Michael Clain on "What is Bitcoin and How Do I Take a Security Interest In It?"
There's almost $10 billion of it in the world and you can use it to buy clothes at Target, cough drops at CVS, sandwiches at Subway and just about anything on Amazon, but can you take a lien on it?
Given its price volatility, regulatory uncertainty, exposure to cyber theft and unsavory reputation, you may want to steer clear of bitcoin. But it's increasingly popular and someday you may find yourself having lunch with the CFO of a bitcoin exchange or, more likely, discover that your client has accepted payment in bitcoin from an overseas buyer, and then you will ask yourself: what is this thing and how do I grab it if I need to?
Bitcoin, for those who are not technically-minded, is a computer protocol, a system of rules, which generates units ("virtual currency", in this case called bitcoins) the participants agree to accept as payment for goods or services or in exchange for some other form of currency. A decentralized public ledger called the "blockchain" keeps track of every bitcoin ever created and every bitcoin transaction ever completed. Bitcoins are stored in their owners' "digital wallets", which generate two mathematically-related cryptographic keys (basically long chains of random numbers and letters), one of which is made available to everyone (the "public key"), while the other is known only to the wallet's owner (the "private key"). To transfer bitcoins, the owner must use her private key to access her digital wallet and then broadcast to everyone engaged in keeping track of bitcoin transactions (estimated at between 20,000 and 60,000 computers worldwide) a string of code that specifies, among other things, how much bitcoin is being transferred, where it came from and where it's going (namely, the public key of the transferee).
For purposes of Article 9 of the UCC, bitcoin is not "money" (because it is not authorized or adopted by a government), it is not an "instrument" (because it is not in written form), it is not a "security" (because it is not an obligation of an issuer or an interest in an issuer or its property or enterprise) and it is not electronic chattel paper (because it doesn't deal with goods). Digital wallets are not deposit accounts (because they are not maintained by banks) or commodity accounts (because they do not carry commodity contracts). They could be shoehorned into the definition of securities accounts, but it would be an uncomfortable fit.
For purposes of Article 9, bitcoin is a general intangible, the residual category of personal property that doesn't fit other defined types of collateral. Creating and perfecting security interests in general intangibles is routine - it requires the execution of a security agreement and the filing of a UCC financing statement. Given the prevalence of blanket liens in secured lending, your collateral may already include bitcoin (that's a discussion you need to have with your borrower). But if you're considering entering into a secured transaction in which bitcoin is a significant asset, you have to keep three things in mind:
- You don't know where it's been. A security interest in general intangibles continues notwithstanding their transfer (and, if properly perfected before the transfer, it has priority over a subsequent lien), unless the secured party releases the security interest or consents to the transfer free of the security interest. To make sure you have a first lien on your debtor's bitcoins you would need to confirm that no prior owner had granted a security interest in its general intangibles to its lender.
- You don't know where it's going. The only way to keep your debtor from transferring his bitcoins is to deny him access to the internet. Bitcoin is a peer-to-peer network, with no one in control. As long as your debtor can access his digital wallet he can transfer his bitcoins to anyone (on an anonymous basis) without the need for third-party approval.
- You don't know how to get to it. You'd need your debtor's private key to access his account - or at least you'd need to know where to get it in the event of a default. You could accomplish this by requiring your debtor to use a digital wallet maintenance service and entering into an agreement with that service similar to a deposit account control agreement. Wallet services have been reluctant to enter into such agreements, but that may change as the market matures.
Virtual currency is still a nascent payment system, but it is common enough for the IRS and the Treasury Department to have developed regulatory guidance and for various states, including New York, to require licensing for related service businesses. Although by no means market standard yet, we've even seen loan document provisions dealing with virtual currency - typically representations that the borrower doesn't own any and covenants that it will not accept any as payment.
If you want to learn more, you'll find an interesting article about how bitcoin actually works here.
And of course you can always call or email me.
Michael Clain is a Partner with a practice focus on the structuring, negotiation, and documentation of a variety of credit products, including broadly syndicated corporate loans, asset-based loans, cash flow loans, trade and supply-chain finance, the purchase and sale of individual loans and loan portfolios, and the workout of troubled assets.
This article is part of a series of concise and readable articles exploring new developments of interest to lenders. Have you run into an issue you find intriguing? Let us know and we'll cover it in a future article.