Blockchain-enabled smart contracts create self-executing transactions that automatically capture assets to satisfy obligations. They are a form of asset partitioning. Some scholars compare smart contracts to self-help, analogous to security interests. Others describe the asset-shielding function of smart contracts, analogous to entity law.
State lawmakers have begun to address the legal status of blockchain and smart contracts, but their approaches treat the technology as a new platform for executing established deal types. They have not digested the difficulty of fitting blockchain-based smart contracts into existing legal frameworks given that these platforms conflate contract and property law functions, and mimic both security interests and entities. Lawmakers should address whether blockchain-based smart contracts constitute security interests under Uniform Commercial Code (“UCC”) Article 9, by virtue of how they function. Short of deeming all smart contracts to be security interests, lawmakers should consider whether UCC Article 9 should govern smart contracts that do not involve assignments that secure obligations in certain contexts.
Blockchain-based smart contracts are a device or platform for transacting, not a deal type. But this device has a legal effect: it dedicates assets to specific transactional counterparties. As such, it is possible to interpret all blockchain-based smart contracts as meeting the statutory requirements for a security interest. At the same time, market actors could proceed as if no blockchain-based smart contract creates an Article 9 security interest given the strong form of partitioning such transactions effectuate, thereby side-stepping statutory rules surrounding notice, priorities, commercially reasonable disposition of collateral, and bankruptcy. Defining the relationship between blockchain-based smart contracts and secured transactions law would situate emerging market activity in relation to a major category of private-law rules that express longstanding policy choices. If lawmakers decline to articulate how blockchain-based transactions implicate contract, property, and entity laws, markets could expand despite inconsistent or incoherent legal status, undermining the capacity to enforce, in the future, rules designed to curtail problematic risks.
Smart contracts on blockchains1 create self-enforcing transactions that automatically capture assets to satisfy obligations.2 This Article explores (i) how blockchain-based smart contracts implicate secured transactions law, and (ii) how and why lawmakers should clarify the relationship between blockchain-based smart contracts and the scope of Uniform Commercial Code (“UCC”) Article 9.3
Specifically, this Article focuses on three emerging-technology-driven issues for secured transactions law. First, the use of blockchain-based smart contracts for transactions that are subject to potential re-characterization (such as equipment leases) raises concerns that may warrant expanding the scope of UCC Article 9. Second, agreements that market actors do not currently associate with UCC Article 9, when expressed as smart contracts, behave like secured transactions. If a liquidated damages clause in a services contract becomes self-executing, for example, then the contract partitions assets to satisfy obligations. Code-based, self-executing mechanisms arguably bring any agreement that utilizes them within the UCC’s statutory parameters for security interests. Third, blockchain-based smart contracts create a functional convergence of security interests and entities. If blockchain-based smart contracts partition assets in ways that are difficult to classify, market actors may proceed on grounds that transactions on a blockchain avoid secured transactions law all together. How do we ensure that the considerations animating UCC Article 9, such as the importance of notice and of reasonable disposition of assets upon default, remain relevant in markets of the future?
This Article explores each of these issues in turn. The first issue is about practical effects of blockchain-based smart contracts in certain instances and how expanding the scope of UCC Article 9 could help to mitigate those effects. The second and third issues are conceptual. It is possible to take the view that all blockchain-based smart contracts meet the statutory requirements for a security interest. Conversely, market actors could proceed as if no blockchain-based smart contract creates an Article 9 security interest, side-stepping all together the policy considerations expressed in secured transactions law.
With respect to the first issue, consider the implications of using smart contracts to express transactions that are potentially subject to re-characterization. A true lease, for example, is not governed by UCC Article 9. In practice, many lease transactions are re-characterized as secured loans if the lessee files for bankruptcy and asserts an interest in the leased equipment. The bankruptcy petition triggers an automatic stay on the debtor’s assets. The bankruptcy trustee then determines which assets comprise the estate. If the debtor is party to a true lease, then the leased equipment is property of the lessor and not part of the estate. If the transaction (though called a “lease”) contains provisions that reflect the economic substance of a secured loan, then the equipment remains part of the estate and the “lessor” participates in the bankruptcy proceedings as a secured creditor.
When a lease is executed on a blockchain platform, if the lessee defaults the equipment may be automatically disabled and transferred from the debtor’s assets. There is no longer the intervention point at which a bankruptcy trustee can assess whether the equipment is property of the lessor or is property of the debtor subject to a lien in favor if the lessor, in determining the fate of the asset. The self-executing transfer that the blockchain-based smart lease effectuates may violate the automatic stay. But the debtor and its other creditors are left with trying to undo the effects of the transfer and disablement ex post, rather than having access to the equipment pending determination of its legal status. Because true leases are not governed by UCC Article 9, creditors of lessees may not have notice of this possibility.
Given this risk and the practical difficulties such a “smart lease” creates, investors in lessees should have notice of the existence of this type of transaction, so that they can price in the risk that these deals present. For this reason, lawmakers should consider whether true leases—along with, perhaps, other transactions that typically involve characterization questions—should be within the scope of UCC Article 9. Part II.A further analyzes this contention. UCC Article 9 already contains provisions that extend its scope beyond secured loans in certain market contexts, applying Article 9’s notice and priority, but not its remedies, provisions to consignments of goods and sales of rights to payment.4 Part II.A makes the case for analogous provisions for certain additional deals when they are expressed using blockchain-based smart contracts.
With respect to the second issue, smart contracts on blockchains are considered a method or device for transacting, not a deal type. Yet, this emerging platform for transactions has a legal effect: it accomplishes asset partitioning.5 Blockchain-based smart contracts commit assets in a range of transactional contexts that market actors may not associate with secured lending, but that invoke UCC Article 9 and the concept of the security interest.6 Consider a services contract that automatically captures assets if services are not rendered on time. The parties may not associate their transaction with secured lending, but their agreement partitions assets for enforcement of a contractual obligation. A court could conceivably characterize such an agreement as a security interest as defined in UCC Article 1, that is enforceable under UCC Article 9.7 If a court found that such a transaction falls within the scope of UCC Section 9-109(a)(1), it could test the smart contract’s asset capture and disposition functions for commercial reasonableness under Section 9-610.8 If states enact limits on electronic self-help (some already have), then those statutory parameters would apply, as well.9
The drafters of UCC Article 9 should speak to the question of whether such a transaction falls within the scope of the statute. Lawmakers could deem smart contracts to constitute security interests on the grounds that they capture assets to satisfy contractual obligations, meeting statutory requirements for a security interest.10 This approach would empower courts and lawmakers to elucidate the boundaries of electronic self-help and of commercial reasonableness11 in the use of smart contracts.12 Part II.B more fully presents how blockchain-based smart contracts—by virtue of how they function—could constitute security interests.
With respect to the third issue, blockchain-based smart contracts mimic both security interests and entities in ways that are difficult to parse out. Market actors may treat these transactions as eluding secured transactions law. Just as it is possible to conceive of all blockchain-based smart contracts as security interests, it is also possible to take the position that none are. This possibility portends a demise of the policy choices animating secured transactions law. Part II.C discusses asset partitioning and the issue of distinguishing security interests from entities in blockchain-based markets.
Scholars have discussed existing market contexts in which security interests and entities seem to converge, and the continuing relevance of security interests as distinct from entities.13 Some scholars compare blockchain-based smart contracts to security interests, focusing on their self-help function.14 Others compare them to entity law, focusing on their asset-shielding function.15 Blockchain-based smart contracts can conflate property and contract functions, making distinctions among private law categories—property, contract, entity law—potentially obsolete. State legislative initiatives to accommodate this technology typically treat it as a new platform for established deal types. Current approaches do not adequately articulate or account for the ways that this technology enables departure from established deal classifications, by conflating and disrupting the functions of contract, property, and entity laws.16
Part III then tells a cautionary tale. If blockchain-based smart contracts segregate assets in ways that are difficult to classify in private-law terms, then market actors may operate without regard for the private-law concepts that provide the legal infrastructure of markets—that enable remedies and facilitate valuation.17 Part III discusses how a disregard of private-law concepts contributed to the financial crisis of 2007-08, using two examples: the mortgage-backed securities (“MBS”) market, and the securities repurchase agreement (“repo”) market. These markets illuminate risks that lawmakers should consider as blockchain-based smart contracts proliferate.
Lawmakers should not be afraid to define new market practices and asset classes in private-law terms. Legal concepts may need to evolve to accommodate new practices, but leaving technologies of legal import beyond private-law classification altogether invites a lack of clarity and a problematic dissonance between legal infrastructure and market expectations. Once certain financial products or practices become “too big to fail,”18 they may elude proper regulatory treatment despite excessive risks. Defining the relationship between blockchain-based smart contracts and secured transactions law is a crucial task because it requires that lawmakers articulate the private-law components and implications of market practices emanating from emerging technologies.
UCC Article 9 expresses policy choices with respect to notice, asset disposition, and priorities.19 Lawmakers need to critically assess the relationship between blockchain-based smart contracts and secured transactions law, to ensure that the policy considerations driving this body of law have traction in markets of the future. Deeming blockchain-based smart contracts to be security interests under the UCC, for example, would establish a regulatory situs for (i) specifying when and how a firm needs to give notice of its blockchain-based transactions, (ii) submitting the automatic enforcement feature of these transactions to the UCC’s commercial reasonableness standards, and (iii) establishing priorities among creditors of firms engaged in blockchain-based business activity.
Part I.A of this Article describes blockchain technology, smart contracts, and assets on blockchains. Part I.B then assesses the relationship between blockchain-based smart contracts and existing private-law categories, explaining how these transactions depart from contract law, conflate property and contract functions, and mimic entities. Part II explores and analyzes the three issues outlined above that blockchain-based smart contracts present for secured transactions law. Part III discusses the importance of understanding emerging market practices in private-law terms.
The UCC codifies private-law doctrines to foster uniformity and to facilitate markets. The articles of the UCC are drafted in a lawmaking process that has a unique relationship to industry and a unique sensitivity to business actors’ expectations.20 Commentators are already expressing concern that state laws pertaining to blockchain technology are creating a non-uniform patchwork of legal treatment that can complicate development of platforms intended for widespread use. The American Law Institute (“ALI”) and the Uniform Law Commission (“ULC”) recently convened a joint study committee on the UCC and Emerging Technologies.21 The ALI/ULC joint study committee has the capacity to generate clarity and uniformity regarding the legal status of blockchain-based smart contracts. This topic requires more thorough legal analysis than state legislatures are likely to undertake.22
This Part describes blockchain and smart contracts, and establishes how this Article uses the terms “blockchain” and “smart contract.” A defining of terms and a basic understanding of distributed ledger technology must underscore any discussion of blockchain transactions’ legal implications. Next, this Part describes the relationship between this emerging technology and existing contract, property, and entity laws. Secured transactions law is an amalgam of contract and property. Understanding how blockchain-based smart contracts implicate these realms of the private law is a crucial prerequisite to assessing whether to treat blockchain-based smart contracts as security interests under the UCC.
A. The Technology
People use the word “blockchain” inconsistently, making the terminology surrounding this technology highly confusing.23 Generally speaking, a blockchain is a type of distributed ledger that records transactions.24 To say that a ledger is “distributed” means that there is no master copy: any participant may maintain a copy of the ledger and yet all participants have confidence that theirs matches all other copies.25 This is a central innovation of blockchain technology. Participants can trust the accuracy of a ledger without reference to a master copy or central authority.
Commentators may refer to “blockchain technology,” “blockchains” or “the blockchain.”26 While currently there are numerous blockchains in operation, it is hypothetically possible that in the future there will be only one blockchain of consequence.27 Or, they may refer to “distributed ledger technology” (“DLT”), or “shared ledgers” or “consensus ledgers.”28 Some contend that the term “blockchain” should refer only to public or permissionless ledgers, while others use “blockchain” to mean any distributed ledger regardless of whether it is open access or permissioned.29
The first blockchain was created for Bitcoin, a cryptocurrency implemented with open source software, in operation since 2009.30 Since the advent of Bitcoin, other blockchains have developed, some that create a native cryptocurrency31 and some that do not.32 Among systems that issue a cryptocurrency, some intend the cryptocurrency to be an investment vehicle (an end in itself),33 while others intend the cryptocurrency as a means to an end: a platform for expression of transactions apart from the value of the cryptocurrency.34 Systems that do not have a cryptocurrency generally are “permissioned ledgers.”35 They are designed for private groups to share and track information and transactions. They are governed by a set of permissions. These permissions can be open (making the ledger function much like a non-permissioned blockchain), or can be quite strict (making the ledger a recording system that functions like any other recording system, but with enhanced capacities for accuracy and security).36
Regardless of what permutation a blockchain takes, all blockchains are constituted by the same primary components: (i) a ledger, (ii) a network, and (iii) consensus, that is (iv) unalterable by feasible means. The ledger is the database that expands as it incorporates approved transactions. Transactions are added to the ledger using cryptographic signatures and keys,37 and they are grouped into blocks.38 Each block contains a cryptographic hash to the previous block, keeping the blocks in order.39 No one can alter a transaction once it is approved, because the blocks are linked in a sequence that cannot be feasibly altered.40 Many describe the blockchain as “immutable,” though this term can be misleading.41
The network is the computer nodes running the software for the application—for example, the nodes running the Bitcoin software, connected in a peer-to-peer network—where each node maintains a complete copy of the blockchain.42 Each new transaction is broadcast to all nodes in the network.43 The nodes add new blocks to the blockchain as transactions are validated.44
Consensus is how blockchains establish trust among trustless participants in the absence of a centralized authority or enforcement mechanism. On the Bitcoin network, for example, consensus is generated with a process called mining.45 The nodes of the Bitcoin blockchain dedicate computing power to solve cryptographic hashing puzzles.46 These puzzles are derived from transactions in a new, proposed block. Some node engaged in the mining process will find a solution to the puzzles every ten minutes or so, creating a new block that is broadcast to the network.47 The other nodes check the solution for the proposed new block for validity.48 Once a node verifies a solution’s validity, the proposed block appends the chain maintained by that node.49 When miners broadcast competing solutions, the solution with the longest chain—the most nodes verifying it—becomes by consensus the new block and is rewarded with Bitcoin.50 Participants trust the resulting blockchain because bad actors would have to exceed the computing power of the network to establish a contrary record of transactions—a possibility that is remote given the computing power required for solving cryptographic hashing puzzles and the incentive of financial reward for generating the consensus-validated solution.51
This consensus mechanism first executed by the Bitcoin blockchain is commonly called “proof-of-work,” or creating consensus with a “proof-of-work algorithm.”52 Many permissionless and some permissioned blockchains rely on proof-of-work algorithms. These require considerable computing power (and energy) for their administration.53 Permissioned blockchains may use a consensus mechanism other than proof-of-work. Hyperledger Fabric, for example, provides a number of consensus algorithms available to participants who use a Hyperledger platform.54 The difficulty of these algorithms, and the computational power they demand, varies.
This Article uses the term “blockchain” to refer to any system comprised of a distributed ledger, a network, and consensus, regardless of whether it is permissioned. In the Parts that follow, discussion of particular blockchain applications and their implications for secured transactions may require specification as to what type of distributed ledger is relevant in the context at issue. Given the variety among blockchains, a decision by lawmakers or market actors to use a distributed ledger platform also involves a decision as to which platform is most appropriate. The only way to discuss legal implications of blockchain technology is with specificity.55 This Article will reference particular blockchains or types of platform as context requires.
A “smart contract” is an agreement that is self-executing and self-enforcing, expressed in digital form.56 There are different forms of blockchain-based smart contract that accomplish different ends. The smart contracts that this Article contemplates are single smart contracts for trade transactions, executed on a decentralized ledger. Such a smart contract is a “decentralized bond between two or more parties on blockchain,” that operates in response to financial incentives.57 This Article does not reach the question of whether other kinds of smart contracts, such as decentralized applications (or “DApps”) constitute security interests.58 The exercise here is to consider how common forms of commercial transaction operate, from a legal standpoint, when transformed into smart contracts on blockchains.
Self-executing agreements have existed for a long time—the vending machine is a classic example.59 Digital agreements have existed for decades—ordinary consumers routinely enter into digital contracts in online transactions.60 However, it is only recently that emerging technologies have made possible the expression of agreements in digital form that self-execute and self-enforce, meaning: enforcement is unavoidable and happens without reference to a court or external authority.61 It is the combination of smart contracts with blockchain technology—expressing contracts in digital form on a distributed ledger—that enables this innovation.
We can divide the assets at issue in blockchain transactions into two general categories: original blockchain-based assets and tokenized assets.62 Cryptocurrencies, native to blockchain, are original blockchain-based assets.63 Tokenized assets are assets that exist apart from a blockchain, rights to which are embedded into the blockchain.64
For the analysis in this Article, it is crucial to differentiate among (i) a security interest in a cryptocurrency or in a tokenized asset, (ii) a security interest in a smart contract, and (iii) treating a blockchain-based smart contract as a security interest. Other commentators have detailed the mechanics of attachment and perfection for security interests in original blockchain-based or in tokenized assets.65 This Article will not repeat that exercise. The focus in this Article is on smart contracts as security interests or as security interest substitutes.
B. Blockchain and the Private Law
This section discusses how smart contracts implicate contract, property, and entity laws, providing context to assess the question of whether smart contracts should be considered security interests. Legal scholars are exploring how smart contracts relate to contract law and conventional notions of contracts as legally enforceable agreements. Scholars have described how smart contracts function like escrow agreements, and how they involve self-help of the type secured creditors enjoy under Part 6 of UCC Article 9. Some state that smart contracts and security interests are substitutes and are “roughly analogous.” Others emphasize that smart contracts are novel and cannot neatly fit into the realm of the escrow agreement or the security interest enforced with self-help.
In addition, scholars have observed that smart contracts conflate contract and property actions. UCC Article 9 contemplates both a conceptual and a practical distinction between contract law and property law. The security interest is a consensual lien—a property interest created by contract. Parties to a secured transaction may contract as to the scope and terms of their loan and security agreement,66 but may not alter property features of the security interest they create, such as the law governing perfection67 of the interest or the requirement that secured parties dispose of collateral in a commercially reasonable manner.68 The fact that blockchain-based smart contracts conflate contract and property functions makes the relationship between smart contracts and secured transactions law complex to digest.
Contract law. Commentators have seized on smart contracts to speculate that contract law may become obsolete. Nick Szabo has written that law and computer security will merge, making the protections of law superfluous.69 Others have declared that smart contracts offer a “technological alternative to the whole legal system,”70 that they may make obsolete some contract causes of action, that they operate “beyond the boundaries of law,”71 and that they do not even need a legal system for their existence.72 Legal scholars have begun to step in and test these speculations, analyzing how smart contracts relate to contract law.
Kevin Werbach and Nicolas Cornell explore the notion that smart contracts “offer a digital bypass around traditional contract law.”73 While they acknowledge that smart contracts present novel possibilities and will require new legal responses, they maintain that smart contracts will not displace contract law.74 In fact, they argue, smart contracts “illuminate the role of contract law more than they obviate it,”75 when we consider that contract law is, in essence, a remedial institution.76 Contract law adjudicates ex post any grievances that arise. While smart contracts obviate remediation by eliminating the possibility of breach, they do not obviate the needs that underscore contract law.77 The results of a smart contract may be inconsistent with the parties’ mutual intent, or may create a criminal or legally unconscionable outcome.78 One way or another, the mechanisms of contractual adjudication will arise to address these scenarios.79 Given the remedial purpose of contract law, smart contracts will not serve to eliminate or substitute for this body of law.80 In contrast, Werbach and Cornell assert, smart contracts accentuate the role of contract law, and may inspire an expansion of regulation into contract’s private law domain.81
At the outset of their analysis, Werbach and Cornell take up the question of whether smart contracts are really “contracts” in the first place.82 They illustrate the complexity of answering this question, given that the term “contract” is susceptible to different and shifting definitions.83 They discuss varying ways to define contract, and compare definitions of contract to the concept of the smart contract. Ultimately, they determine that contracts are agreements “meant to have practical consequences on the rights and duties of the parties—that is, not merely aspirational.”84 This characterization of contracts presents some difficulty for smart contracts because smart contracts do not impose duties or obligations; they do not commit a party to do anything.85 They implement a mechanism, rather than an exchange of promises. Werbach and Cornell conclude that smart contracts are “contracts” despite the fact that they do not involve promises, because smart contracts “are voluntary mechanisms that purport to alter the rights and duties of the parties.”86 Smart contracts commit to a future outcome, but not by making a promise. They find that “this hybrid between ex ante commitment and ex post enforcement is novel.”87 Nothing prevents expression of a mutual agreement that is formulated in code, they observe. They also discuss the nuance that smart contracts are unilateral in the sense that only one party actually places them onto the blockchain.88
Max Raskin distinguishes between “strong” and “weak” smart contracts.89 Strong smart contracts are those with prohibitive costs of revocation and modification; weak smart contracts are those that a court could alter with relative ease.90 Weak smart contracts are subject to traditional methods of enforcement: consider for example a revocable money transfer between financial institutions (executed with a smart contract) that a court could order reversed or modified.91 Strong smart contracts, in contrast, obviate the possibility of non-performance or wrong-performance, creating a non-traditional method of enforcement.92 They are not subject to interpretation, modification or enforcement by a court.93
Weak smart contracts, Raskin observes, fit squarely within existing contract law. “If a court has the power to interpret and then enforce a contract,” he notes, “then it is the smart actor and will abide by previous precedential rules and statutory frameworks.”94 Strong smart contracts, however, present novel legal questions. Raskin uses the example of a car loan and starter interrupter, where a car’s “contractware” is programmed so that inputs and outputs are assessed by a blockchain.95 If the debtor pays the creditor the right amount at the right time, the contractware searches the blockchain for such a transaction, finds it, and the car can start.96 If the contractware does not find such a transaction on the blockchain, the car cannot start.97 The disinterested blockchain enforces the contract’s terms. This type of smart contract departs from traditional contracts because it does more than what traditional contracts can do: it independently enforces an ex ante agreement, with a third-party enforcer (a decentralized ledger).98
Usha Rodrigues argues that smart contracting on a blockchain departs in a fundamental way from contract law because it provides no place for the law to step in to supply default rules.99 A crucial function of law is to provide gap fillers, given that contracts are incomplete. Agreements expressed as smart contracts will also be incomplete, yet they will function apart from the gap-filling capacity of contract law because they lack a “legal intervention point” given that they are self-executing and self-enforcing.100 “The lack of a legal intervention point means that law on the blockchain works in a fundamentally different way from law in the corporeal world,” Rodrigues observes.101
Escrow. Werbach and Cornell, among others, compare smart contracts to escrow agreements.102 Smart contracts function like escrow agreements because they suspend assets on the blockchain until performance of an agreement is complete.103 Unlike conventional escrow, however, smart contracts on blockchain do not require a trusted third party or escrow agent.104 They hold assets temporarily according to automated terms verified by the distributed network.105
Self-help. Raskin, and Werbach and Cornell, describe smart contracts as a form of self-help. In his discussion of starter interrupters, Raskin states that such devices comport with the provisions of Part 6 of UCC Article 9, which provide for self-help upon default for secured creditors. Werbach and Cornell write that “viewing smart contracts as self-help mechanisms accurately places the emphasis on the ex post enforcement function.”106 They also contrast smart contracts and self-help, pointing out that self-help is a mechanism to enforce a contract whereas distributed ledger software both instantiates and enforces contract terms.107
Property. In the realm of private law theory, the existence and function of a viable contract/property distinction has been a subject of debate.108 Generally speaking, however, contract rights are enforceable by and against parties in privity of contract with one another, whereas property rights are enforceable against third parties.109 Because contracts are private—known to and enforceable by the parties to the contract—they may be as complex or customized as the parties desire, limited only by the boundaries of criminality or other unconscionability.110 Property interests, in contrast, must be legally recognizable to be enforceable against third parties. Property systems express the concept of numerus clausus, or “the number is closed,” to limit market actors to forms of property interest that the law recognizes.111 The property concept of unreasonable restraints on alienation limits market actors’ capacity to customize property interests in ways that make them excessively illiquid.112 Property law links enforceability against competing claimants to notice. While notice takes different forms in different contexts,113 the concept that notice of property interests justifies enforceability against competing claimants pervades property systems.
These basic differences between contract and property rights inform much of the infrastructure of the private law. Blockchain technology challenges this distinction. Ofer Eldar and Andrew Verstein observe:
Blockchain makes privately created contracts publicly available to those with access to the blockchain. In this way, the contract becomes binding on third parties who are members of the blockchain. In doing that, blockchain technology essentially blurs the distinction between contract law and property law, because it facilitates instruments that can be highly customized, yet are resilient against third-party claims.114
If the architecture of UCC Article 9 incorporates a contract/property distinction that determines mandatory versus default rules for secured transactions, how will the emergence of a transacting platform that collapses this distinction affect collateralized obligations?
The concept that blockchain technology facilitates the enforcement of highly customized claims against third parties raises two separate issues. First, if the technology conflates contract and property actions, how do blockchain-based claims compare to the security interest as a form of asset partitioning? Second, secured transactions law (along with private law generally) does not permit the enforcement of highly customized claims against third parties when this customization is for the purpose of contracting around otherwise applicable statutory requirements. Secured transactions law encompasses transactions involving assignments intended to secure obligations, regardless of their form, subjecting them to notice and remedies requirements, and commercial reasonableness standards. How will market actors’ execution of agreements on a blockchain that have unambiguous terms—but that create property interests of ambiguous scope—affect notice and statutory protections for assets upon default? This question lies at the heart of this Article’s analysis.
Entity law. Rodrigues describes how smart contracts can effectuate more than is possible under traditional contract law, focusing on their asset-shielding function.115 She discusses the example of asset partitioning with limited liability, versus with smart contracts operating in a decentralized autonomous organization (“DAO”).116 Rodrigues compares smart contracts to entity law as a form of asset partitioning, finding that entity law, the device that shields assets from owners’ creditors, is superfluous in the DAO context.117 Traditionally, contract alone is insufficient to accomplish the asset partitioning function of limited liability entities. The corporate form has the unique capacity to insulate a firm’s assets from claims of investors’ creditors.118 In the world of smart contracts, however, an agreement can effectuate entity shielding because a smart contract can disallow liquidation.119 She explains that “[e]ven if a court rendered judgment in favor of a particular creditor, if the code did not permit a liquidation, then any attempt by a creditor or a coder in the creditor’s employ to update the blockchain to liquidate the entity would be rejected by the consensus of miners.”120
To illustrate, consider Rodrigues’s description of how assets assigned with a smart contract are unreachable by an investor’s creditors because code may be structured to not recognize creditors’ judgments.121 She writes that in the virtual world, contract can play the role that secured transactions or entity laws play in traditional contexts. But there is a distinction between assets that are beyond the reach of creditors because creditors’ interests cannot legally attach, versus assets that are beyond creditors’ reach because of enforcement logistics. Contractual prohibitions on assignment do not prevent the attachment of a security interest in assets, under UCC Article 9.122 So, do smart contracts partition assets in a way that makes them unreachable by counterparties’ creditors because they elude attachment (like entity law), or because code can be a barrier to enforcement (of a security interest)?123
How we answer this question has consequences. As a theoretical matter, it affects how we conceive of the relationship between smart contracts and secured transactions law. As a practical matter, if security interests attach to assets assigned in blockchain transactions, then they also attach to any proceeds of those assets.124 Given, there is not the capacity to trace cryptocurrency in the way creditors trace other kinds of assets, because cryptocurrencies are fungible. But for assets other than cryptocurrencies, or in contexts where tracing is not required, to the extent blockchain-based assets are converted into or traded for traditional assets, those assets would be reachable by creditors. If, on the other hand, smart contracts partition assets in a way that defies attachment of creditors’ interests, then the assets and any proceeds are unreachable in any event. This framing question underscores this Article’s consideration of whether and why drafters of UCC Article 9 might deem smart contracts to be within the statute’s scope.
The logic of contemporary secured transactions law rests on certain, central pillars. These include the concepts that (i) collateral security rules provide for notice of interests and for priorities among investors conditioned on compliance with notice requirements, and (ii) the unitary security interest lowers transaction costs and minimizes secret liens. Whether a given transaction falls within the scope of Article 9 depends upon the economic substance of the transaction and the intent of the parties, not just the language the parties use to characterize an assignment.125 Legal scholars and policy makers should digest the implications of blockchain for secured transactions law now, so that lawmakers can make affirmative choices about how secured transactions law should operate in markets of the future.
Before the enactment of UCC Article 9, different asset classes and industries followed different laws for collateral security.126 The drafters of Article 9 debated the wisdom of attempting to condense these various regimes into one comprehensive set of collateral security rules.127 The result is Article 9’s “unitary security interest”128: the statute permits a creditor to take an interest in diverse asset types with one assignment.129 This feature of Article 9 minimizes secret liens and lowers transactions costs.130 It is considered one of the central innovations of the statute. If transfers on blockchains proliferate, will significant assets elude attachment of security interests held by investors with blanket liens? Why bother with a secured lender if a smart contract achieves monitoring and accomplishes automatically what a secured transaction requires additional formalities to do?
In some regard, these questions strike a familiar chord. The rise in prominence of entity partitioning and securitization years ago generated discussion of “the death of secured lending.”131 In other regards, these questions are novel. The analysis in this Article enables scholars and lawmakers to consider the implications of a new realm of asset partitioning that could operate either apart from UCC Article 9 or within it, depending upon policy choices.
If lawmakers undertake to effectuate any of the ideas provided in this Article, numerous, detailed drafting questions would arise. Agreeing upon a precise statement of the class of agreements to which Article 9 would extend would require industry input and be a critical part of the drafting process.132
A. Implications of Smart Contracts in Contexts Involving Characterization Risk
A transaction involves characterization risk if it takes the form of a certain deal, like a lease, but contains terms that reflect intention to create another kind of deal, like a secured loan. Leases and loans involve different kinds of property interest, subject to different legal rules and regulations. Some markets—equipment leasing, sale-leaseback transactions, consignments, for example—are prone to characterization risk. Common law doctrines govern the characterization of a transaction, providing factors for courts to consider in determining the economic substance and intent of the parties. Depending on how a transaction is characterized as a matter of law, it may or may not be governed by UCC Article 9, and the assets involved may or may not be subject to bankruptcy proceedings.
Deal characterization turns on the concept that a contract can take a form that is inconsistent with the scope of property interest the transaction creates. Given that smart contracts can render non-performance and non-enforcement impossible, any characterization analysis of a smart contract would happen ex post, if an aggrieved party demands an interest in assets captured under the smart contract. If other creditors of a party to a smart contract have notice of the existence of the smart contract transaction, they can be aware that value belonging to their debtor may be captured automatically upon the occurrence of certain events.133
The definition of “security interest” in UCC Article 1 includes any transaction that falls within the scope of UCC Article 9.134 Under Section 9-109(a)(1), any obligation secured by an interest in personal property is a secured transaction, regardless of form.135 In addition, Section 9-109(a) deems certain other transactions—consignments and sales of certain rights to payment—to be within its scope despite the fact that these transactions do not involve assignments that secure obligations.136 As such, in secured transactions law we reference “SISOs,” or “security interests that secure obligations,” and non-SISOs, or interests that are governed by Article 9 despite that fact that they do not involve an extension of credit secured by personalty.
While non-SISOs are governed by UCC Article 9, they are not subject to Part 6 of the statute because they do not implicate creditors’ remedies.137 Security interests that are not SISOs must comply with the perfection provisions of Article 9 in order to retain priority vis-à-vis other creditors’ claims. So, Article 9 governs perfection and priority of non-SISO security interests, but not asset disposition after default.
The capacity to distinguish between SISO and non-SISO assignments on blockchain depends upon the persistence of a viable distinction between asset partitioning by security interest versus by entity law. Eldar and Verstein’s theory138 offers one framework for thinking about how we might distinguish SISOs from other assignments in blockchain-based markets.139 For purposes of deal characterization, courts could examine agreements expressed in code to determine if they create fixed, versus floating, priority schemes.140
Consider the UCC Article 9 provisions that currently govern non-SISO security interests: Section 9-109(a)(4) (consignments of goods) and Section 9-109(a)(3) (sales of rights to payment). Analogous provisions for leases on blockchain could be enacted in a new subsection of Section 9-109(a).
Consignments. UCC Section 9-109(a)(4) extends the scope of Article 9 to commercial consignment transactions. A “consignment” under the code is a bailment for purposes of sale that is not of consumer goods, involves deliveries in excess of $1,000 each, in which the consignee is not an auctioneer or otherwise generally known to deal in the goods of others.141 When a consignor places goods for sale with a consignee, the consignor must file a UCC-1 financing statement or risk subordination to the consignee’s creditors. In other words, the consignor must file a notice of its interest even though it is the owner of the assets. The consignee should have no rights in consigned goods to which its creditors’ interest could attach,142 and yet UCC Article 9 subordinates an unperfected consignor to a perfected secured creditor of a consignee.
There are specific policy objectives behind this counter-intuitive result. First, it can be difficult to distinguish true consignments from inventory financings.143 Because the parties may be using the form of a consignment to disguise an inventory financing—or if they do not know how a court would characterize their transaction—the statute puts other creditors of the consignee on notice of the consignor’s interest.
In addition, consignments create ostensible ownership issues. Inventory in the possession of a consignee, within the meaning of the code, appear to other investors to be assets in which the consignee has rights. By requiring consignors to file to retain their priority, the statute allocates transaction costs in a specific way. Due diligence costs for secured creditors in the face of ostensible ownership can be high.144 The costs of filing a UCC-1, and giving additional notice to existing creditors to retain purchase-money security interest (“PMSI”) priority,145 are relatively low.
Again, if the consignee defaults or enters bankruptcy, the consignor, if it has perfected its interest, takes the goods and does not have to comply with any statutory requirements for exercising remedies. It has a “security interest,” but not a SISO. Section 9-109(a)(4) makes characterization questions irrelevant unless and until there is a default and a consignee, or its creditors demand an interest in the consigned assets. It makes the characterization challenge upon default the legal intervention point for characterization analyses.
Sales of accounts, chattel paper, payment intangibles, or promissory notes. UCC Section 9-109(a)(3) extends the scope of Article 9 to sales of certain classes of rights to payment. For payment intangibles and promissory notes, perfection is automatic upon attachment, so purchasers need not take additional action to retain their interests against creditors of the seller.146 Purchasers of accounts must file a UCC-1 to retain priority.147 Purchasers of chattel paper must either file, or perfect by control (electronic paper) or possession (tangible paper).148
The purpose of these rules is similar to those for consignment, though these assets do not necessarily present the same ostensible ownership issues. As the drafters state: “This approach generally has been successful in avoiding difficult problems of distinguishing between transactions in which a receivable secures an obligation and those in which the receivable has been sold outright. In many commercial financing transactions the distinction is blurred.”149 UCC Article 9 explicitly contemplates that commercial actors will create transactions designed to achieve competing objectives, the ultimate character of which may require fact-intensive analysis. Deeming true sales of the certain rights to payment to be statutory “security interests” eliminates the need for characterization in the absence of default and a challenge by the seller/debtor.
A new subsection of 9-109(a) for blockchain-based leases. UCC Article 9 could treat smart contract leases much like the statute treats consignments. Such leases would be security interests (but not SISOs), requiring the lessor to perfect its interest in order to maintain priority vis-à-vis creditors of the lessee. The blockchain-based lease would create a PMSI in equipment. With respect to PMSIs in equipment created by smart contract leases, the drafters could impose an additional notice requirement to existing, perfected creditors of the lessee, as a condition for later-in-time priority for the lessor. Section 9-324(b) requires such notice for PMSI-holders with interests in inventory to assert PMSI super-priority. Similar provisions in Section 9-324(a) concerning equipment, when the equipment is subject to a smart contract lease, would maximize the notice benefits of subjecting these leases to UCC Article 9. Existing and future investors would have notice, enabling them to request information, investigate, and “price in” the risk that the blockchain-based lease presents.150
There may be other, common commercial transactions that warrant security interest designation when expressed on blockchains, such as assignments of goods in certain contexts. This section presents just the lease example to illustrate the potential utility, when a debtor transacts on a blockchain platform, of expanding the scope of UCC Article 9 to include, as non-SISOs, transactions prone to characterization challenges.
B. Self-Executing Agreements and the Statutory Requirements for a Security Interest
Blockchain and smart contracts comprise a device for transacting that, in theory, parties can use to effectuate any type of deal. But this device has a legal effect, by virtue of how it functions. It partitions assets to satisfy obligations. It makes liquidated damages clauses the functional equivalent of security interests. To the extent that it shields assets from creditors’ claims that the code does not recognize, it mimics entity law as an asset partitioning device as well.
Under UCC Section 1-201(b)(35), “‘security interest’ means an interest in personal property or fixtures which secures payment or performance of an obligation.”151 UCC Section 9-109(a)(1) applies to “a transaction, regardless of its form, that creates a security interest in personal property or fixtures by contract.”152 While parties to smart contracts, in many instances, may not associate their transactions with secured lending, the self-executing feature of smart contracts captures assets to satisfy obligations.
As described above, smart contracts do not impose duties—they do not involve an exchange of promises.153 Rather, they implement a mechanism.154 They commit to a future outcome by submitting the parties to self-executing terms expressed in code. As such, they do alter, by consent, the rights and duties of the parties to the smart contract.155 Given that they do not involve duties or obligations—to be performed or not at the discretion of contracting parties—they are different in nature from the traditional contracts to which Section 9-109 refers. Despite this difference, parties agree to a smart contract mechanism that commits them to a future outcome in which assets are segregated in satisfaction of the contract’s terms. As such, lawmakers could view them as security interests within the current scope of the statute.
Section 9-203 establishes when a security interest is enforceable.156 It requires that value be given, that the debtor have rights in the collateral, and that there be evidence of intent to create a security interest in specified assets (in the form of an authenticated security agreement describing the collateral, or as demonstrated by a secured party’s possession or control of collateral).157 In the context of smart contracts, provisions for asset capture upon default segregate personal property for satisfaction of contractual obligations, either transferring or releasing them, depending upon a transaction’s terms and the parties’ performance.
The “value given” requirement of Section 9-203 mirrors the consideration requirement in contract law.158 A smart contract enforceable as a contract at law contains consideration. It is possible that some smart contracts would not be enforceable as contracts if challenged, for want of consideration, if the parties believed that the self-enforcing nature of smart contracts obviated the need for establishing consideration. Property conveyances do not require consideration to be valid. Hypothetically, we can imagine a blockchain-based transaction involving a transfer of assets at a specified time; consideration may or may not exist. But as stated above, the smart contracts that this Article contemplates are single smart contracts for trade transactions: decentralized relations among parties on blockchains that operate in response to financial incentives.159 The financial incentives driving a trade transaction likely involve “value given” in conjunction with the transaction.
The requirement that the debtor have rights in the collateral160 expresses the basic property concept that the party assigning an interest in assets must have an interest to assign. If a smart contract partitions assets pending satisfaction of an obligation, the capacity to subject the assets at issue to execution by smart contract indicates that the party partitioning the assets has rights to do so.
With respect to evidencing a security agreement,161 Section 9-203(b)(3) creates two possibilities. The smart contract that describes assets to be segregated could be deemed authenticated by the debtor (by electronic means, by reference to the debtor’s cryptographic key), satisfying Section 9-203(b)(3)(A). Or, the fact of segregation of assets pursuant to contract terms that cause their disposition when specified could be sufficient evidence of intent to create a security interest. Section 9-203(b)(3)(D) recognizes that control of assets by a secured party satisfies the 9-203(b)(3) requirement. If the code enacts definitions of blockchain-based assets, and enacts the definition of control with respect to those assets, then control could evidence the existence of an enforceable security interest.
Though the functionality of smart contracts could enable a court to apply the statute as outlined above, a litigant opposed to security interest treatment could argue against it. Such a litigant could argue that their agreement is not a “contract” within the meaning of the UCC, and therefore not a security interest. Or, a litigant could argue that a blockchain-based asset transfer puts assets beyond the reach of the assignor’s creditors. This second possible argument is the subject of Section C below. The ULC should clarify the status of these transactions, given the possibilities that litigants could present.
The effects of finding that self-executing agreements fall within the scope of Section 9-109, by virtue of how smart contracts work (regardless of the type of deal they express), are several. First, with respect to deals not otherwise governed by UCC Article 9, the legal consequences of using a blockchain-based smart contract to accomplish transactions would include compliance with statutory provisions that are not applicable when the same deal type is executed by traditional means. This may not comport with market expectations. It is for the UCC drafters to consider the effects of smart contracts on the contracting parties, and on affected third parties, in determining whether this approach is appropriate.
Second, subjecting all transactions executed via smart contract to UCC Article 9 would bring the remedies provisions of Part 6 of the statute to bear upon these transactions. Such a development would give courts and state legislators a specific, statutory framework in which to articulate the boundaries of commercial reasonableness, and of self-help, taking into account third-party effects that parties to smart contracts are unlikely to contemplate.
Third, this approach would raise a host of drafting and of practical implications. Lawmakers would need to carefully consider how new requirements will affect market participants, how to formulate provisions for perfection and priorities, and how to define the class of smart contracts to be subject to the statute. This Article does not undertake to resolve practical, statutory drafting questions.
C. The Convergence of Security Interests and Entities
If lawmakers decline to simply treat all blockchain-based smart contracts as security interests, they must contend with (i) the difficulty of determining what is, and what it not, a secured transaction in blockchain-based markets, and (ii) the possibility of a “death of secured lending” and diminished relevance of secured transactions law. These challenges follow from how blockchain-based transactions collapse the functions of security interests with those of entities. It is essential that scholars and lawmakers recognize that this emerging mode of creating commercial transactions sits at the juncture of various private-law devices. To the extent that blockchain-based smart contracts present a convergence of contract and property, security interests and entity law, lawmakers will have to choose whether to recognize a new type of legal device or whether to categorize blockchain-based smart contracts within existing private-law categories as context allows.
This section discusses asset partitioning. If blockchain-based smart contracts accomplish asset partitioning in a new way, lawmakers should determine how to classify this form of asset partitioning. Otherwise, they leave it to the market and courts to either parse out security interests from entities in blockchain-based markets, or tolerate a disregard of their convergence.
When commentators state that smart contracts enable parties to do more than what traditional contract alone can achieve, they are referring to the fact that smart contracts achieve asset partitioning. As discussed above, Raskin focuses on the self-help aspects of smart contracts—finding them analogous to the security interest.162 Rodrigues focuses on the asset-shielding function of smart contracts in the context of DAOs—finding them analogous to entity law.163
Asset partitioning, generally speaking, is the practice of dividing assets into pools that can be assigned to different creditors.164 Henry Hansmann and Reinier Kraakman elucidated the concept of asset partitioning in their article, The Essential Role of Organizational Law, in 2000, contending that entity law enables legal actors to do things that they cannot accomplish with contract law alone.165 Specifically, in an organized business entity business assets are shielded from claims of creditors of the business’s owners.166 This “entity shielding” or “asset partitioning” function of entity law enables business creditors to concern themselves only with the creditworthiness of the business itself (and not that of the business owners).167 Hansmann and Kraakman find that “the partitioning off of a separate set of assets in which creditors of the firm itself have a prior security interest”168 is the essential contribution of entity law, the feature that distinguishes it from contract, property, and agency laws. While scholars may debate whether asset partitioning is the only or most essential function of entity law,169 Hansmann and Kraakman’s description of asset partitioning as a central function of entity law continues to inform scholarly understandings of business entities.
Some legal scholars discuss asset partitioning as unique to entity law, treating security interests as a separate form of assigning prior interests to creditors. Other scholars treat security interests as a form of asset partitioning. Hansmann and Kraakman identify a likeness between security interests and asset partitioning in that both devices reduce information costs by giving designated creditors prior claims to certain assets.170 Security interests are akin to what they call “weak-form” asset partitioning: the subordination of a set of creditors without consent.171 But this weak-form asset partitioning is achievable with contract and property laws—with the law of secured transactions.172 In contrast, “strong-form” asset partitioning (shielding assets entirely from a firm’s owners’ creditors) is achievable only with entity law.173
Legal scholarship references “asset partitioning” in contexts beyond entity law.174 Secured transactions law scholarship refers to security interests as a form of asset partitioning,175 building on Hansmann and Kraakman’s articulation of the concept and elaborating on the functions of security interests. For example, Richard Squire contends that asset partitioning should be understood as falling into two basic categories: symmetrical and asymmetrical.176 He describes asset partitioning as “the nonconsensual subordination of creditor claims to particular assets.”177 Security interests are a form of asymmetrical asset partitioning: they give prior claims to some creditors but not others, “advantaging select creditors by according them both a prior claim to one asset pool and a pro rata claim to remaining debtor assets.”178 The relevance of Squire’s work, here, is just to show how one scholar treats security interests and entities as two different forms of asset partitioning.
Blockchain-based smart contracts, because they are self-executing and automatically capture assets to satisfy stipulated obligations, present a novel form of asset partitioning. Given this reality, will the distinction between security interests and entities remain relevant? The functions of security interests and entities already converge in some contexts.179 Blockchain-based smart contracts appear to augment this convergence.
If the distinction between entities and security interests is to remain relevant in blockchain-based markets, there must be a method of distinguishing among blockchain-based smart contracts in terms of the type of asset partitioning they effectuate. Eldar and Verstein offer a theory of the distinction between business entities and security interests, given their convergence in certain contexts.180 Towards the end of their article, they observe that “blockchain technology might substitute for security interests because it can create fixed priorities to specific assets that bind third parties.”181 They ask “how might blockchain and the collapse of the contract/property divide affect the distinction between entities and security interests?”182 They then contend that their theory of the distinction between entities and security interests will persist through the proliferation of blockchain-based market activity.
Eldar and Verstein posit that “[s]ecurity interests and entities coexist in the world and in particular structures because they offer different and irreplaceable priority schemes for creditors.”183 Security interests create fixed priority in assets, in the sense that it is not possible for an administrator to pledge the assets to change the existing priorities.184 Business entities create floating priority, in the sense that an administrator of the assets may pledge the same assets to other creditors.185 Business entities are advantageous, to accomplish asset partitioning, when creditors want managers to have discretion.186 Security interests are advantageous when creditors prefer a fixed scheme that lessens the need for monitoring.187 These two forms of asset partitioning are irreplaceable: only security interests can create fixed priority, and only entities can effectively allow floating priority over an asset pool.188
While business entities and security interests seem to converge in certain markets, they remain distinct.189 For example, in an asset securitization, a special purpose entity issues a security interest to investors in the pool of securitized assets. If the investors took a security interest from the originator, the assets would not be bankruptcy remote. If the investors took an interest in the special purpose entity without taking a security interest in the pool of assets, they could be subject to dilution if the entity takes on other creditors. Securitization requires both entities and security interests to achieve the degree of asset partitioning that creditors and originators desire.190
Eldar and Verstein assert that the distinction they articulate is enduring, that it will withstand legal and technological innovations:
The property-like function in blockchain will still come in floating and fixed priority variants. Parties will stipulate whether they want a given creditor’s claim on a pool to be utterly certain or to be subject to demotion in order to accommodate later creditors. This choice is the essential choice between security interests and entity, and parties will tailor their blockchain commitments in ways that reflect that fundamental choice. . . . [W]e speculate that the species of entity and security interest will survive long after the genus of property has dissolved.191
They contend that the distinction between security interests and entities will remain salient in blockchain-based markets, but what will be the relevance of these traditional forms of asset partitioning in the context of a completely new one?
If we accept Eldar and Verstein’s prediction, it suggests an approach for analyzing the relationship among asset partitioning, blockchain-based smart contracts, and secured transactions. Their statement implies two different things. On the one hand, based on their contention we could posit that when a smart contract creates a fixed priority scheme, it is a security interest and the concepts and policy objectives of secured transactions law should apply.192 If nothing prevents the expression of contract terms in code, nothing prevents parties who intend to enter into an Article 9 secured transaction from expressing their agreement as a smart contract. A creditor may prefer this given the automatic execution and enforcement smart contracts provide. In this context, we are talking about security interests within the scope of Section 9-109(a)(1) that take the form of smart contracts. On the other hand, however, the way that smart contracts conflate property and contract functions renders them an extreme form of asset partitioning, not the “weak form” that Hansmann and Kraakman associated with security interests.193 A litigant opposed to security interest treatment could invoke this difference to assert a more expansive interest.
Eldar and Verstein’s prediction assumes that third parties will be able to distinguish between smart contracts that express fixed (security interest), versus floating (entity), priority variants. But this type of distinction can be difficult to make. This difficulty, combined with the observation above that transactions can transpire on blockchains coded to reject creditors’ claims, could result in a demise of secured transactions law. Despite the intent or economic substance of a deal, the transaction platform itself can obviate security interest treatment and application of the policy choices expressed in UCC Article 9.
Disregard of private-law rules invites systemic risk. This Part provides examples of two markets that illustrate how this is so: the MBS market and the repo market. These examples underscore the importance of articulating the status of blockchain-based smart contracts in private-law terms. During and after the 2007-08 financial crisis, investors in MBS suffered from lack of clarity regarding the legal status of assets collateralizing issuances.194 For another example, the market prominence and utility of securities repurchase agreements led lawmakers to define these agreements as sales despite the fact that they function as extensions of credit.195 This sale treatment, based on form (regardless of economic substance), helped to facilitate a repo run on banks that scholars identify as central to the causes of the financial crisis.196
Defining the relationship between blockchain-based smart contracts and secured transactions law will situate this market activity in relation to a major category of private-law rules that express longstanding policy choices. If lawmakers decline to articulate how blockchain-based transactions implicate contract, property, and entity laws, markets could expand despite inconsistent or incoherent legal status, defying regulators’ capacity to enforce rules that would curtail problematic levels of risk.
A. Private-Law Rules and Systemic Risk
In the wake of the financial crisis, numerous scholars invoked the regulatory potential of private-law concepts.197 This section presents a relationship between private-law rules and systemic risk in two market contexts that were integral to the crisis of 2007-08 and its aftermath.
The MBS market. The role of subprime mortgage products and securitization in the financial crisis has been widely discussed.198 The relevance of the MBS market, here, is to consider the legal difficulty that many purchasers of MBS faced when they tried to foreclose on real estate, and the decline in value of MBS associated with legal uncertainty. When homebuyers defaulted on mortgages, some holders of MBS found that they could not establish that they were holders of mortgage notes for purposes of state foreclosure laws.199 In some instances, this was due to a lack of clarity in the law, and in other instances it was the result of poor due diligence and documentation in the course of assignments for MBS issuances. Either way, a lack of regard for underlying, state property laws resulted in a loss of value for purchasers of MBS, contributing to the systemic crisis.
The repo market. The repo market demonstrates how disregard of well-established private-law rules can contribute to systemic risk. A repo, or securities repurchase agreement, is a financial transaction in which one party (a repo seller) transfers specified securities to a counterparty (a repo buyer), and at the same time enters into an agreement to re-acquire the securities at a future date at a designated price (the original price plus an additional amount). If the securities depreciate before the repurchase date, the repo seller must provide additional securities to adequately protect the repo buyer. If the repo seller fails to repurchase the securities as specified, or defaults on any other provision of the agreement, the repo buyer may sell the securities. Repo agreements function much like margin trading agreements, except using sale and re-purchase terms instead of secured loan terms.
Typically, distinguishing between a margin trading agreement (in which brokers have a security interest in securities and must dispose of them in a commercially reasonable manner on default) and a repo (in which brokers own securities outright and can assign them at any time and in any manner) was traditionally determined by looking at the economic content of the transaction.200 Repos are hybrid transactions that can present complex characterization questions.201 And yet, in response to the sheer size and utility of the repo market in the late 2000s, lawmakers disregarded the private-law concept that property interests are determined by their economic substance and not the form that the parties use in any given transaction. When faced with a challenge to the status of repos, the court in In re American Home Mortgage Holdings, Inc.202 held that the form of a securities repurchase agreement determines its characterization, not its economic substance.
The case involved a repo transaction between Lehman Brothers Inc. (as repo buyer) and American Home Mortgage Investment Corp. (as repo seller). The In re American Home Mortgage court reasoned that repos provide liquidity that financial institutions had come to depend upon.203 The court refused to do an economic substance analysis to potentially re-characterize a repo on the grounds that such an exercise would have deleterious market effects.204
Repos, like derivatives, enjoy special status under the U.S. Bankruptcy Code.205 They are exempt from the automatic stay, enabling the repo buyer to unilaterally terminate the repo and to sell the repo securities without regard for a repo seller’s bankruptcy petition. This bankruptcy safe harbor was an important factor driving the growth of the repo market.206 Gary Gorton and Andrew Metrick have argued that the financial crisis of 2007-08 was, in essence, a repo “run” on financial institutions.207 A traditional run on banks involves widespread withdrawals of deposits, making banks insolvent. A repo run on banks involves widespread, increasingly high “haircuts” or discounts that drove banks into insolvency.208 Investment banks became dependent on securitized banking—the practice of packaging and reselling loans. Repo transactions were a primary source of funds for banks’ securitizations of their portfolios.209 If repo buyers have the capacity to dispose of the repo securities without regard for the solvency of the repo seller, and without any requirements to demonstrate commercial reasonableness, the repo buyers can impose higher and higher haircuts, and fire-sale securities if the repo seller cannot perform. Gorton and Metrick demonstrate how this phenomenon became a major driver of the financial crisis.210
Congress made a policy decision to exempt repos from the automatic stay in bankruptcy. But then, because of the sheer size of the market, the court deemed all transactions that parties call a securities repurchase to be sales and repurchases (and not secured loans governed by UCC Article 9) regardless of their economic substance. If the court had abided by long-established private-law principles for characterizing transactions, then when the haircuts on repos increased, the higher haircuts may have in many instances indicated a secured loan. If the repo were a secured loan, the repo securities would be subject to the automatic stay if the repo seller filed for bankruptcy. Repo buyers would have to have had some concern for the size of the haircut and for repo seller solvency. It would not have been so easy to create a repo run on banks (causing the banking sector to become insolvent) if repo buyers could not have continued to increase haircuts without regard for the transaction’s status and for repo seller solvency.
The relevance to this Article of the repo market, and how its exponential growth and subsequent legal treatment contributed to systemic risk, is to illustrate that private-law rules matter in prudent administration of markets. Blockchain-based smart contracts may or may not be implicated in any possible future financial crisis. That said, this technology presents the possibility for remarkable growth as market actors participate on blockchain platforms, utilizing self-executing transactions expressed in code that can defy appropriate private-law characterization if left undefined.
B. Blockchain-Based Markets and the Potential for Disregard of the Private Law
The relationship of blockchain-based smart contracts to contract, property, and entity laws is complex and unresolved, as Part I discusses. Market actors have discretion to assume the most favorable legal status (for themselves, from a pricing standpoint) of the transactions they design, even if that legal status is potentially inaccurate and is undesirable from a policy standpoint.
Consider what could happen if lawmakers decline to define whether or not, and when, blockchain-based smart contracts are security interests governed by UCC Article 9, and self-executing contracts that partition assets on blockchain become common. Without a legislative directive, market actors could choose to treat and price these transactions as agreements that are not subject to UCC Article 9’s requirements for commercially reasonable disposition of collateral, even though they arguably meet the statutory requirements for a security interest. They could deem assets transferred on blockchain platforms to be beyond the reach of creditors, regardless of whether the economic substance of the transaction warrants treating the relevant party as having no continuing interest in the assets. Portfolios of these agreements could be securitized. If markets for securities backed by such agreements expand, the costs of subjecting the agreements to UCC Article 9 ex post may become prohibitive, even though permitting the contracts to operate as designed causes undesirable externalities.
Several states in recent years have moved to facilitate the use of blockchain technology in their jurisdictions.211 Wyoming’s legislature, for example, has been pro-active in expressly authorizing and defining blockchain-based assets and business practices.212 Wyoming’s enactments are practical responses to industry issues. Enacting definitions of “digital assets,” “smart contracts,” “control,” and the like is essential work.213 But this work should accompany a consideration, rooted in private-law theory and practice, of the legal nature of blockchain-based smart contracts. The work that lawmakers have done as of yet to understand these forms of agreement in private-law terms is only preliminary.
The ways in which blockchain-based smart contracts merge contract and property functions, and security interests and entities, make understanding their legal contours challenging. Scholars and lawmakers should nonetheless take up this challenge and elucidate the relationship between blockchain-based smart contracts and UCC Article 9. We should do so before market practices expand to a point at which applying well-considered policies animating secured transactions law to blockchain-based market activity may disrupt expectations and impose excessive costs.