Warning to Bitcoin enthusiasts: if you airily try dismissing UCC Article 9 as a nothigburger, you’ve just established you are unqualified to comment on commercial transactions in the US. Read what follows and be warned.

A new post at Credit Slips by Bob Lawless, based on a discussion with Professor Lynn LoPucki, raises a fundamentally important issue that will severely hamper the use of Bitcoin in commercial transactions once the issue is understood. As we’ve indicated in previous posts, the idea that Bitcoin might someday as anything other than a vehicle for speculation and a curiosity depends on whether it obtains a decent level of acceptance as a means of purchasing real economy goods and services. And as we will discuss in due course, forget about changing the UCC to accommodate Bitcoin; new Basel regimes are decided and implemented faster than changes to the UCC.

Readers who have followed us during the foreclosure crisis and read posts on chain of title issues will have heard us mention the UCC, because it played a critical role in analyzing securitizations. For newbies who are not lawyers (and forgive this for being a bit of a broad-brush treatment), UCC stands for “Uniform Commercial Code”. It is foundational legislation which was devised with considerable care and has been adopted in some form by all 50 states. Key sections from Wikipedia:

The Uniform Commercial Code (UCC or the Code), first published in 1952, is one of a number of uniform acts that have been promulgated in conjunction with efforts to harmonize the law of sales and other commercial transactions in all 50 states within the United States of America… The UCC is the longest and most elaborate of the uniform acts. The Code has been a long-term, joint project of the National Conference of Commissioners on Uniform State Laws (NCCUSL) and the American Law Institute (ALI), who began drafting its first version in 1942… The overriding philosophy of the Uniform Commercial Code is to allow people to make the contracts they want, but to fill in any missing provisions where the agreements they make are silent. The law also seeks to impose uniformity and streamlining of routine transactions like the processing of checks, notes, and other routine commercial paper.

Article 9 governs secured transactions in movable property (as opposed to real estate). A secured transaction enables a lender to take a security interest in property to provide a means of obtaining repayment if the borrower defaults. In other words, if the borrower does not make good on his loan payments, the lender can seize specific, agreed upon collateral. Of all the articles of the UCC, Article 9 has been the most widely copied abroad. Again from Wikipedia:

Article 9, which established a unified framework for security interests in personal property, directly inspired the enactment of Personal Property Security Acts in every Canadian province and territory but Quebec from 1990 onward, followed by the New Zealand Personal Property Securities Act 1999 and then the Australia Personal Property Securities Act 2009.

So what does this have to do with Bitcoin? I’m going to quote liberally from the Credit Slips post and unpack as needed:

As many readers will know, all 50 states have enacted the UCC with only minor variations. Article 9 governs security interests in personal property…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… 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.

Yves here. Here is the layperson recap. If anyone takes Bitcoins from a business that has a blanket lien (and you as someone dealing with that business won’t know the state of their finances) and that business gets in trouble, the bank can go after any current holder of Bitcoins that have passed through that business’ accounts. This is not the case with money because Bitcoin is considered to be property under the UCC, not money. As the post stresses, “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.

This by the way, happens to conform with the definition used by FinCEN, the bureau of the US Treasury that handles money-laundering and FinCEN’s definition is almost certain to be adopted by the IRS. So people who use money to engage in transactions with businesses don’t have that problem, but Bitcoin users will.

So to recap: Bitcoin is property, and when you exchange the property of a business (its goods, like its doughnuts or other inventory for sale) for other property, like your Bitcoins, the next person who takes the Bitcoins (now regarded as property of the bakery) has any blanket liens of the bakery attach to those Bitcoins.

How big a deal is this? Because liens are not reported by type, good statistics are non-existent. However, it’s a very real possibility that many of the small businesses you deal with have a blanket lien. Small business credit is extremely difficult to come by. Unless its needs can be financed by credit cards (which are almost always guaranteed personally by the owner in the fine print), borrowing against the businesses’ real estate (if it has any with enough equity) or it only needs to finance specific equipment (like a car or truck), a blanket lien is likely to be its cheapest route. And bigger businesses, which are in a better position to get business loans (against the cash flow of the operation) can also be required to take a blanket lien if they fall behind and the lender reworks their loan (they’ll take more collateral as the price of forebearance). From Equipment and Tool Institute:

Most loans will require collateral unless you’re a very strong client. Usually this will be a ‘blanket lien’, meaning they will file UCC-1’s on all your business assets. Other common collateral can be in the form of a home or automobile, land and commercial buildings, CD, savings or investment accounts…There is no easy way to get a 1:1 relationship between the collateral and your equipment, you can’t repossess half a building, so often times the banks ask for a lot more collateral than what you’re borrowing.

Now Bitcoin enthusiasts will try arguing, “Haha, Bitcoin is anonymous, just see if those banks can find who has the bakery’s Bitcoins now!” As a lawyer wrote us regarding similar claims on our post regarding the likely IRS treatment of Bitcoins:

The better word for Bitcoin is traceable. If it can be traced, it ain’t anonymous. All it requires is a subpoena–a rather primitive piece of paper. The irony is that the longstanding reason people refuse to go cashless is because they know Monex and other electronic money are traceable. It’s always been possible for the whole system to be cashless.

Lynn LoPucki, in comments, explained how this might go in practice (in this case, the party that took Bitcoin from the bakery is a supplier):

…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.

So everybody in the transaction chain from the bakery onward has an incentive to rat out the next party in the Bitcoin transfer chain. If they identify the next Bitcoin party, they’ve passed the lien hot potato onward. Otherwise, they have to pay hard cash if they fraudulently transfer the Bitcoins (and dumping Bitcoins to try to stay out of the bank’s clutches has extremely high odds of being deemed to be a fraudulent transfer).

The Credit Slips article did go through some possible remedies for the UCC mess, but did not seem terribly optimistic about any of them. In theory, a government could authorize Bitcoin as a medium of exchange in such a manner that the UCC will regard it as money. But that is utterly at odds with the pet idea of Bitcoin promoters that it is free of and needs no official supervision, backing, or control. For legal eagles, there’s also a discussion of the rules for co-mingled collateral, but the post authors didn’t think it would be likely as a save, and no one in the post’s comment section disagreed.

And as we said, don’t even think of getting the UCC amended to deal with this issue. Of all the possible fixes, that is the most remote. The solons at the American Law Institute who work on UCC matters are extremely slow and deliberate. They are now occupied with considering how to modify the UCC to deal with securitizations and foreclosures in light of the chain of title mess (in other words, they are looking at the UCC as a backdoor route to coming close to having a uniform foreclosure statute). This project has already been in motion for years (some draft language was proposed in 2010) and it is still not even at the stage where language has been drafted for review and approval by the states.

Moreover, the ALI has proposed a major amendments that have failed to be implemented. For instance, in 2003, NCCUSL and the ALI presented major amendments to Article 2 along with changes to Articles 2A and 7. Not a single state passed the fixes after eight years, so NCCUSL and the ALI withdrew the proposal in 2011. Bitcoin isn’t even remotely on the ALI’s radar. And there is not any evidence of states feeling the need to change their laws to accommodate Bitcoin fans.

The Credit Slips post concludes:

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.

And finally, Georgetown Law professor Adam Levitin, who has more real world and policy experience than most professors, and is also an expert on the UCC and payment systems, thinks that the claim that Bitcoin will result in big savings to merchants would not persist at meaningful transaction volumes, which require far more infrastructure. His remarks via e-mail:

Critically, there doesn’t seem to be any particular social good from Bitcoin. I don’t see why I would want to use Bitcoins over dollars. The no merchant fee thing is hogwash. There are no merchant fees currently because there’s low transaction volume. As transaction volume rises, we will see transaction fees, and given that they’ve got to be individually negotiated with whoever is doing the mining, I don’t see a way to make this work seamlessly for large scale commerce. Regulators haven’t banned bit coins yet because there isn’t an real strong case for doing so, but there isn’t any case for facilitating it either.

The IRS and UCC issues each have the potential to considerably dim interest in Bitcoin, and the cheery assumption that it will have much lower transaction fees to merchants were it to every scale up is likely to prove illusory. So with the basic premises of this form of property looking more dubious the more it is scrutinized, it’s an open question how long this bubble will last.