The Hazards of Lending to Bitcoin Users

Many businesses and consumers have taken an interest in emerging payment systems, such as Bitcoin. Such systems present overlooked legal issues for creditors, particularly with respect to perfection of security interests and recovery of collateral.

Some of these systems may provide the opportunity for borrowers to quickly—and potentially irreversibly—transfer collateral funds. Creditors and their legal counsel need to understand emerging payment systems to realize the collateral value present in these systems, and to prevent the loss or transfer of collateral away from the creditor’s control, in each case through careful due diligence and attention to drafting the loan documents.

Money transmitters serve as middlemen transferring money between buyers and sellers. Users of the newest electronic platforms fund transactions either by linking a bank account or credit card to their account on the platform or by loading funds directly into such account. The accumulation of funds on the platform offers a source of collateral for the user’s creditors. Although a money transmitter may hold funds for its users, in at least one well-known instance, the FDIC has indicated the money transmitter is not acting as a "bank" for purposes of federal banking laws.

Creditors wishing to take collateral as security for their loans perfect that security interest under the applicable state’s version of Article 9 of the Uniform Commercial Code which governs security interests in personal property (i.e. collateral that is not real estate). Under the UCC, a creditor in a commercial transaction perfects a security interest in a deposit account by having "control" over that account. This is usually accomplished when the debtor, the debtor’s bank and the creditor sign a deposit account control agreement. However, if the platform is not a bank, the accounts are not "deposit accounts" as defined in the UCC. Instead, such accounts could be more appropriately characterized as "payment intangibles" under the UCC, which requires a creditor to file a UCC-1 financing statement with the appropriate state authority.

Relying on a UCC-1 rather than a control agreement means a creditor does not have the advance agreement of the debtor’s bank allowing it to quickly remove funds from the debtor’s account. Thus, it takes more time and expense for a creditor to recover funds from a payment platform account as compared to an actual bank deposit account.

Careful due diligence may uncover cash maintained by a borrower on payment platforms. Lending documents may contain clauses restricting or limiting amounts held on a platform and representations and warranties that platform accounts are to be used in the ordinary course of business only.

Bitcoin is a fast-growing software-based system that enables users to transfer payments between one another like other money transmitters. The payments are denominated in bitcoins, a digital currency with no central issuer or backer. The Treasury’s Financial Crimes Enforcement Network requires Bitcoin exchanges and processors to register as money services businesses. In addition, several state regulators, including in California and New York, have issued interpretations or regulations requiring Bitcoin exchanges and service providers to register as or obtain licenses as money transmitters or money service businesses. Otherwise, Bitcoin is a largely unregulated payment system. Bitcoin is used in an ever-increasing number of cross-border transactions, thus drawing the focus of transferor’s creditors.

Each user has at least one digital Bitcoin "wallet" where funds are stored. Funds are obtained as a reward for serving as a "miner" (i.e. allowing the network to use your computational resources) or by purchasing Bitcoin on a currency exchange or by selling goods and services for bitcoins. All Bitcoin transactions are recorded on a decentralized, public ledger called the "blockchain." However, users remain anonymous and transactions are irreversible by system design. As a result it can be difficult or impossible for creditors to discover who is conducting transactions or shifting funds.

Owned Bitcoin has the potential to be collateral for loans, but creditors are likely more concerned with restricting Bitcoin acquisition or use by borrowers due to the uncertain regulatory landscape, irreversible nature of payments, extreme volatility of value and anonymity of the system. Thus, credit agreements may contain covenants prohibiting borrowers from using or accepting Bitcoin, or operating Bitcoin accounts. In addition, diligence questionnaires and credit agreements may contain representations and warranties that the borrower does not use or accept Bitcoin, nor does the borrower have a Bitcoin wallet. Such provisions are just beginning to appear in credit agreements when use of an emerging payment system is apparent.

Perfecting a security interest in Bitcoin is challenging. Identifying the appropriate wallet may be difficult or impossible due to the system’s anonymity. Bitcoin is not tangible and therefore it does not appear possible to perfect by possession, nor is a Bitcoin wallet a bank deposit account, meaning it does not appear possible to perfect by control either. Instead, if a wallet is identified, the collateral description in the security agreement should be broadened to cover it, and the security interest perfected by filing a UCC financing statement. Should a borrower transfer collateral funds out of a Bitcoin wallet, it is likely impossible for a creditor to recover since transactions cannot be reversed. Once again, without a control agreement, the option of sweeping the Bitcoin wallet is not available.

It remains to be seen if Bitcoin becomes widely adopted. However, as it and other payment systems evolve, creditors may find they hold valuable collateral for traditional lending transactions.

Pamela J. Martinson is a partner and Christopher P. Masterson is an associate in the Palo Alto office of Sidley Austin LLP.