NFTs and Other Digital Assets: States Begin to Adopt UCC Amendments That Will Enable Transactions in Developing Technologies

NFTs and Other Digital Assets: States Begin to Adopt UCC Amendments That Will Enable Transactions in Developing Technologies

November 1, 2022, Covington Alert

Companies continue to explore non-fungible tokens (“NFTs”) and other digital assets as a way to exploit existing intellectual property rights, including using NFTs to distribute new content in metaverse platforms. Media companies can tie any type of content they wish to NFTs, and many utilize NFTs as a type of digital merchandise, creating entire product lines solely or primarily available through the purchase of NFTs. Centaur Studios, for example, minted and sold 10,000 NFTs connected to a digital web series called “The Glue Factory.” Production company Hello Sunshine recently partnered with NFT collective World of Women to adapt World of Women’s artwork into movies and television shows. Companies also utilize NFTs to connect consumers to unique experiences or unique physical objects outside of the digital world. Adidas, for example, collaborated with Bored Ape Yacht Club to release NFTs that allowed holders to claim physical merchandise like tracksuits and hoodies.

The market for this valuable new asset class remains in its early stages but it is clear that digital assets can and will be monetized in various ways—for example, as an outright sale of the NFT or by using it as collateral to secure financing to fund ongoing projects.

While NFTs provide endless commercial possibilities for media companies and investors, current commercial law leaves several key questions unanswered that bear on transactions involving these digital assets. Among the most critical questions are:

• Can digital assets be acquired free from adverse third party property claims?
• What rights are transferred along with a digital asset?
• How and when is a security interest in a digital asset perfected?
• How is priority determined in the case of competing claims over a digital asset?

Recognizing the imperfect fit between existing law the and the new technologies, the Uniform Commercial Code (“UCC”) has been updated to expressly address transactions involving digital assets like NFTs. These changes are expected to provide greater certainty and enable the growth of commercial transactions involving digital assets.

As of October 28, 2022, Iowa, Indiana, Nebraska and New Hampshire have adopted legislation to give effect to the amendments.

One general caveat to the discussion that follows. When considering these commercial law questions in connection with NFTs, in particular, it’s important to bear in mind that the NFT itself serves only as the unique token of ownership of certain rights in the associated content, services or products. Any rights in those associated items would be governed by a terms of use that binds the NFT purchaser. For example, an NFT associated with digital content would typically permit the token holder to view the content for personal use but not make derivative works. The discussion that follows focuses solely on commercial issues related to the NFT itself, and which are addressed by the proposed UCC amendments. Transfers and pledges of any underlying contract rights that provide access to content, services or products associated with an NFT would require analysis of the particular contract rights involved, but would not necessarily raise novel or difficult questions under commercial law.

The Unclear Treatment of NFTs under Current Law

The current UCC does not include a class of property that expressly includes digital assets. Under existing law and current commercial practice, therefore, digital assets need to be analogized to other types of property already addressed by the UCC. Transactions then need to be structured to comply with existing law. Unfortunately, digital assets don’t fall neatly into an existing category. They could be treated as:

• A “general intangible,” like a contract right, a security interest in which is perfected by filing;
• “Investment property,” like a stock or bond, a security interest in which is perfected by filing or by control; or
• “Money,” a security interest in which is perfected by possession.

Treatment of digital assets under any of these potential property classes raises difficult questions. Unlike other assets, which can be represented by a physical instrument, like a deed, stock certificate or physical note, digital assets have no physical embodiment. So it is not clear whether they can be “possessed” or “controlled” within the current meaning of the UCC. This leaves a purchaser or lender unsure under existing law whether it has taken all the steps needed to create a first-priority security interest or acquired an asset free of competing claims.

Treatment of NFTs under the Proposed Law

The proposed UCC amendments would clarify the treatment of NFTs and other digital assets by adding a new Article 12 (Controllable Electronic Records) and amending provisions of Article 9 (Secured Transactions) and other substantive articles of the code. The core approach of the amendments is to create new types of assets within existing categories of property with new mechanisms to establish ownership and control.

NFTs as “Controllable Electronic Records”

The amended UCC would classify NFTs as a type of “digital asset” called a controllable electronic record (“CER”).

An NFT must be susceptible to “control” to qualify as a CER. A CER is susceptible to control when the person holding the CER has:

• The power to enjoy “substantially all the benefit” of the CER;
• The exclusive power to prevent others from enjoying “substantially all the benefit” of the CER;
• The exclusive power to transfer control of the CER; and
• The ability to identify themselves as the person having control of the CER.

A person may establish their identity as controller of the CER using a cryptographic key or account number. Exclusivity can be established even if the recording platform allows for shared control, “multi-sig”, or similar arrangements, or if changes automatically occur as a protocol within the system. Control may also be established by a person in control acknowledging that it has control on behalf of another person.

The UCC amendments incorporate the concept of “tethering” certain rights to a CER. The rights to payment included under the current UCC definitions of “account” or “payment intangible,” when embodied in a CER, create a “controllable account” or “controllable payment intangible” if the payment obligor (the “account debtor” in UCC jargon) has agreed to pay the person in control of the CER.

Purchase of CERs

The purchaser of a CER acquires all the rights in the CER that the transferor held. Additionally, qualifying purchasers would benefit from a “take-free” rule, and take the CER free from any competing claims to the CER. A qualifying purchaser is one who obtains control of the CER:

• For value;
• In good faith; and
• Without notice of another property claim to the CER.

As with negotiable instruments, filing a financial statement would not, in and of itself, be notice of a property interest in a CER. This means that holders of interests in CERs (for example, a joint owner or licensee) must be vigilant about asserting their rights in a manner that reasonably informs prospective purchasers of the right.

Other areas of law would govern what substantive rights are embodied in a CER and whether “take-free” rules apply to those rights. For example: copyright law would determine what copyright rights are embodied in an NFT tethered to intellectual property and whether a “take-free” rule applies to those rights.

As referenced above, a “controllable account” or a “controllable payment intangible” travels with the CER.

Secured Lending

For purposes of secured lending, NFTs and other CERs would be classified as “general intangibles.” A secured lender could perfect a security interest by filing a UCC-1 financing statement.

But the proposed amendments would also allow for perfection by “control.” As with other types of property, a security interest perfected by control would have priority over a security interest perfected solely by the filing of a financing statement.

“Control” for purposes of perfection would be determined under the control definition for CERs outlined above. The UCC does not dictate any particular practice for implementing control of digital assets and no market practice has developed yet. Because the control provisions provide for shared control and control by a third party, however, the digital asset provisions should accommodate a “control agreement” structure, similar to that used for deposit and securities accounts. This could take the form of an agreement among the owner of the NFT, a custodian, and the lender that sets forth the detailed terms on which control will be shared and, upon foreclosure, shift exclusively to the lender.

Because the applicable collateral categories for NFTs and other CERs use existing UCC terms—“general intangible,” “account” and “payment intangible”—it should be possible to rely on existing collateral descriptions in security agreements and financing statements. Careful review of existing documentation would be required, though, to ensure that there are no perfection issues.

Choice of Law

The proposed amendments largely follow existing choice of law rules for financial assets. The law that applies, generally, will be the law of the jurisdiction where the CER is located, meaning:

• The jurisdiction expressly provided by the CER;
• The jurisdiction that governs the system in which the CER is located if none is expressly provided by the CER;
• Otherwise, the law of Washington, D.C.

The current debtor location rules would apply to perfection of a security interest by filing. The choice of law amendments recognize that transactions involving digital assets may occur across jurisdictions and involve parties located, or doing business, in more than one jurisdiction. Because each state will adopt and enact its own version of the proposed amendments, it is important to know which jurisdiction’s law will apply.

If you have any questions concerning the material discussed in this advisory, please contact the members of our Finance and Technology practice groups.