LITIGATION ALERT: Texas Virtual Currency Act Incorporates Cryptocurrency Into Existing Financial Framework

I. Introduction to Virtual Currencies

The advent of the digital era has not only popularized online transactions but has also led to the development of virtual currencies to expedite business transactions. The Financial Action Task Force, an independent intergovernmental body, defines virtual currency as “a digital representation of value that can be digitally traded and functions as a medium of exchange, and/or a unit of account, and/or a store of value, but does not have legal tender in any jurisdiction. It is not issued or guaranteed by any jurisdiction and fulfills the above functions only by agreement within the community of users of the virtual currency.”^[i]

Virtual currencies can be divided into both convertible and nonconvertible currencies in that nonconvertible currencies cannot be exchanged for fiat currency. These currencies can be further divided into centralized and decentralized currencies because centralized currencies have a single administrating authority that directly controls the system. Bitcoin, the most popular virtual currency right now, is a convertible decentralized currency because it has no central administrating authority and thus no centralized monitoring system. As such, different strategies are required in order to regulate Bitcoin as opposed to centralized virtual currencies where top-down-based regulation would be easier.

Virtual currencies are unregulated money that is electronically stored and created so that control lies with the developers rather than a central bank. The main limitations on virtual currency are that it is not generally considered legal tender and is only accepted in certain establishments online—for example, one cannot pay their U.S. tax bill in bitcoin. However, this decentralized nature has also led to the growth of virtual currencies in that more merchants are accepting them due to the low transaction fees, security benefits, and overall payment freedom.

II. Recent Bitcoin Legal Developments

Since September 1, 2021, Texas has amended the Business & Commerce Code in order to incorporate the regulation of virtual currency into its existing financial framework. Tex. Bus. & Comm. Code § 12.001 now defines virtual currency as “a digital representation of value” that (1) “is used as a medium of exchange, unit of account, or store of value” and (2) “is not legal tender”. Further, the statute also excludes certain transactions and gaming tokens from the definition of virtual currency and will help users and lenders better determine how to perfect their interests.

Tex. Bus. & Comm. Code §12.003 provides cryptocurrency holders with explicit legal rights as it makes cryptocurrency holders similar to bona fide purchasers of negotiable instruments. 12.003(g) allows for notice of adverse claims either directly or indirectly if a person is aware of sufficient facts to indicate a significant probability that the claim exists and deliberately avoids information that would establish its existence. Based on this, lenders may still try to file some type of record online even though 12.003(h) explicitly notes that filing a financing statement for a virtual currency is not sufficient notice of an adverse claim. Therefore, a lender needs to establish control over the virtual currency in order to perfect their interest.

12.004 states that “control” of a Virtual Currency occurs when the person or entity has:

• “power to derive substantially all the benefit from the virtual currency” and “the exclusive power to prevent others from deriving substantially all the benefit from the virtual currency”;
• “the exclusive power to transfer control of the virtual currency to another person”; and
• the person is readily identifiable (via the virtual currency itself, a record attached thereto or “logically associated” therewith, or a virtual currency recording system).

This control requirement will make it more difficult for virtual currency to be used as collateral as secured lenders will have a hard time perfecting their interest in virtual currency. As a result, lenders may prefer to err on the side of caution and require possession of the security key associated with the virtual currency upfront. However, the Texas Department of Banking has affirmed that Texas banks may provide customers with virtual currency custody services in both a fiduciary and non-fiduciary capacity.^[ii] As a result, this control requirement and the increased legitimization of virtual currencies may push for the growth of escrow services that can help lenders perfect their crypto security interests.

More tech-savvy lenders may take advantage of 12.004(b) in order to establish control. Section 12.004(b) specifically addresses this control problem by clarifying that a lender can establish control through a protocol “programmed to result in a transfer of control”. These protocols are sometimes referred to as “smart contracts” and depending on the applicable technology could allow a lender to automatically acquire pledged virtual currencies upon default or maturity. Therefore, this could lead to a shift in preference for virtual currencies where these functionalities are already in use.

While the new changes to the Texas Business & Commerce Code provides legal rights for investors and facilitates virtual currency transactions, virtual currency law will continue to change at the local, state, and federal level. This process will no doubt be expedited by the Uniform Law Commission and American Law Institute’s new virtual currency amendments to the Uniform Commercial Code.^[iii] This also means that businesses in the virtual currency space will need to continue to engage in due diligence or hire legal counsel in order to stay up to date on existing regulations and anticipated regulations from local legislatures and regulators such as the SEC, IRS, etc.

^[i]  FATF Report - Virtual Currencies: Key Definitions and Potential AML/CFT Risks

^[ii] Texas Department of Banking Industry Notice

^[iii] Unif. Com. Code & Emerging Techs. (Unif. L. Comm’n & Am. L. Inst. 2022), available here.

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