.
A lien is an interest in a borrower’s property that serves as collateral to be used to pay off a lender, should the borrower default. If there are liens on bitcoins, the blockchain wouldn’t provide that information.
For now, it just indicates assurance of ownership.
Bitcoins are encumbered with security interests granted by one or more prior owners – this is the fatal flaw of the ecosystem. A securities intermediary – someone that would agree to treat bitcoins credited to a securities account as a financial asset – could be the solution.
The following report looks at the way this flaw leaves bitcoins potentially subject to security interests that would reduce their economic value to owners and how it can be resolved.
Today’s bitcoin ecosystem – The fatal flaw
Bitcoin provides transparency by having all transactions listed on a public ledger that allows one to trace the ownership of each bitcoin. This transparency – together with the irreversibility of each transfer of bitcoins – creates the assurance that the transferee is receiving ownership of the bitcoins being transferred. Unfortunately, the public ledger only identifies ownership. It provides no information on liens.
Article 9 security interests are created on personal property (known as collateral) by the owner granting the secured party a security interest. The secured party must take certain action to “perfect” its security interest in order to have the full benefit of the rights provided by Article 9.
Article 9 divides collateral into types, which are defined in the Uniform Commercial Code (UCC),[1] and provides different rules with respect to the different types. Under the current bitcoin ecosystem, bitcoins are “general intangibles” – the UCC’s catchall type.
A security interest in general intangibles is perfected only by filing a financing statement in the appropriate public office. The financing statement must describe the collateral, which description can be as vague as “all assets,” or as specific as the secured party decides to make it.
A security interest in general intangibles like bitcoin continues, notwithstanding the sale, license or other disposition of the collateral, unless the secured party consents to the transfer free of its security interest, the obligations secured by the security interest have been satisfied or the security interest has otherwise terminated.[2]
Thus, each time a bitcoin passes through the hands of an owner whose property is subject to a security interest in general intangibles that bitcoin becomes burdened with that security interest.
Security interests in general intangibles are very common, especially for a business with a bank secured line of credit. It is the combination of bitcoins being general intangibles, security interests in general intangibles not being automatically released upon transfer and the ubiquity of security interests in general intangibles that creates the fatal flaw – bitcoins that are encumbered with security interests granted by one or more prior owners.
UCC Article 8 – The Solution
The fatal flaw can be eliminated by changing the Article 9 collateral type of bitcoins from general intangibles to “investment property,” which is accomplished by using a structure that causes them to be Article 8 financial assets.
“Financial assets” are assets held by a “securities intermediary”[3] that maintains “securities accounts”[4] for others (“accountholders”) in the ordinary course of business, provided the intermediary agrees to treat the assets as financial assets under Article 8.
Thus, the bitcoin metamorphosis from general intangibles to investment property is accomplished by a securities intermediary agreeing to treat bitcoins credited to a securities account as a financial asset subject to Article 8.
The Article 8 structure has the following benefits:
- A security interest in the accountholder’s account could be perfected by a control agreement (rather than a public filing), which maintains privacy
- Bitcoins are no longer subject to liens granted in general intangibles
- Bitcoins can be transferred free from existing security interests, provided the accountholder gave value for the bitcoins in the account without notice of existence security interests [5]
- Bitcoins held in such accounts are not property of the intermediary and would not be subject to claims of the intermediary’s creditors [6]
- Existing (but unknown) security interests are eliminated.
- Perfection by control also gives the secured creditor superior control, which should make credit both more available and less expensive.
- Since transfers of bitcoins are made by the intermediary on instructions of the accountholder, there is an additional layer of privacy for the accountholder
- The intermediary has the obligation to maintain bitcoins in a quantity corresponding to the total of all bitcoins credited to such accounts [7]
- This structure is well-known in commercial transactions, creates legal certainty, makes bitcoins held this way more attractive as collateral and will facilitate leveraging bitcoin investments with debt financing.
Summary
Under the current Bitcoin ecosystem, parties lack information regarding existing security interests. This circumstance leaves acquirers of bitcoins with the risk that their bitcoins may be subject to security interests that diminish or eliminate the economic value of the bitcoins to owners.
For bitcoins to become useful in significant commercial transactions, the present uncertainties regarding existing security interests must be removed. These uncertainties not only affect the ability of the acquirer to be certain it is receiving the value it bargained for, but also greatly diminishes the ability of the acquirer to finance such investments.
The Article 8 structure provides the solution for these deficiencies. It is a system that has worked well for securities and is flexible enough to do the same for bitcoins.
[1] Collateral types under Article 9 (exclusive of sub-types) are: accounts, chattel paper, commercial tort claims, deposit accounts, documents, general intangibles, goods (which includes inventory, equipment, fixtures and consumer goods), instruments, investment property, letter-of-credit rights, letters of credit, money and oil, gas and other minerals before extraction.
[2] UCC §9-315(a).
[3] “Securities intermediary” is defined in UCC §8-102(a)(14). The prototypical securities intermediary is a trust company or a brokerage firm.
[4] “Securities accounts” are a type of account defined in UCC §8-501(a).
[5] UCC §8-502
[6] UCC §8-503(a), UCC §8-507.
[7] UCC §8-504(a).