Financing Digital Assets - Part Two
Written by: Steven N. Kurtz, Partner, Levinson Arshonsky Kurtz & Komsky, LLP
As we move into a more digitalized way of transacting business, the law will of course, change and develop with technology. For those in the traditional or more mainstream commercial finance world, the assets that have typically served as the main collateral sources for your factoring advances or loans and the medium where these assets exist and are tracked are changing. Soon enough, much of your collateral will either exist digitally or rely upon technology and software more advanced than what is being used now.
Part one of this Article discussed the concept of a controllable electronic record (a “CER”), but here’s a little primer again. A CER is a record in electronic form that is susceptible to control. For a person to have control over a CER, the person must have the following: the power to enjoy substantially all the benefits of the CER, the exclusive power to prevent others from having control over the CER, and the exclusive power to transfer control over the electronic record. Assets which can exist in a CER include, but are not limited to, digital currencies and electronic payment rights. While most of you are not financing or otherwise using digital currencies in your funding and account debtor payments, most of you are currently dealing with technology platforms that will morph into a CER. For example, most of you are working with payment portals, setting up automatic payments and debits, using electronic signature platforms, and dealing with electronic or web-based contracts. Some of these now exist in controllable electronic format. In the near future, much of what you will be working with will be blockchain and CER based.
There are assets which may be financed that exist within the CER. An example would be a portal-based system where accounts can be financed. With one exception discussed below, the UCC outside Article 12, entitled Controllable Electronic Records, will govern. An example of something where compliance with Article 12 will be required might be the person financing a sophisticated, secure electronic load board controlled by one person where everything functions digitally. The lender to this hypothetical load board will need compliance with Article 12. This will also apply to healthcare financial people as many of the healthcare platforms are CERs.
Perfection of a CER in one respect is no different than most assets, with a catch. One can always perfect a security interest in a CER through a properly filed financing statement. One can also perfect by control. Old school UCC control was often done through physical possession. For example, a creditor who lends against a stock interest in a corporation can perfect by control through taking physical possession of the stock certificate. One can’t typically obtain physical possession of a CER because it is digital. Thus, control of a CER under Article 12 requires direct control, third party control agreements, or certain “smart contracts”. If one perfects a CER through control, that person has priority over any other creditor who perfected through a financing statement. For example, the CER based load board owner gets secured loans from three secured parties (an “SP”). SP-1 perfects with a UCC-1. SP-2 also perfects with a UCC-1. SP-3 would be in a third person using a financing statement. But SP-3 jumps into a first position if it perfects via control. This is true even if SP-3 knows about SP-1 and SP-2 because the UCC favors those who perfect first, and if two methods of perfection work, the first one to perfect in the superior manner wins.
If you are financing accounts, general intangibles, and payment intangibles, which exist within a CER, the current UCC constructs stay the same. If the account exists within the CER, it is still an account but known as a controllable account. Perfection is still through a financing statement. A payment intangible existing within a CER is now a controllable payment, perfected through a financing statement. An account debtor existing within a CER is still an account debtor perfected when you file your UCC-1.
Account debtors who exist within a CER do require special attention. A redirection letter will still work to cause the account debtor to pay you once you send the notice. The problem develops when the account debtor requests more information. Account debtors can always ask for more information from the secured party, and it’s the secured party’s obligation to provide the additional information, which typically would be the redacted financing agreement, your UCC-1, and possibly something that may link the UCC service company to you if you use a third party for those services. However, if an account debtor exists within the CER, then the additional information and rules for providing the same must exist within the CER itself. If there is no protocol within the CER, the account debtor can ignore the notice of assignment, pay the client/borrower factor, and discharge its obligations by paying over the notice. Therefore, for those financing entities doing business within a CER and want to do notices of assignment, it must be done through the CER system itself in order to lock down the account debtor. This form of business is literally within its “newborn baby stage” and protocols and practices must be developed.
The more developed CER world involves digital currencies. Outside the digital currency world, there are several payment processing companies that handle payments and all that goes with it, such as digital security, different currencies, and things of the like. The payment processing companies will likely develop into forms of CERs. Banks may also enter into the CER business. For those who are developing specialized payment platforms for transportation, this will also migrate into the CER world. Finally, large business entities that have online vendor platforms can turn those platforms into a CER when such platforms move to a blockchain.
One would hope that antitrust and unfair competition laws would work to prevent someone who has market dominance in an industry-specific payment processing segment from blocking out competitors in the financing business. Because the CER business world is so new, the rules and protocols to allow free market financing and not closed-off systems need to be established.
Besides potential antitrust and unfair competition problems that can develop if a market or industry dominant CER owner affiliated with one lender blocks out competitors, other litigation issues will likely develop. One example will be account debtors. As mentioned, an account debtor existing within a CER can get out of a redirection notice depending upon the protocol within the CER. One large potential litigation issue on the horizon will be what is a CER. Another litigation issue may be what constitutes elements of control. When there is a convergence of new and yet to be developed technology, transacting business, and financing the same, bugs and problems will develop and will eventually find their way into the court system.
The key for doing business within the CER world is to develop protocols. People will always sell goods and services and are looking for easier ways to transact business and get their business to the market. Free market economies encourage innovation. The old saying when there is a will, there’s a way, holds true for doing business within the CER world. Stay tuned. It will be an interesting ride and there will be more on this subject to follow that will do a deeper dive into some of those topics as things develop.
About Steve N. Kurtz
Steve Kurtz is a seasoned attorney with expertise in commercial and bankruptcy litigation, as well as complex commercial finance transactions. He has led numerous high-stakes commercial cases and now divides his time equally between litigation and transactional work, serving a diverse clientele, including financial institutions and fintech lenders.
Beyond his legal practice, Mr. Kurtz has served as a Judge Pro-Tem in Los Angeles County and actively engages in pro bono work. He is also deeply involved in his community, serving as the President of the Calabasas Shul and leading an active lifestyle with his family.
He holds a B.S. in Psychology from San Diego State University and a J.D. from McGeorge School of Law. He is affiliated with several prestigious legal organizations and has been recognized as a "Super Lawyer" by Los Angeles Magazine for multiple years. Additionally, he is a published author and frequent speaker at finance and legal conferences.
The views expressed in the Commercial Factor website are those of the authors and do not necessarily represent the views of, and should not be attributed to, the International Factoring Association.