Is UCC Article 9 the Achilles Heel of Bitcoin?

Last week, Professor Lynn LoPucki called me up and asked a good question. Why hasn’t Bitcoin fallen apart because of the operation of Article 9 of the Uniform Commercial Code (UCC)? It is a really good question. With Lynn’s permission, I am writing up a blog post about our conversation, but it was Lynn who first identified the issue.

As many readers will know, all 50 states have enacted the UCC with only minor variations. Article 9 governs security interests in personal property – that is, movable and intangible property as opposed to land and buildings. The bank that gave you a car loan has an Article 9 security interest in the automobile serving as collateral for the loan, and the bank providing operating capital for your corner bakery similarly may have an Article 9 security interest in the inventory, equipment, and accounts at the store. Article 9 is one of those laws that only specialists tend to know, but it plays an important role in the flow of commerce.

The bakery example was deliberate given this news about a Durham, NC, bakery accepting bitcoins. I have no idea about the financial circumstances of this particular bakery, but to understand the point assume it has loan from a bank secured by the bakery’s “inventory, goods, equipment, accounts, and general intangibles.” Such an arrangement would not be uncommon and would effectively give the bank an Article 9 security interest in all of the bakery’s property that is not real estate, sometimes referred to as a “blanket lien.”

When a customer pays the bakery with bitcoins, those bitcoins certainly now become part of the bank’s collateral. Given that one bitcoin is worth over $600 today, the customer either has ordered the world’s most expensive donut or technically will have paid with bitcoin subunits. For ease of exposition, let’s just call them “bitcoins.”

The bank’s security interest will attach to the bakery’s bitcoins. When the bakery uses bitcoins to buy flour from a supplier, the bank’s security interest will continue to encumber them. UCC section 9-315(a)(1) provides that the bank’s security interest “continue in collateral notwithstanding . . . disposition thereof unless the security party authorized the disposition free of the security interest. The supplier is not protected by the “buyer in ordinary course” provision of 9-320(a) because that provision only strips security interests from “goods.” 

Further, the security interest will remain with the bitcoins through subsequent transfers (UCC § 9-325). A remote transferee of the bitcoins will take the bitcoins subject to the bank’s security interest. Assuming the bank has taken the easy steps to perfect its security interest, which it almost always will have, the bank can seize the bitcoins as collateral if the bakery’s debt goes unpaid. The possibility of another party with superior property interest in a bitcoin would seem to substantially dampen their utility as a medium of exchange.

Transferees of money take free of a preexisting security interest (UCC § 9-332). Thus, you do not have to worry that the U.S. currency the bakery gives you as change for your transaction is encumbered by a security interest.  That way, money circulates like . . . well, money.

A Bitcoin defender might respond that the UCC should treat bitcoins like money. Regardless of the merits of such a principle in the abstract, the UCC has a definition of money, and it does not appear to include bitcoins. Specifically, “money” is a “medium of exchange currently authorized or adopted by a domestic or foreign government” (UCC § 1-201(b)(24)). To the best of our knowledge bitcoins are not currently authorized or adopted by a domestic or foreign government. One solution to the UCC problem might be to get a domestic or foreign government to authorize bitcoins as a medium of exchange such that they then may receive the UCC treatment for “money.” But that solution will come too late for the thousands of wallets probably already infected with bank liens.  Those liens will remain with the coins to which they attached.

Another out for Bitcoin defenders might be the rules for commingled collateral. For example, if the bakery deposits your payment for donuts in its bank account, the bank account may contain some of the bank’s collateral and some of the bank account may be non-collateral. In these situations, the UCC simply directs that the court is to use “equitable principles” to resolve any disputes that arise. In the context of traditional bank accounts these “equitable principles” are a series of well-established practices. Once in a bitcoin wallet, a free-wheeling interpretation of “equitable principles” might wash the security interest away, but that would be a very untethered free-wheeling.

Even if there some arguments that the security interest does not stay with the bitcoins, the problem is the uncertainty, and the uncertainty would seem to be enough to undo the attractiveness of bitcoins. Either Lynn and I have missed something about how bitcoins work and their interaction with Article 9, or the Bitcoin proponents have failed to notice how Article 9 could unravel the whole enterprise. Up until now, bitcoins have not become a substantial part of mainstream commerce such that the Article 9 problem may have been of little consequence, but if bitcoins are to become part of mainstream commerce, the Article 9 problem must be solved.

Bitcoin image courtesy of Shutterstock.

Comments

[Jack Ayer]

I think you are exaggerating the obstacles. Began w Lord Mansfield in a Miller v Race and recognize that the bill there in question was to be treated as money and pass in currency because it was so treated by the general consent of mankind.

[Bob Lawless]

Yeah, Jack, except for the fact there is a statute here with very precise language.

Or, another way to put it is mankind may consider the painting hanging in the bank lobby to be art, but to the UCC, it is equipment.

[Ebenezer Scrooge]

Bitcoin was meant for square-jawed John Galt types and drug dealers, not mainstream commerce. Somehow, I don't think that UCC 9 will be a problem with the intended audience.

I'm not sure that the Miller v. Race road is precluded by statute. 9-332 says what it says. However, it doesn't preclude anything, and "equitable tracing" says nothing. A judge has plenty of room to decide that bitcoins can't be equitably traced out of the account. Bankruptcy judges are practical folk, after all. If they grok the issue, they'll find a way.

[Ebenezer Scrooge]

PS:
The need for certainty mainly exists in the opinionating bar, which after all was a chief driver of the Article 9 revision effort. Business people extended secured credit even before Article 9, against what lawyers would now consider intolerable uncertainty. AFAIK, wholesale payment law is the only body of law that demands really high certainty. The rest of the perceived demand is merely the braying of the defendants' bar.

[Astezar]

Bob, say you are right, say UCC Article 9 allows banks to claim the bitcoin back.

How would the bank proceed? They cannot have it back anyway. I mean practically, physically, cryptographically, they can’t just have it back, they have no power on it.

The "new owner" (maybe anonymous) has nothing to fear.
Therefore there is actually no problem.

[Lynn M. LoPucki]

Astezar, consider the example of the bakery and the supplier. After the bank calls the bakery's loan and gets a judgment against the bakery, it conducts discovery to see where the bakery's bitcoins went. The bakery will be compelled to testify as to the identity of the supplier. Then the supplier will be compelled to testify as to the present contents of the supplier's bitcoin account. If the supplier fraudulently transfers the coins before the bank can seize them, the supplier is liable to the bank -- in real dollars.

[Lynn M. LoPucki]

Ebenezer, the equitable tracing rule Bob is referring to is the "lowest intermediate balance rule." If the bitcoins went into the recipient's account they are in it permanently to the extent of the lowest later balance in the account. A drug dealer can periodically empty the account and that will take care of the problem. But legitimate business people -- even John Galt -- aren't going to want to be bothered with hiding the currency they use.

[Turnip Truck]

I don't really know much about Article 9, but why doesn't 9-320(a) make specific reference to "goods," whereas, e.g., 320(b) does?

[Ken T]

I'm pretty sure John Galt founded and hid in a secret mountain town concealed by advanced illusion creating technology in order to avoid sharing, or paying taxes on, perpetual motion technology. So to needlessly weigh in on this question, John Galt would definitely empty his bitcoin account regularly, at least if he disagreed with the law that would allow them to be taken by another.

As to Supplier and tracing, Supplier can just deny being paid in bitcoins by Baker, making the case difficult. Proving Supplier has an account does nothing. Proving Supplier cashed some out proves nothing. As I understand it, the whole point of bitcoin is that you will not be able to show bitcoins from Baker's [or drug buyer's] Wallet going to Supplier's [I guess I do not need to change this one's name] Wallet.

[Ebenezer Scrooge]

Lynn,
9-315(b)(2) does not refer to the lowest intermediate balance rule: comment 3 only suggests it. IMO, a bankruptcy judge won't take the trustee up on the suggestion. LIBR is ok for first-order proceeds, but no judge is interested in tracing proceeds of proceeds of proceeds, as could happen with money. (Btw, asset forfeiture law recognizes the savvy drug dealer problem, and has a special rule of its own.)

[LeftCoastTom]

Is the bakery really selling donuts for bitcoins, or is it immediately exchanging those bitcoins for actual currency issued by a sovereign? In the latter case wouldn't the answer to the Professor's question be: "It's not a problem because Bitcoin can't actually be used by the bakery to buy anything, this is the e-equivalent of accepting chickens in lieu of cash"?

[LeftCoastTom]

Hmm...maybe I can answer my own question here. Yes, its the e-equivalent of accepting chickens in lieu of cash, but immediately dumping the chicken solves the problem because someone will eat it, but dumping the bitcoin won't solve the problem because it'll sit, identified, in the public ledger until whomever was silly enough to buy it is identified by the bank. So the flour distributor doesn't have a problem because they won't really take bitcoins, but other exchange participants may well have a problem.

[Astezar]

Lynn, you say "the supplier is liable to the bank -- in real dollars"

Isn't that meaning that Bitcoin has a dollar equivalent? if this is true, then Bitcoin IS money and problem disappears.

On the contrary, if what you said is not true, then the supplier must give back the Bitcoin itself, not its dollar equivalent (because there is no dollar equivalent in that case).
Therefore the solution is that the supplier just doesn't give it to the bank :) They cannot force them to send it.
Unless they force them by making them pay? But then again it means there is a dollar equivalent. Back to the first solution.

[Ken T]

Astezar, pretty much everything has a dollar value equivalent. Not everything is money.

[David Peterson]

While backers call bitcoins "money" the fact is that bitcoins are not very useful as money. Their value fluctuates wildly, and only a small number of parties will accept them. That is not a very useful form of money. Most of the people who hold bitcoins do so for speculative investment purposes, which is not what you'd expect in the case of money. Yet, there are a lot of people who continue to back bitcoins and to talk about their use as money. Recently, it has become apparent that bitcoins are hackable, notwithstanding claims to the contrary. If these people are not deterred from transacting in bitcoins by all of these other problems, then why would they be deterred because of the fact that a bank's security interest in proceeds might attach to the bitcoins?

[David Peterson]

The implied assumption of the blog post is that a bitcoin would be treated as a "general intangible" under Article 9. I think that might be the case. However, I also think that it could be argued that a bitcoin is actually a security under Article 8. If so, then the fact that the bank is perfected by filing may not put the bank in the driver's seat. If the bitcoin transferee can show that he has "control" of the bitcoins or took "delivery" of the bitcoins under Article 8, then he beats out the bank even though the bank's security interest in the bitcoins may be perfected by filing. I admit, however, that establishing "control" and "delivery" under Article 8 may not be an easy task. Someone would need to examine all of the steps that are taken in a bitcoin transaction in order to see if they amount to delivery or result in control by the transferee.

[Gregory King-Underwood]

Shouldn't we also focus on the UCC provision itself? Is it sustainable in the long term? Reason being, the Bitcoin development has let the genie out of the bottle in terms of the currencies of the future. Mediums of exchange are being transformed.

In simple terms, haven't currencies needed the authority of the State to make them function? Hence, if a currency functions without the authority of the state, for whatever reason, then the definition of what constitutes money needs to be changed. No?

For my part, this 'macro' problem might be easier to solve than disentangling co-mingled equitable interests.

[Ken Doran]

"Bitcoin recognized by Germany as 'private money'"; http://www.cnbc.com/id/100971898. Does that constitute "authorized or adopted"? If the answer is no, chances are excellent that another challenge will be forthcoming.

[Adam]

I think the answer is really simple here: nobody doing Bitcoin is aware of UCC Article 9. Bitcoin is seen as a payments issue, so why the heck would anyone think of looking at a law of security interests? Of course the world isn't so simple, but because Bitcoin has until now been primarily a speculative investment and (to a small degree) a c2c payment system, rather than a b2b payment system, no one has had to think about how it interacts with real commercial transactions.

fwiw, Bitcoin faces not just a UCC definition problem, but also an IRC problem: "currency" is defined for tax purposes much like "money" is for the UCC--it's got to be state-issued. And that likely means that Bitcoins are not currency, which has pretty damning tax implications. Lee Shepard has a nice article on this in Tax Notes.

[Joe Pacheco]

Interesting write up gentlemen. I may be mistaken but it looks like the state of California is working to define bitcoin as money. We this be sufficient to meet the definition of "money?"

http://www.coindesk.com/california-bill-bitcoin-lawful-money/

[Brian Meldrum]

There's another practical answer: most vendors who are accepting bitcoins presently are not actually accepting and holding bitcoins. They have signed a contract with an intermediary (such as Coinbase) who processes the bitcoin transaction and settles it in cash with the seller at the exchange rate prevalent at that moment. They are doing this to mitigate a bigger problem with accepting the actual currency: exchange rate volatility and risk.

Also, in a different context (SEC case), a federal magistrate has ruled that BTC is money. See http://rt.com/usa/bitcoin-sec-shavers-texas-231/

[IT Guru]

I don’t think understand Bitcoin transitions. If you consider Bitcoins property, how would this property be tracked? Serial number?

Part of the effort to anonymize transitions Bitcoins are destroyed when spent. Lets take your bakery example.

I walk in with Bitcoin Serial #1 to pay for a donut.
The bakery enters the transaction and Bitcoin serial #1 ceases to exist and the baker is issued Bitcoin serial #3.

The Bakery goes to the flower mill to buy flower and pays with Bitcoin #3. When the mill registers the transition Bitcoin #3 is destroyed and Bitcoin # 5 is issued. How does the bank repossess Bitcoin #3 when it no longer exists? The mill does not own the same Bitcoin as the bakery shop.

The concept is that due to the two parties not knowing the past and future serial numbers that the transactions would be untraceable. As the algorithm causes a fixed number of Bitcoins in its existence I immediately did not like them as I saw the system as a pyramid scheme to make the creators a boat load of money as the coins start to be come scarce. Note I fist check out Bitcoins back in 2009 when they were <$3. Part of me wishes I jumped on the pyramid back then.

[Steve]

Ken Doran,

That CNN article's headline is a little misleading. Germany's Ministry of Finance declared Bitcoins a "unit of account." The UCC definition of money can include a unit of account under certain circumstances. Section 1-201(24) states : The term (money) includes a monetary unit of account established by an intergovernmental organization or by agreement between two or more countries.

Germany is the only country (that I know of) to recognize Bitcoins as a unit of account. To my knowledge, no intergovernmental organizations or agreements between two or more countries have established Bitcoins as a "unit of account." It would seem that Bitcoins are, sadly, a general intangible.

[Ted Rogers]

Will the first lawyer on this site who recommends to the bank's board that they should g after the bitcoins spent at the small bakery please raise their hand?
I am a former lawyer turned entrepreneur and I'd like to respectfully interject a viewpoint from the business side. To wit: as more and more merchants begin accepting bitcoin, and more and more users begin spending bitcoin, the likelihood of Banks claiming an interest under Article 9 goes down exponentially.
Why? The bank that goes after bitcoins that pass through its clients' stores under such an arcane, specious (at least to the general public) justification will suffer a PR crisis that would blacken the bank's brand for years.

[David Schubert]

People do not own bitcoins. They own bitcoin addresses whose values rise and fall depending on market forces and the actions of the owners and others. The bank owns the bakery's bitcoin address which became less valuable when they performed a service that they were justly compensated for. Its like I paid the fair market value to someone to blow up his truck. My truck became more valuable because the supply of trucks decreased. But the bank only has claim to his truck and the compensation I provided. It has no claim to my truck.