Secured Lender Protection Limited When Bitcoin is Collateral

by Bilzin Sumberg

On June 17, 2014, the U.S. Bankruptcy Court in Dallas granted recognition under chapter 15 of the Bankruptcy Code of the bankruptcy proceeding in Japan of failed bitcoin exchange, Mt Gox. Mt. Gox shut down after claiming to lose over $500 million (at current values) of customers’ bitcoins, some of which were later located. Mt Gox sought chapter 15 protection in the United States to prevent U.S. customers from seizing assets and proceeding in a class action that has since settled, subject to court approval. Under chapter 15, Mt Gox’s assets in the United States are protected by the automatic stay and its foreign representative can pursue assets in the United States and file lawsuits, but does not have the avoidance powers of a trustee in a U.S. bankruptcy.

The overnight disappearance of most of the bitcoins held by Mt Gox on behalf of its customers raises questions about the reliability and safety of bitcoin. In order for bitcoin to make the transition from a vehicle for speculation to a mainstream currency, users will need to be able to trust that their bitcoin will still be there and will be promptly accessible to them when needed. More germane to this blog, secured creditors must be able to reliably obtain and perfect security interests in bitcoin and have an effective remedy to realize upon their collateral if the time comes.

Setting aside the volatility of bitcoin values, which is likely a symptom that will subside as the marketplace matures, lenders have good reason to be concerned about a loan that is collateralized by bitcoin. Bitcoin has no central issuer or backer. Bitcoins are held by users in a digital “wallet,” and while Bitcoin transactions are recorded on a decentralized public ledger, the users are anonymous and the transactions are irreversible by design. This makes it very difficult for creditors to discover that Bitcoins are being transferred or to whom after the fact.

Article 9 of the Uniform Commercial Code likewise does not provide a simple mechanism for a lender to protect its interest in Bitcoin collateral. Perfection by possession is not viable because Bitcoin is not tangible and, more importantly for UCC purposes, is not “money” under UCC § 1-201 because it has not been adopted or exchanged by any government. A Bitcoin “wallet” is not a “deposit account” that can be perfected by control pursuant to UCC § 9-104, because existing Bitcoin exchanges are more akin to transmitters of money than they are to banks, thus would almost certainly not be considered “banks” under federal banking laws. Instead, Bitcoins are likely general intangibles and, accordingly, the secured party is left to perfect its security interest by filing a UCC-1 Financing Statement. This leaves the secured party with a perfected security interest, but no fast mechanism to prevent a borrower from transferring its Bitcoins after a default or other triggering event.

This conclusion, as observed by another commenter, leads to other problems for transferees of Bitcoins. While a transferee of money takes free of a preexisting security interest under UCC § 9-332 and UCC § 9-320(a) cleanses goods purchased in the ordinary course of prior security interests, UCC § 9-315(a) and UCC § 9-332 provide that a security interest travels with a general intangible to transferees and subsequent transferees unless the secured party authorizes the disposition free of the security interests. While lenders can easily authorize such dispositions for ordinary course operations, it is impossible for a transferee to know what liens may have previously attached to the Bitcoins it stands to receive.

As the Bitcoin marketplace develops, the law will need to likely develop to better accommodate the unique nature of Bitcoin. In the interim, secured parties can protect themselves by requiring borrowers to agree not to own or transact in significant amounts of Bitcoin or, where exposure to Bitcoin is unavoidable, by convincing reluctant Bitcoin “wallet” providers to contractually agree to permit lenders to control transfers after a default.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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