Investors have long been accustomed to borrowing to finance the purchase of securities. Therefore, they may assume that the rules are the same when borrowing to buy virtual currency. Unfortunately, this is not the case at the moment.

When an investor borrows against either securities or virtual currency, the resulting security interest is governed by Articles 8 and 9 of the Uniform Commercial Code. However, when Article 9 was most recently revised, the use of virtual currency as collateral was in its infancy. Neither the Article 9 revisions nor the 2010 amendments to Article 9 clarified exactly what steps the lender must take to perfect security interests in virtual currency held in a custodial account for a borrower. The lack of resolution on these steps presents issues for both investors and their lenders.

For lenders, the problems arise from the current treatment of virtual currency under Article 9. Virtual currency today would likely be characterized as a “general intangible” for purposes of Article 9, and thus the lender is required to file in order to perfect. This has the following unfortunate consequences:

• In order to be entitled to the virtual currency upon the user's bankruptcy, and to get a better right to the virtual currency than any other secured creditor (in Article 9 language, to achieve “perfection and priority”), the lender would have to take numerous complicated and expensive steps to make sure that its rights have priority over competing claims. These steps include filing notices in the state's UCC filing system, searching for earlier filings, and securing specific releases or subordination agreements from competing interest-holders.
• The filing system works well for many types of collateral, but may present issues for virtual currency: How is the virtual currency to be described in the user agreement and financing statement? Does a description that covers “Bitcoin” cover a future purchase of “Ethereum”? How will the lender determine the user's legal name (i.e., the name used for the financing statement) if the user, with whom the lender has dealt remotely, is an individual and does not exhibit a New York State driver's license, which is the Article 9-approved method of ascertaining the correct name under which an individual filing should be made? How will the lender be able to deal with users who, as evidenced by a search of the filing office records, have an existing security agreement with another person listing virtual currency as collateral?
• Expenses of dealing with such issues, including searching the records of and filing in the filing office and obtaining subordinations or releases from competing secured parties, may make it unprofitable to take virtual currency as collateral under terms that are likely to attract users.

For investors, the risks arise from the same deficiencies in the legal rules. Because a lender may find it difficult or undesirable to work with the filing system, it may be tempted to keep all of the virtual currency held for investors in an aggregated account under its sole control. The potential consequences to investors of this approach are highlighted by the recent mysterious disappearance (and presumed death) of Gerald Cotten, CEO of QuadrigaCX, together with the virtual currency held for customers.

In order to protect investors and lenders from such situations, the Uniform Law Commission (ULC) has drafted an Act known as the Uniform Supplemental Commercial Law for the Uniform Regulation of Virtual-Currency Businesses Act (Supplemental Commercial Act). This Act (which is available on the ULC web site, uniformlaws.org), resolves these issues by providing that the lender can perfect by executing an agreement (known as a Control Agreement) (discussed below) among the investor, the lender, and the person holding the virtual currency. This Act would, in most cases, render it unnecessary for a lender to resort to the filing system.

As originally drafted, the Supplemental Commercial Act was to intended to be enacted in conjunction with a prior ULC uniform regulatory act providing rules for the licensing of virtual currency businesses.

However, New York has already been in the forefront of the movement to require licensing of such businesses. It has a regulatory scheme called the BitLicense, and does not need to amend its regulatory scheme to enact a uniform licensing act. Therefore, the City Bar Committee on Commercial Law & Uniform State Laws (the Committee) has recommended a modified version of ULC's uniform Act to work with the existing New York regulatory and licensing scheme (the NY Act). The proposed legislation is provisionally titled the “Supplemental Commercial Law for Virtual Currencies.” It is available from the author ([email protected]) or Alan Kolod, chair of the Committee ([email protected]).

The NY Act may encourage entities interested in offering such customer services to apply for licenses from the Department of Financial Supervision to the extent that they do not hold them now, as its benefits will apply to such licensees. It also may create user demand for licensure of such custodial businesses. (Note that one popular virtual currency custodian is now advertising that it is regulated and licensed.) As of this writing, the NY Act has not been introduced in the legislature.

The NY Act generally provides rules governing the relationships between licensed businesses that offer custodial services to owners of virtual currencies and their customers (users).

The NY Act provides that if the virtual currency is placed in an account controlled by a BitLicensee, the virtual currency and rights to it may now be characterized for Article 9 purposes as “investment property.” (This characterization does not affect the issues of whether such virtual currency is a commodity or security under federal or other state laws and regulations.) Therefore, a security interest in virtual currency is perfected and achieves priority over competing claimants by being subject to a “control agreement.”

Control agreements have been used by banks and brokers for years and are now a relatively standardized financing device. They are simple to use, and do not require that the lender have specialized knowledge about the filing system (or that it update financial statements periodically in order to avoid loss of perfection). Investment property “control agreements” are “one and done” propositions.

Furthermore, the NY Act protects users' assets against misuse by the licensee under UCC Article 8 rules. The user's rights in such currency should not be subject to the claims of creditors of the BitLicense holder. Thus, customers of BitLicense holders will receive protections afforded to customers of other New York-based custodians under UCC Article 8.

Additionally, the NY Act:

• incorporates the adverse claim cut-off rules of UCC Article 8 so that NY law will treat adverse claims against virtual currency in the same way as Article 8 treats adverse claims against securities held with an Article 8 intermediary. Therefore, a person taking an interest in virtual currency generally would not need to worry about the virtual currency being subject to a competing ownership claim or a claim of a security interest granted by a prior owner of the virtual currency. This will make virtual currency function, as it was intended to do, like fiat money.
• requires that the governing law of the user-licensee agreement will be the law of a jurisdiction that has enacted UCC Article 8. Since New York's Article 8 is substantially similar to Article 8 as enacted in other U. S. jurisdictions, this rule protects users from the surprise of discovering that the agreement is governed by unfamiliar foreign (non-U.S.) law.
• requires that licensee-user agreements provide that the licensee will not grant a security interest in the virtual currency it holds for a user to another person absent user consent (as may now be done, for example, in some margin accounts), and establishes priorities if this rule is violated by the custodian.
• requires, at a minimum, licensees must act with “due care in accordance with reasonable commercial standards” in maintaining the account. The licensee, therefore, cannot, provide in its agreement that it is relieved from liability if it has merely avoided willful and wanton misconduct. And,
• prohibits licensees from waiving or varying these requirements by agreement, adding that any attempt to do so is ineffective.

The result is that enactment of the NY Act will give all parties to a custodial account holding virtual currency substantially the same benefits and protections as are available to parties to a bank or broker account holding securities under Articles 8 and 9 of the UCC, and that the custodian will be subject to the same rigorous oversight that New Yorkers have come to expect of licensed financial institutions.

Sandra Stern, a partner at Nordquist & Stern in New York City, is a New York representative on the Uniform Law Commission, which drafted the Supplemental Commercial Act discussed herein.