Jack Shadid, Hinshaw & Culbertson LLP, Chicago
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An In-Depth Look at the Amendments to the UCC: Emerging Technologies and Controllable Electronic Records
Adopted by a total of 30 states to date, including Illinois in August 2024, the amended Article 12, Controllable Electronic Records, of the Uniform Commercial Code (UCC), 810 ILCS 5/1-101, et seq., addresses commercial transactions involving novel business entities referred to as decentralized autonomous organizations (DAOs) as well as emerging distributed ledger technologies, also called blockchains, and the digital assets that are transacted on blockchains, such as cryptocurrencies, nonfungible tokens (NFTs), smart contracts, and the digital wallets used in online commerce. To a limited extent, the amendments also address issues related to artificial intelligence. The amendments revised most of the Articles of the UCC and added a new Article 12 primarily addressing certain digital assets.
Like the UCC in general, the amendments establish only state commercial law rules. The new UCC provisions do not directly amend any federal laws or regulations, state taxation of digital assets, or money transmitter or anti-money laundering laws, whether state or federal. The amendments defer to law outside of the UCC with respect to those matters.
The amendments respond to market concerns about the absence of definitive commercial law rules for transactions involving digital assets and address other technological developments affecting electronic chattel paper, negotiable instruments, payment systems, documents of title, and sales and leases of goods. In particular, the amendments clarify the scope of Articles 2 (Sales) and 2A (Leases) when transactions combine the sale or lease of goods with other matters, a topic of importance in transactions affected by emerging technologies.
Article 12 Overview
The new UCC Article 12 governs the transfer of property rights in certain intangible digital assets (“controllable electronic records”) that have been or may be created and may involve the use of new technologies. These assets include, for example, certain types of (non-fiat) virtual currency and NFTs. The new provisions will help facilitate the use of digital assets as collateral for loans, among other benefits.
The concept of “control” with respect to digital assets is best understood in a general sense as a functional equivalent to “possession” of a traditional asset. Accordingly, control is a necessary condition for protection as a good-faith purchaser for value (a “qualifying purchaser”) of a controllable electronic record. Article 12 confers an attribute of negotiability on controllable electronic records because a qualifying purchaser takes its interest free of conflicting property claims to the record.
NOTE: The words “negotiable” and “negotiability” take on a unique meaning under the UCC, but instruments can generally be said to be “negotiable” if they facilitate the unconditional promise or order to pay a fixed amount of money, are payable to the bearer, are payable on demand or at a definite time, and do not state any other undertaking or instruction by the person promising or ordering payment to do any act in addition to the payment of money. While the UCC does not directly define the words negotiable or negotiability, the concept is defined and applied within specific contexts, most notably in Article 3 (Negotiable Instruments) (UCC §3-104) and Article 7 (Documents of Title) (UCC §7-104), and now, in a similar fashion, in Article 12 (Controllable Electronic Records) (UCC §§12-104 and 12-105). The UCC uses the terms “negotiable” and “negotiability” as terms of art, with their meaning and application determined by the context of the specific article and section.
Controllable electronic records also provide a mechanism for evidencing certain rights to payment — controllable accounts and controllable payment intangibles. An account debtor (obligor) on such a right to payment agrees to make payments to the person that has control of the controllable electronic record that evidences the right to payment. Assignments and other aspects of these rights to payment are governed by revisions to UCC Article 9 and Article 12. Because a “qualifying purchaser” of a controllable account or controllable payment intangible will take free of competing property claims, these rights to payment also would have this attribute of negotiability. Article 12 provides special rules with respect to the payment obligations and conditions of discharge of account debtors on controllable accounts and controllable payment obligations.
Article 12 also includes a choice-of-law rule for the matters that it covers in connection with transactions in controllable electronic records. A record is information that is retrievable in perceivable form. UCC §1-201(b)(31) (defining “record”). A controllable electronic record is a record that is stored in an electronic medium and that can be subjected to “control,” as defined in §12-105. See UCC §§1-201(b)(16A) (defining “electronic”); 12-102(a)(1) (defining “controllable electronic record”). The electronic record must have some “use” or benefit that one person can enjoy and can exclude all others from enjoying, e.g., the power to “spend” a Bitcoin (or, more precisely, the power to include an unspent transaction output (a UTXO) in a message that the Bitcoin protocol will record to its blockchain).
A person must be able to transfer to another person this exclusive power to use and the exclusive power to transfer the electronic record. To remain exclusive, the transfer must divest the transferor of the power to use the electronic record. A person must be able to demonstrate to others that the person has the power to use and transfer control of the electronic record. Control also serves as a method of perfection of a security interest in a controllable electronic record and as a condition for achieving a non-temporal priority of a security interest. The meaning of “control” in the UCC depends on the type of property involved. See UCC §§7-106 (electronic documents of title); 8-106 (four different types of investment property, each with a different definition of “control”); 9-104 (deposit accounts); 9-105 (chattel paper); 9-105A (electronic money). The Comments to UCC §12-105 explain the requirements for obtaining control of a controllable electronic record.
The language introduced in the 2022 amendments applies not only to existing electronic (intangible) assets that are currently in use, but they also aspire to apply to electronic assets that may be created using technologies that have yet to be developed or even imagined.
Section 12-104(d) of the UCC adopts the “shelter” principle, under which a purchaser of a controllable electronic record acquires whatever rights the transferor had or had power to transfer. A similar rule appears in Articles 2, 3, 7, and 8. See §§2-403(1) (goods); 3-203(b) (negotiable instruments); 7-504(a) (documents of title); 8-302(a) (certificated and uncertificated securities). The ability to take a controllable electronic record free of third-party property claims appears to be necessary for a controllable electronic record to have commercial utility.
Consider an example in which B contracts to buy Bitcoin from S:
Law other than Article 12 generally would determine whether S is the owner of the Bitcoin. Law other than Article 12 would resolve issues concerning the formation of the contract of sale between B and S and the obligations of the parties under the contract. Except to the extent provided by Article 12, law other than Article 12 would determine what steps are necessary for Bto acquire rights in the Bitcoin. By acquiring rights in the Bitcoin by sale, B would become a purchaser of the Bitcoin within the meaning of UCC Article 1. Article 12 provides that if B becomes a purchaser, B will acquire whatever rights S had or had power to transfer. As a general matter, law other than Article 12 would define these rights. B would acquire these rights regardless of whether B obtained control of the Bitcoin.
In this example, law other than Article 12 includes UCC Article 9, which determines the steps necessary for a security interest to attach to a controllable electronic record. More generally, Article 9 governs any conflict between Article 9 and Article 12. UCC §12-103(a).
Now assume that O is the owner of the Bitcoin and that S is a hacker, who acquired control of the Bitcoin illegally from O.
Just as a buyer of goods can obtain possession from a seller that has no rights in the goods, B can obtain control of the Bitcoin, even if S “stole” it from O. If B obtains control of the Bitcoin for value, in good faith, and without notice of any claim of a property interest, B would be qualifying purchaser. Even if B would not have acquired any rights in the Bitcoin under non-Article 12 law (for example, because S, a “thief,” had no rights to give), as an Article 12 law qualifying purchaser, B would acquire the Bitcoin free of all claims of a property interest in the Bitcoin. S’s control of the Bitcoin gave S the power to transfer rights to a qualifying purchaser, such as B. Even if O could locate B, B would defeat O’s claim of ownership and own the Bitcoin free and clear. (The same result would obtain if B bought a non-digital negotiable instrument from a thief under circumstances in which B became a holder in due course. This distinguishes “negotiable” property from property such as goods, as to which a buyer from a thief normally obtains no rights).
The general rule under UCC §12-107(a) is that the local law of a “controllable electronic record’s jurisdiction” governs matters covered by Article 12. The controllable electronic record’s jurisdiction is determined by an express provision in the record or in the system in which the record is recorded. If not so designated, it is determined based on the designation of the law governing the record or the system generally. Absent any such designations, at the bottom of this “waterfall” of alternatives, the governing law will be that of the District of Columbia. UCC §12-107(b) provides an exception for the rights and duties of account debtors under UCC §12-106 if an agreement between the account debtor and an assignor of the record provides for the law of another jurisdiction to govern those rights and duties.
The law of the controllable electronic record’s jurisdiction also governs perfection and priority of security interests in controllable electronic records, controllable accounts, and controllable payment intangibles. Perfection by filing, however, is governed by the law of the location of the debtor. See UCC §9-306B.
Scholarly Disputes Over Language
Article 12 creates a new exception to the nemo dat principle (“no one can give what they do not have”) by defining the term “qualifying purchaser” to mean “a purchaser of a controllable electronic record or an interest in a controllable electronic record that obtains control of the controllable electronic record for value, in good faith, and without notice of a claim of a property right in the controllable electronic record.” See UCC §12-102(a)(2). Critics of the language argue that under circumstances in which a thief or hacker acquires possession of a controllable electronic record (i.e., a void title interest), the definition of “qualifying purchaser” leaves to other law the question of whether any interest in property rights is initially acquired by the transferee of record. How would it be possible for the hacker to transfer any interest at all?
Critics also contend that since no other law would provide an exception to the notion that a thief cannot pass any sort of property interest, it naturally follows that a person who takes a controllable electronic record from a hacker would not be participating in a transaction that creates an interest in property. Accordingly, the critics argue that such a person could not be a “purchaser” and, thus, should not be able to qualify as a “qualifying purchaser.”
Within the context of “purchasers,” the UCC does allow for title to transfer from a thief to a “good-faith purchaser” pursuant to the good-faith purchaser doctrine (UCC §2-403), which holds that a transferee who acquires property in good faith, for value, and without notice of any defects or claims to the property can obtain a better title than the transferor.
The UCC does, however, incorporate the good-faith purchaser doctrine through the “holder in due course” language contained in Article 3. The holder in due course doctrine is a specific application of the good-faith purchaser doctrine within the context of negotiable instruments. See UCC §3-302. A holder in due course is a person who acquires a negotiable instrument for value, in good faith, and without notice of any defects or claims. Moreover, the holder in due course doctrine provides that a holder in due course takes the instrument free from many defenses and claims that could be asserted against the transferor, thereby ensuring the negotiability and reliability of such instruments.
The critics propose that the drafters should have chosen a term other than “purchaser” to describe the beneficiary of Article 12’s take-free rule. More specifically, the critics suggest that the drafters should have utilized the term “qualifying holder” instead of “qualifying purchaser,” consistent with the UCC’s holder in due course doctrine. The critics contend that such a change would align the statutory language of Article 12 with the rest of the UCC.
Revisions to the UCC’s Secured Transactions Article
The 2022 amendments to the UCC further extensively revise Article 9 to conform and adapt to Article 12. The first notable change to Article 9 involves the addition of two new kinds of collateral: controllable account (a subset of account) and controllable payment intangible (a subset of payment intangible, which is a subset of general intangible). See UCC §§9-101(a)(27A), 9-101(a)(27B). A controllable account or controllable payment intangible is created when the account or payment intangible is evidenced by a controllable electronic record, which results if the account debtor obligated on the account or payment intangible has agreed to pay the person in control of the controllable electronic record.
Perfection of a security interest in a controllable electronic record, controllable account, or controllable payment intangible may be by control or by filing a financing statement. Control of a controllable electronic record is determined under UCC §12-105. Control of a controllable account or controllable payment intangible is achieved by obtaining control of the controllable electronic record that evidences the account or payment intangible. See UCC §9-107A(b). A security interest in a controllable account, controllable electronic record, or controllable payment intangible that is perfected by control has priority over a security interest held by a secured party that does not have control. See UCC §9-326A.
According to the drafters, as is the case for secured parties protected by take-free rules under other articles, the rights of a secured party that takes free of competing property interests under UCC §12-104(e) or that is protected from certain actions under UCC §12-104(g), as a qualifying purchaser of a controllable account, controllable electronic record, or controllable payment intangible, are respected under Article 9. See UCC §9-331.
The governing law applicable pursuant to UCC §12-107 governs perfection by control and priority of a security interest in a controllable account, controllable electronic record, or controllable payment intangible. See UCC §9-306B(a). The law of the jurisdiction in which a debtor is located governs perfection by filing (but not by priority) for such collateral. UCC §9-306B(b).
The second notable change to Article 9 in the 2022 amendments addresses issues with respect to transactions in chattel paper. These changes primarily focus on (1) eliminating uncertainty concerning the definition of “chattel paper” and (2) clarifying the distinction between “tangible chattel paper” and “electronic chattel paper.” See UCC Comment 5.b, 810 ILCS 5/9-102.
As to the definition of “chattel paper,” the prior definition created uncertainty in “bundled” or “hybrid” transactions in which monetary obligations exist not only under a lease of goods but also with respect to other property and services relating to the leased goods, such as sale-leaseback transactions. Frequently, the value of the non-goods aspect of a transaction is substantially greater than the value of the lessee’s rights under the lease of goods. Uncertainty existed among those who finance chattel paper and other rights to payment as to whether these transactions give rise to chattel paper. The revisions resolve this issue by treating only those transactions whose predominant purpose was to give the obligor (lessee) the right to possession and use of the goods as giving rise to “chattel paper.” Some similar issues arise in connection with chattel paper that includes a security interest securing specific goods.
As to the distinction between “tangible chattel paper” and “electronic chattel paper,” the 2022 amendments address problems relevant to cases of multiple originals of writings as well as situations in which separate writings covered different components of chattel paper. With respect to electronic chattel paper, the safe harbor for control created in the 1998 revision to the UCC was based on a “single authoritative copy” of the chattel paper. Moreover, in some situations tangible chattel paper is converted to electronic chattel form and electronic chattel paper is converted to tangible form. Additional uncertainty existed when one or more records comprised one or more authoritative tangible copies of the records that evidenced the right to payment and rights in related property and one or more authoritative electronic copies of those records also existed.
Under the revisions to Article 9 under the 2022 amendments, the UCC provides a single rule, under which a security interest in chattel paper can be perfected by taking possession of the authoritative tangible copies, if any, and obtaining control of the electronic authoritative copies, if any. This single rule addresses cases when some records evidencing chattel paper are electronic and some are tangible or when a record in one medium is replaced by a record in another.
The 2022 revisions to Article 9 also define “chattel paper” more accurately, as the right to payment of a monetary obligation that is secured by a security interest in specific goods or owed under a lease of specific goods, if the right to payment and interest in the goods are evidenced by a record. UCC §9-102(a)(11).
Other Revisions
UCC §1-201(b)(24) defines “money” as including “a medium of exchange that is currently authorized or adopted by a domestic or foreign government.” There is no way of knowing how money in an intangible form might develop, but there are indications that some countries might authorize or adopt intangible tokens as a medium of exchange and others might authorize or adopt deposit accounts with a central bank as money. For example, the countries of El Salvador and the Central African Republic have adopted Bitcoin as their official currencies.
In many contexts, there is no need for the UCC to distinguish among types of money, but within the context of Article 9 and secured transactions, distinctions must be drawn. Only tangible money is susceptible to perfection by possession. Moreover, the steps needed for perfecting intangible tokens (such as controllable electronic records) by control are insufficient for perfecting an interest in deposit accounts with a central bank. For this reason, the revisions provide an Article 9 definition of “money” that is narrower that the Article 1 definition. The Article 9 definition expressly excludes deposit accounts (but not CBDC (central bank digital currency) that is a token). Thus, “electronic money,” defined in §9-102 as “money in an electronic form,” would not include deposit accounts. The Article 9 definition of “money” also excludes money in an electronic form that cannot be subjected to control under §9-105A.
The Article 9 provisions governing “deposit accounts” would remain suitable for accounts with a central bank, even if a government has adopted these accounts as money. The revisions leave Article 9’s treatment of deposit accounts largely unchanged. Under the revisions, a security interest in electronic money as original collateral can be perfected only by control. The requirements for obtaining control of electronic money under §9-105A are essentially the same as those for obtaining control of a controllable electronic record under Article 12.
The 2022 amendments’ revisions to Article 9 also make changes to the take-free rules for transferees of money found in §9-332, including the addition of a new rule applicable to electronic money and transferees of funds from deposit accounts.
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