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A Split Emerges In Blockchain Law: Wyoming’s Approach Versus The Supplemental Act
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A Split Emerges In Blockchain Law: Wyoming’s Approach Versus The Supplemental Act

How should digital assets be treated under U.S. commercial law? A split has emerged, and the rift reveals a foundational disagreement: should commercial laws provide the best protections to digital assets owned directly by individuals, or only to those owned indirectly through intermediaries? How the disagreement is resolved has major implications for the development of blockchain and the financial ecosystem overall.

The direct approach was enacted into law by Wyoming last week, and Missouri is also proposing to enact the direct ownership approach. By contrast, the indirect approach was drafted last year into a proposed law, called the “Supplemental Act,” by the Uniform Law Commission–a group whose mission is to keep U.S. state laws as uniform as possible. Four states have introduced the Supplemental Act (California, Nevada, Oklahoma and Hawaii) but no state has yet enacted it.

The split has elicited strong reactions on both sides. Last week, the Wyoming Legislature’s Blockchain Task Force released a letter responding to two requests made a month ago by the Uniform Law Commission to Wyoming legislators, asking them mid-session to withdraw their legislation in favor of the Uniform Law Commission proposal. Wyoming declined the request, passed the bill overwhelmingly, and Governor Mark Gordon signed it into law last week.

Why such strong reactions? The difference boils down to whether individuals should gain access to the “super-negotiability” protections of commercial law, or whether these vital protections should be restricted to securities intermediaries only. Super-negotiability is, as I’ll explain later, the “holy grail” of commercial law. Why confer a powerful, regulatory-created advantage on old-world securities intermediaries, especially when a slew of new intermediary-less, peer-to-peer exchanges and lending platforms for digital assets are coming online? Blockchain-based assets are inherently peer-to-peer assets that are mostly owned directly by individuals, not intermediaries, and forcing them into the hands of intermediaries would neutralize their best attributes. It’s no surprise that the securities industry would throw its considerable heft behind a legal regime that imposes intermediaries as an attempt to preserve its hegemony and assert control over this powerful, disruptive technology.

But why would the Uniform Law Commission create a structural advantage for the securities industry — whether inadvertent or not — particularly at a time when the inefficiencies and irregularities in the current U.S. securities settlement system are well documented?

The Supplemental Act mandates that owners of virtual currency relinquish their property rights to intermediaries and receive in return mere security entitlements, nothing more than what one commentator* has described as an “attenuated form of property right that looks more like a contract claim against the intermediary.” The same commentator, D.C. Donald, correctly points out that, under the indirect ownership regime, securities intermediaries are not required by law to have on hand the securities they sell to you.

Yes, you read that right. Intermediaries have the power to conjure securities (specifically, security entitlements) from thin air, which is granted by state commercial laws (called the Uniform Commercial Code, UCC). Mr. Donald points out that, under UCC Article 8, “…a claim to securities is created by a credit of such securities to the claim holder’s account, regardless of whether the intermediary actually has such securities in its holdings.”** This provision in Article 8 is the root cause of most of the securities industry’s ledger irregularities. The Supplemental Act proposes to apply the very same UCC provisions to virtual currencies.

BACKGROUND: WHAT IS THE UCC?

The UCC is the foundational law of commerce in the U.S. It is state law — U.S. states have power over commercial laws, not the federal government — and it provides a comprehensive legal regime for all business transactions involving personal property (i.e., excluding real estate). Adopted in all 50 states to a large degree (Louisiana has a slightly more limited UCC because of their civil law tradition), the UCC covers commercial activities, such as the transfer of personal property, sale of goods, securities and secured lending using property as collateral. It also defines the rules by which property can be transferred to a purchaser free of encumbrances. Jeanne L. Schroeder, esteemed law professor from the Cardozo School of Law and author of “Bitcoin and the Uniform Commercial Code,” calls the UCC the “plumbing of finance.”

She’s right. I know this from my work experience involving Article 9 of the UCC (which governs secured transactions), first while serving as assistant general counsel for one of the largest provider of UCC services, and then during my 4-year stint with the Delaware Secretary of State’s Office. I even created a UCC Handbook to help filers avoid common mistakes and also saw many UCC legal issues and disputes up close as I worked with clients and practitioners to get them resolved.

State-enacted UCC laws are generally derived from UCC model laws, which are drafted by attorneys in the Uniform Law Commission. State legislatures may enact the laws as presented, with modifications, or not at all.

The “holy grail” of commercial law, as mentioned previously, is super-negotiability. Super-negotiability means, in most cases, that the purchaser takes the asset free and clear of any encumbrances (such as a lender’s lien) unless it knew of such claims and colluded to defraud the lender. Under the UCC, super-negotiability is only available to (1) money and (2) securities owned indirectly through securities intermediaries — referred to as security entitlements (in other words, not the real thing!). Both the Wyoming and Uniform Law Commission approaches bestow super-negotiability on virtual currencies, but super-negotiability in Wyoming applies to virtual currencies and digital securities — not just to virtual currencies alone — and applies regardless of whether individuals own the digital assets directly or indirectly via a securities intermediary. In stark contrast, the super-negotiability of the Uniform Law Commission’s Supplemental Act is attenuated because its super-negotiability applies to a mere claim rather than to the actual assets, and it applies to virtual currencies only.

In summary, the key differences between the two approaches are (1) which assets attain the “holy grail” of super-negotiability, and (2) whether that super-negotiability applies to the actual asset rather than a mere claim on it. Before we discuss more, let’s step back to a high-level comparison.

WHAT IS THE UNIFORM LAW COMMISSION’S PROPOSAL?

Given the proliferation of digital assets, it is not surprising that the Uniform Law Commission created model laws to bring clarity to the treatment of digital assets under the UCC. To that end, the Uniform Regulation of Virtual Currency Businesses Act (URVBCA) and the Supplemental Act (collectively, the Model Acts) provide a statutory framework for regulating companies that engage in virtual-currency business activity*** as well as transactions that involve virtual currency.

Under the Model Acts, virtual currency is defined as a digital representation of value that is used as a medium of exchange, unit of account, or store of value, but is not legal tender. The Model Acts do not cover all types of digital assets, only virtual currencies, leaving a substantial gap in coverage of the wide range of types of other digital assets which should be covered by the UCC. Failing to include other kinds of digital assets greatly diminishes their potential commercial adoption and market value.

Setting aside that the scope is limited to virtual currencies, what is most troubling about the Model Acts is that they require the parties to a commercial transaction involving virtual currencies to “opt in” to the provisions of Article 8 of the UCC (which govern security entitlements). Because Article 8 sets forth a regime of indirect ownership — the very same regime that governs traditional securities — only virtual currencies that are owned via securities intermediaries in omnibus accounts are likely eligible to participate in the UCC statutory framework.

This classification of virtual currency within the existing securities intermediary framework also is curious because most forms of virtual currency likely are not securities. Why should they be treated like securities then?

For these reasons, requiring virtual currency owners to submit to a regime of indirect ownership is problematic. Not only does it ignore the direct ownership nature of virtual currency, and creates a structural advantage for the securities industry, but it also inadvertently creates solvency risk for financial institutions dealing in virtual currencies.

Continuing with D.C. Donald’s point from above, intermediaries are permitted by UCC Article 8 to sell you an asset they do not own. In the name of negotiability, Article 8 permits intermediaries that do this to avoid the need for a purchaser to do due diligence, i.e., to take the time to confirm that the intermediary owns the security before selling it. As Mr. Donald acknowledges, this Article 8 shortcut creates a danger of “overissue” of “shadow” securities. He adds, “imposing strict standards on intermediaries can reduce this problem, but not ultimately eliminate it.”

The “overissue” problem is significant — it means more owners have valid claims to an asset than the quantity that exists, and by definition this suppresses the price of securities by inflating their supply artificially. The best example of this issue is In re Dole Food Company, a 2017 class action lawsuit before the Delaware Chancery Court in which investors alleged that the shares were undervalued at the time of a management buyout. A total of 49.2 million “facially valid” claims to Dole Food shares, all backed up by brokerage statements as proof of ownership, were filed for the 36.7 million shares outstanding. A fascinating question about this situation is how much the “shadow” shares themselves caused some of the undervaluation, since artificial increases in supply suppress the stock price? No one will ever know for sure, but those “shadow” shares created an uncovered short position in the stock that very likely suppressed its price and skimmed value from legitimate owners. This practice is wrong, but it’s legal.

In the context of virtual currencies, “overissue” is not only bad — it can be lethal to financial institutions and cause major losses for innocent consumers because, as Caitlin Long of the Wyoming Blockchain Coalition correctly points out, virtual currencies do not have the fault tolerance in their settlement systems available to the securities industry (because virtual currency transactions settle nearly instantaneously). Bitcoin and similar virtual currencies are designed for perfect ledger accuracy, and they usually have caps on the quantity of coins outstanding that cannot be breached. There is no lender of last resort. This means a financial institution that creates “shadow” bitcoin is at high risk of failing in a classic run-on-the-bank. There is no way to paper over the problem, which should never have arisen in the first place. Placing virtual currencies under Article 8’s indirect ownership regime is a recipe for creating problems down the road that are entirely avoidable.

Yes, you read that right. Intermediaries have the power to conjure securities (specifically, security entitlements) from thin air, which is granted by state commercial laws (called the Uniform Commercial Code, UCC). Mr. Donald points out that, under UCC Article 8, “…a claim to securities is created by a credit of such securities to the claim holder’s account, regardless of whether the intermediary actually has such securities in its holdings.”** This provision in Article 8 is the root cause of most of the securities industry’s ledger irregularities. The Supplemental Act proposes to apply the very same UCC provisions to virtual currencies.

BACKGROUND: WHAT IS THE UCC?

The UCC is the foundational law of commerce in the U.S. It is state law — U.S. states have power over commercial laws, not the federal government — and it provides a comprehensive legal regime for all business transactions involving personal property (i.e., excluding real estate). Adopted in all 50 states to a large degree (Louisiana has a slightly more limited UCC because of their civil law tradition), the UCC covers commercial activities, such as the transfer of personal property, sale of goods, securities and secured lending using property as collateral. It also defines the rules by which property can be transferred to a purchaser free of encumbrances. Jeanne L. Schroeder, esteemed law professor from the Cardozo School of Law and author of “Bitcoin and the Uniform Commercial Code,” calls the UCC the “plumbing of finance.”

She’s right. I know this from my work experience involving Article 9 of the UCC (which governs secured transactions), first while serving as assistant general counsel for one of the largest provider of UCC services, and then during my 4-year stint with the Delaware Secretary of State’s Office. I even created a UCC Handbook to help filers avoid common mistakes and also saw many UCC legal issues and disputes up close as I worked with clients and practitioners to get them resolved.

State-enacted UCC laws are generally derived from UCC model laws, which are drafted by attorneys in the Uniform Law Commission. State legislatures may enact the laws as presented, with modifications, or not at all.

The “holy grail” of commercial law, as mentioned previously, is super-negotiability. Super-negotiability means, in most cases, that the purchaser takes the asset free and clear of any encumbrances (such as a lender’s lien) unless it knew of such claims and colluded to defraud the lender. Under the UCC, super-negotiability is only available to (1) money and (2) securities owned indirectly through securities intermediaries — referred to as security entitlements (in other words, not the real thing!). Both the Wyoming and Uniform Law Commission approaches bestow super-negotiability on virtual currencies, but super-negotiability in Wyoming applies to virtual currencies and digital securities — not just to virtual currencies alone — and applies regardless of whether individuals own the digital assets directly or indirectly via a securities intermediary. In stark contrast, the super-negotiability of the Uniform Law Commission’s Supplemental Act is attenuated because its super-negotiability applies to a mere claim rather than to the actual assets, and it applies to virtual currencies only.

In summary, the key differences between the two approaches are (1) which assets attain the “holy grail” of super-negotiability, and (2) whether that super-negotiability applies to the actual asset rather than a mere claim on it. Before we discuss more, let’s step back to a high-level comparison.

WHAT IS THE UNIFORM LAW COMMISSION’S PROPOSAL?

Given the proliferation of digital assets, it is not surprising that the Uniform Law Commission created model laws to bring clarity to the treatment of digital assets under the UCC. To that end, the Uniform Regulation of Virtual Currency Businesses Act (URVBCA) and the Supplemental Act (collectively, the Model Acts) provide a statutory framework for regulating companies that engage in virtual-currency business activity*** as well as transactions that involve virtual currency.

Under the Model Acts, virtual currency is defined as a digital representation of value that is used as a medium of exchange, unit of account, or store of value, but is not legal tender. The Model Acts do not cover all types of digital assets, only virtual currencies, leaving a substantial gap in coverage of the wide range of types of other digital assets which should be covered by the UCC. Failing to include other kinds of digital assets greatly diminishes their potential commercial adoption and market value.

Setting aside that the scope is limited to virtual currencies, what is most troubling about the Model Acts is that they require the parties to a commercial transaction involving virtual currencies to “opt in” to the provisions of Article 8 of the UCC (which govern security entitlements). Because Article 8 sets forth a regime of indirect ownership — the very same regime that governs traditional securities — only virtual currencies that are owned via securities intermediaries in omnibus accounts are likely eligible to participate in the UCC statutory framework.

This classification of virtual currency within the existing securities intermediary framework also is curious because most forms of virtual currency likely are not securities. Why should they be treated like securities then?

For these reasons, requiring virtual currency owners to submit to a regime of indirect ownership is problematic. Not only does it ignore the direct ownership nature of virtual currency, and creates a structural advantage for the securities industry, but it also inadvertently creates solvency risk for financial institutions dealing in virtual currencies.

Continuing with D.C. Donald’s point from above, intermediaries are permitted by UCC Article 8 to sell you an asset they do not own. In the name of negotiability, Article 8 permits intermediaries that do this to avoid the need for a purchaser to do due diligence, i.e., to take the time to confirm that the intermediary owns the security before selling it. As Mr. Donald acknowledges, this Article 8 shortcut creates a danger of “overissue” of “shadow” securities. He adds, “imposing strict standards on intermediaries can reduce this problem, but not ultimately eliminate it.”

The “overissue” problem is significant — it means more owners have valid claims to an asset than the quantity that exists, and by definition this suppresses the price of securities by inflating their supply artificially. The best example of this issue is In re Dole Food Company, a 2017 class action lawsuit before the Delaware Chancery Court in which investors alleged that the shares were undervalued at the time of a management buyout. A total of 49.2 million “facially valid” claims to Dole Food shares, all backed up by brokerage statements as proof of ownership, were filed for the 36.7 million shares outstanding. A fascinating question about this situation is how much the “shadow” shares themselves caused some of the undervaluation, since artificial increases in supply suppress the stock price? No one will ever know for sure, but those “shadow” shares created an uncovered short position in the stock that very likely suppressed its price and skimmed value from legitimate owners. This practice is wrong, but it’s legal.

In the context of virtual currencies, “overissue” is not only bad — it can be lethal to financial institutions and cause major losses for innocent consumers because, as Caitlin Long of the Wyoming Blockchain Coalition correctly points out, virtual currencies do not have the fault tolerance in their settlement systems available to the securities industry (because virtual currency transactions settle nearly instantaneously). Bitcoin and similar virtual currencies are designed for perfect ledger accuracy, and they usually have caps on the quantity of coins outstanding that cannot be breached. There is no lender of last resort. This means a financial institution that creates “shadow” bitcoin is at high risk of failing in a classic run-on-the-bank. There is no way to paper over the problem, which should never have arisen in the first place. Placing virtual currencies under Article 8’s indirect ownership regime is a recipe for creating problems down the road that are entirely avoidable.

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