Article By Andrea Tinianow
The split has elicited strong reactions on both sides. Last week, the Wyoming Legislature’s Blockchain Task Force released a letter responding to two requests made a month ago by the Uniform Law Commission to Wyoming legislators, asking them mid-session to withdraw their legislation in favor of the Uniform Law Commission proposal. Wyoming declined the request, passed the bill overwhelmingly, and Governor Mark Gordon signed it into law last week.
Why such strong reactions? The difference boils down to whether individuals should gain access to the “super-negotiability” protections of commercial law, or whether these vital protections should be restricted to securities intermediaries only. Super-negotiability is, as I’ll explain later, the “holy grail” of commercial law. Why confer a powerful, regulatory-created advantage on old-world securities intermediaries, especially when a slew of new intermediary-less, peer-to-peer exchanges and lending platforms for digital assets are coming online? Blockchain-based assets are inherently peer-to-peer assets that are mostly owned directly by individuals, not intermediaries, and forcing them into the hands of intermediaries would neutralize their best attributes. It’s no surprise that the securities industry would throw its considerable heft behind a legal regime that imposes intermediaries as an attempt to preserve its hegemony and assert control over this powerful, disruptive technology.
But why would the Uniform Law Commission create a structural advantage for the securities industry — whether inadvertent or not — particularly at a time when the inefficiencies and irregularities in the current U.S. securities settlement system are well documented?
The Supplemental Act mandates that owners of virtual currency relinquish their property rights to intermediaries and receive in return mere security entitlements, nothing more than what one commentator* has described as an “attenuated form of property right that looks more like a contract claim against the intermediary.” The same commentator, D.C. Donald, correctly points out that, under the indirect ownership regime, securities intermediaries are not required by law to have on hand the securities they sell to you.
Yes, you read that right. Intermediaries have the power to conjure securities (specifically, security entitlements) from thin air, which is granted by state commercial laws (called the Uniform Commercial Code, UCC). Mr. Donald points out that, under UCC Article 8, “…a claim to securities is created by a credit of such securities to the claim holder’s account, regardless of whether the intermediary actually has such securities in its holdings.”** This provision in Article 8 is the root cause of most of the securities industry’s ledger irregularities. The Supplemental Act proposes to apply the very same UCC provisions to virtual currencies.
BACKGROUND: WHAT IS THE UCC?
The UCC is the foundational law of commerce in the U.S. It is state law — U.S. states have power over commercial laws, not the federal government — and it provides a comprehensive legal regime for all business transactions involving personal property (i.e., excluding real estate). Adopted in all 50 states to a large degree (Louisiana has a slightly more limited UCC because of their civil law tradition), the UCC covers commercial activities, such as the transfer of personal property, sale of goods, securities and secured lending using property as collateral. It also defines the rules by which property can be transferred to a purchaser free of encumbrances. Jeanne L. Schroeder, esteemed law professor from the Cardozo School of Law and author of “Bitcoin and the Uniform Commercial Code,” calls the UCC the “plumbing of finance.”
She’s right. I know this from my work experience involving Article 9 of the UCC (which governs secured transactions), first while serving as assistant general counsel for one of the largest provider of UCC services, and then during my 4-year stint with the Delaware Secretary of State’s Office. I even created a UCC Handbook to help filers avoid common mistakes and also saw many UCC legal issues and disputes up close as I worked with clients and practitioners to get them resolved.
State-enacted UCC laws are generally derived from UCC model laws, which are drafted by attorneys in the Uniform Law Commission. State legislatures may enact the laws as presented, with modifications, or not at all.
The “holy grail” of commercial law, as mentioned previously, is super-negotiability. Super-negotiability means, in most cases, that the purchaser takes the asset free and clear of any encumbrances (such as a lender’s lien) unless it knew of such claims and colluded to defraud the lender. Under the UCC, super-negotiability is only available to (1) money and (2) securities owned indirectly through securities intermediaries — referred to as security entitlements (in other words, not the real thing!). Both the Wyoming and Uniform Law Commission approaches bestow super-negotiability on virtual currencies, but super-negotiability in Wyoming applies to virtual currencies and digital securities — not just to virtual currencies alone — and applies regardless of whether individuals own the digital assets directly or indirectly via a securities intermediary. In stark contrast, the super-negotiability of the Uniform Law Commission’s Supplemental Act is attenuated because its super-negotiability applies to a mere claim rather than to the actual assets, and it applies to virtual currencies only.
In summary, the key differences between the two approaches are (1) which assets attain the “holy grail” of super-negotiability, and (2) whether that super-negotiability applies to the actual asset rather than a mere claim on it. Before we discuss more, let’s step back to a high-level comparison.
WHAT IS THE UNIFORM LAW COMMISSION’S PROPOSAL?
Given the proliferation of digital assets, it is not surprising that the Uniform Law Commission created model laws to bring clarity to the treatment of digital assets under the UCC. To that end, the Uniform Regulation of Virtual Currency Businesses Act (URVBCA) and the Supplemental Act (collectively, the Model Acts) provide a statutory framework for regulating companies that engage in virtual-currency business activity*** as well as transactions that involve virtual currency.
Under the Model Acts, virtual currency is defined as a digital representation of value that is used as a medium of exchange, unit of account, or store of value, but is not legal tender. The Model Acts do not cover all types of digital assets, only virtual currencies, leaving a substantial gap in coverage of the wide range of types of other digital assets which should be covered by the UCC. Failing to include other kinds of digital assets greatly diminishes their potential commercial adoption and market value.
Setting aside that the scope is limited to virtual currencies, what is most troubling about the Model Acts is that they require the parties to a commercial transaction involving virtual currencies to “opt in” to the provisions of Article 8 of the UCC (which govern security entitlements). Because Article 8 sets forth a regime of indirect ownership — the very same regime that governs traditional securities — only virtual currencies that are owned via securities intermediaries in omnibus accounts are likely eligible to participate in the UCC statutory framework.
This classification of virtual currency within the existing securities intermediary framework also is curious because most forms of virtual currency likely are not securities. Why should they be treated like securities then?
For these reasons, requiring virtual currency owners to submit to a regime of indirect ownership is problematic. Not only does it ignore the direct ownership nature of virtual currency, and creates a structural advantage for the securities industry, but it also inadvertently creates solvency risk for financial institutions dealing in virtual currencies.
Continuing with D.C. Donald’s point from above, intermediaries are permitted by UCC Article 8 to sell you an asset they do not own. In the name of negotiability, Article 8 permits intermediaries that do this to avoid the need for a purchaser to do due diligence, i.e., to take the time to confirm that the intermediary owns the security before selling it. As Mr. Donald acknowledges, this Article 8 shortcut creates a danger of “overissue” of “shadow” securities. He adds, “imposing strict standards on intermediaries can reduce this problem, but not ultimately eliminate it.”
The “overissue” problem is significant — it means more owners have valid claims to an asset than the quantity that exists, and by definition this suppresses the price of securities by inflating their supply artificially. The best example of this issue is In re Dole Food Company, a 2017 class action lawsuit before the Delaware Chancery Court in which investors alleged that the shares were undervalued at the time of a management buyout. A total of 49.2 million “facially valid” claims to Dole Food shares, all backed up by brokerage statements as proof of ownership, were filed for the 36.7 million shares outstanding. A fascinating question about this situation is how much the “shadow” shares themselves caused some of the undervaluation, since artificial increases in supply suppress the stock price? No one will ever know for sure, but those “shadow” shares created an uncovered short position in the stock that very likely suppressed its price and skimmed value from legitimate owners. This practice is wrong, but it’s legal.
In the context of virtual currencies, “overissue” is not only bad — it can be lethal to financial institutions and cause major losses for innocent consumers because, as Caitlin Long of the Wyoming Blockchain Coalition correctly points out, virtual currencies do not have the fault tolerance in their settlement systems available to the securities industry (because virtual currency transactions settle nearly instantaneously). Bitcoin and similar virtual currencies are designed for perfect ledger accuracy, and they usually have caps on the quantity of coins outstanding that cannot be breached. There is no lender of last resort. This means a financial institution that creates “shadow” bitcoin is at high risk of failing in a classic run-on-the-bank. There is no way to paper over the problem, which should never have arisen in the first place. Placing virtual currencies under Article 8’s indirect ownership regime is a recipe for creating problems down the road that are entirely avoidable.
WHAT IS WYOMING’S APPROACH?
There is a better way. The bill referred to as SF 125, which was signed into Wyoming law by Governor Gordon last week, eschews a mandatory indirect ownership regime, making it optional instead, and most importantly, allows owners of digital assets to retain their direct property rights under the UCC regulatory framework without sacrificing lender protections. It applies super-negotiability to all virtual currency and digital securities, not just virtual currencies owned via intermediaries.
SF 125 is a statutory regime for digital assets that harmonizes its laws within the existing UCC legislative framework by mapping digital assets to existing UCC categories, thereby keeping Wyoming’s UCC intact and uniform. It offers a host of benefits to all parties interacting with digital assets in commercial transactions, including:
- classifying digital assets within existing laws;
- specifying that digital assets are intangible personal property within the UCC;
- authorizing security interests in a range of digital assets while respecting the technological realities of these assets; and
- establishing an opt-in framework for banks to provide custodial services for digital assets — resolving many of the lingering issues surrounding the legal status of digital assets which have prevented banks from becoming qualified custodians under existing law.
Below, I take a deeper dive into key aspects of Wyoming’s legislation to explain how it differs from the Uniform Law Commission’s proposed Model Acts and why it provides optimal — and critical — infrastructure for all commercial transactions involving digital assets.
Importantly, SF 125 covers the full range of digital assets, which are categorized into three groups: digital consumer assets, digital securities and virtual currencies, each one corresponding to a different existing category of property under the UCC. Mapping the different types of digital assets to UCC property categories is generally important because, under UCC rules, identifying the appropriate property category is the first step in assessing how to perfect a security interest (in other words, to create an enforceable lien) in collateral that has been pledged to secure a loan. Here, however, with respect to the three groups of digital assets set forth (below), the analysis is fairly straightforward since they may all be perfected through control (which, as discussed below, is a well-defined term in SF 125):
- Digital consumer assets are defined under SF 125 as digital assets that are used or bought for consumptive, personal or household purposes, as well as other types of digital assets which do not constitute digital securities or virtual currency. These are commonly referred to as “utility tokens.” Wyoming was the first jurisdiction in the United States to recognize utility tokens as a distinct asset class in 2018 and six other states are considering similar legislation this year. SF 125 classifies digital consumer assets as “general intangibles,” for purposes of the UCC. Under UCC rules, security interests in general intangibles are generally perfected by filing a financing statement with the Secretary of State’s office in the jurisdiction of the borrower, which is a manual process. But under SF 125, lenders may also perfect by means of control, which is consistent with the technology underlying utility tokens.
- Digital securities are defined under SF 125 as digital assets which constitute a security, but also explicitly exclude digital consumer assets and virtual currency from the definition so as to prevent confusion (because many other government agencies are unsure how to classify these digital assets). Under the UCC, the preferred method of perfecting a security interest in securities is through control. Therefore, it is also the optimal way to perfect a security interest in digital securities — and thereby digital securities have super-negotiability protections. This is true whether the digital securities are certificatedor uncertificated blockchain securities, both of which the Wyoming Legislature has recently authorized corporations to issue under Wyoming corporate law.
- Virtual currencies, the third group of digital assets under SF 125, is characterized as money for purposes of Article 9 of the UCC. This means that virtual currencies, such as bitcoin, are imbued with super-negotiability under the UCC and may be transferred freely and unencumbered by any adverse claims, except where the debtor and the transferee have colluded in violation of the secured party’s rights. Notably, this characterization of virtual currencies as “money” and not “general intangibles” is a departure from the UCC rules currently in operation. Recall that security interests in general intangibles are perfected by filing a financing statement in the jurisdiction of the debtor. Here, however, a security interest in virtual currency may be perfected through control.
SF 125 requires that a secured party enter into a control agreement with the debtor before perfecting its security interest via control, which is consistent with existing law. It is by design that security interests in all three sub-groups of digital assets may be perfected by control. And, quite smartly, SF 125’s definition of control includes an explicit description of how to obtain “control” since the asset is in digital form — again respecting and facilitating the technology that makes creation of these digital assets possible. Control is equivalent to “possession” of the digital asset’s private key in Wyoming, and either a party or a smart contract may take control as follows:
“A secured party, or an agent, custodian, fiduciary or trustee of the party, has the exclusive legal authority to conduct a transaction relating to a digital asset, including by means of a private key or the use of a multi-signature arrangement authorized by the secured party;
A smart contract created by a secured party which has exclusive legal authority to conduct a transaction relating to a digital asset. ‘Smart contract’ means an automated transaction or substantially similar analogue, which is comprised of code, script or programming language that executes the terms of an agreement, which may include taking custody or transferring an asset.”
So, SF 125 does not require the secured party to take physical possession of the collateral to perfect its security interest by control — that would be difficult with digital assets! Instead, secured parties take control by means of a private key or, if authorized by the secured party, a multi-signature arrangement or, quite significantly, by means of a smart contract. This is a huge innovation that paves the way for decentralized, peer-to-peer lending of digital assets.
There are also two additional important and unique features of Wyoming’s SF 125.
First, SF 125 creates expansive jurisdiction for Wyoming over possessory security interests in digital assets, i.e., security interests in digital assets perfected by control. Significantly, SF 125 casts a wide net — within existing UCC provisions — over who may avail themselves of Wyoming’s comprehensive statutory regime — essentially, any digital asset “located” in Wyoming. Of course under the UCC, this would encompass digital assets created by a Wyoming entity. However, SF 125 further provides that a digital asset is located in Wyoming under several different scenarios: (1) when the asset is held by a Wyoming custodian; (2) the debtor or secured party is physically located in Wyoming; or (3) the debtor or secured party is incorporated or otherwise organized in Wyoming. Therefore, if a party to a commercial transaction is connected to Wyoming — either because the debtor or secured party is located in Wyoming or a Wyoming entity, or the property is held by a Wyoming custodian — Wyoming law will likely govern.
Second, with respect to security interests in digital assets that were notperfected by control, SF 125 removes encumbrances two years after being purchased by a third party who takes the property without knowledge of any adverse claims. Think about it. This type of (lien) cleansing mechanism facilitates liquidity for digital assets that may otherwise be marginalized or discounted due to fears that a dormant lien could crop up at some time in the future. With this provision, an individual can purchase digital assets and, two years later in Wyoming, be confident that the digital assets are free and clear of security interests or other adverse claims with few exceptions, such as IRS and child support liens.
SF 125 also includes a set of opt-in rules for institutional digital asset custody, which is beyond the scope of this post, but is covered here. There is, however, one important nuance of digital asset custody that flows from Wyoming’s direct ownership approach under the UCC for digital assets. Wyoming’s digital asset custodians offer custody under a “bailment” theory of law, which is akin to valet parking because the owner gives up control but retains ownership. It is one of the most secure (and oldest) forms of legal relationship available. An attenuated form of custody under a bailment is available in securities custody today (legally it’s a bailment, but the indirect ownership of securities effectively renders the bailment moot because the bailment covers an IOU, not the real asset). Unfortunately, bailment protections in this instance are ethereal at best, because in the event that an intermediary fails, it may be unable to return to the investor the underlying asset associated with the security entitlement which (at the end of the day) is only a pro rata share of the intermediary’s omnibus account. In short, no securities custodian today can offer investors what a Wyoming-based custodian can offer for digital assets: a bailment while retaining direct ownership. It is a beautiful thing!
This approach is designed to bring ledger accuracy to securities markets over time, as more and more issuers choose to natively-issue their securities on blockchains, and as the technology can facilitate negotiability without the need for the Article 8 legal regime to impose negotiability artificially. Historically, securities negotiability was not possible without the imposition of such artificial legal mechanisms, since confirming that a seller owned the securities before completing a sale was a manual, labor-intensive process. The Article 8 indirect ownership regime once filled a need by fostering liquidity, albeit at the costs of ledger inaccuracy and likely some price suppression from the sale of “shadow” securities.
Today, thanks to blockchain, that trade-off is no longer necessary. It makes no sense to apply the outdated indirect ownership regime of Article 8 to blockchain assets, for which the technology enables near-instantaneous confirmation that the seller owns the asset. With blockchain there’s no need to trade off ledger accuracy for negotiability!
In short, Wyoming’s SF 125 is a comprehensive, detailed and carefully drafted law and should be given serious consideration by states as a thoughtful and meaningful alternative to the Supplemental Act.
BRINGING IT ALL TOGETHER
Blockchain law is at an interesting cross-roads. Ideally, the commercial laws of all 50 states would treat digital assets uniformly to facilitate commerce within the US. But there’s a split among the states. Only one state — Wyoming — has enacted any law in this area to date. Will other states join Missouri in following the new Wyoming approach? Let’s hope so!
Vice Chancellor Travis Laster of the Delaware Court of Chancery criticized the indirect ownership regime for securities in his 2016 speech to the Council of Institutional Investors and called blockchain a “plunger” that could unclog the capital markets.**** He encouraged institutional investors to “take back the voting and stockholding infrastructure of the U.S. securities markets” by replacing indirect ownership with a system in which shareholders own shares directly via blockchain.” Vice Chancellor noted in his speech that “[t]he current system works poorly and harms shareholders,” and gave several examples of inaccuracies in the proxy voting process for publicly-traded companies which has been caused by the indirect ownership regime.
The Uniform Law Commission’s use of the Article 8 indirect ownership regime for digital assets renders their proposed Model Acts unworkable because it not only perpetuates the same flawed system for digital assets, it makes things worse. As the founding director of the Delaware Blockchain Initiative, I cannot stay silent about a law that would extinguish the power of blockchain technology to clean up problems in capital markets. Unfortunately, by mandating indirect ownership treatment for virtual currencies, I fear that’s what the Model Acts would do.
Deciding between these two competing statutory regimes has real consequences. And, you, dear reader, should know what’s at stake. It is up to you to become knowledgeable on these issues so that you can guide your state legislators to make the right choice about how the UCC should apply to the emerging digital asset market.
There is a better way, and it can be found in the direct ownership approach defined in Wyoming’s SF 125.