Blockchain Loans as Uncertificated Securities
In a previous post, I examined the risk that efforts to employ distributed ledger technology to trade syndicated loans could result in their reclassification as “securities” for purposes of federal securities laws. I will now explain why such a system may need to treat blockchain syndicated loans as “securities” for purposes of the Uniform Commercial Code (“UCC”). It should be possible to treat loans as securities under the UCC without necessarily subjecting them to registration with the SEC.
Why Syndicated Loans Take so Long to Transfer
Traditionally, a bank loan is evidenced by a promissory note. Article 3 of the UCC governs the transfer of promissory notes. Article 3 treats a note as a unique and unitary instrument: only the holder of the note is entitled to payment and the holder cannot subdivide it into separate interests. When a bank holds a $10 million note and wants to sell $5 million, the bank must return the note to the borrower and ask the borrower to execute two new notes for $5 million apiece.
A bank may transfer a note by endorsing and delivering it to the buyer. But this will not fully protect the buyer’s interest, insofar as the note normally requires payments to be made to the original bank rather than to the buyer. Thus, the bank must either direct the borrower to make future payments to the buyer or obtain a replacement note payable to the buyer.
Syndicated loans simplify this by having payments made to an agent bank, which then allocates them among the syndicate members. A collateral agent also holds any collateral on behalf of the syndicate. The agent bank and collateral agent must update their records and documentation to reflect loan transfers, however. And buyers still generally obtain (and some must obtain) notes made out in their or their nominee’s name.
Even in these days of e-sign, it takes several days to prepare, circulate and execute new notes and other documents necessary to affect a transfer. This is why syndicated loan trades can have “settlement periods of 20 business days or more.”
Blockchain Loans Should Use Article 8 Instead
Professor Schroeder at the Cardozo School of Law published an article early this year explaining why Article 8 of the UCC is well suited for blockchain trading. Article 8 governs the transfers of securities, including “uncertificated securities.” Section 8-301(b)(1) provides that:
Delivery of an uncertificated security to a purchaser occurs when … the issuer registers the purchaser as the registered owner[.]
Professor Schroeder (and I) “can see no reason why an issuer cannot adopt a blockchain as its ledger” to register owners.
Section 8-102(a)(15) includes in the definition of “security” any:
medium for investment [that] by its terms expressly provides that it is a security governed by this Article.
In other words, a bank syndicate and its borrower can opt into Article 8 (and out of Article 3) by providing that their loans are Article 8 securities. An “uncertificated security” is simply “a security that is not represented by a certificate.” §8-102(a)(18).
A “protected purchaser” under §8-303 is the equivalent of a “holder in due course” under Article 3. A purchaser of an uncertificated security for value takes free of any adverse claims of which it does not have notice. A UCC financing statement does not create notice of an adverse claim. §8-105
Therefore, if a syndicated loan “expressly provides that it is a security governed by” Article 8, then the new blockchain system should be able to settle trades without the exchange of documentation, speeding up the settlement process.
Securities for the UCC but not the SEC
Intuitively, it might seem difficult to claim that a loan is a security for purposes of the UCC but not for purposes of SEC regulation. Treatment of a note under the UCC was not one of the factors considered in Reves v. Ernst & Young, however. Moreover, my previous post recommended that borrowers rely primarily on the third Reves factor (“the reasonable expectations of the investing public”) rather than try to argue that loans are not investments. So long as the blockchain system is limited to at least accredited investors, buyers could creditably represent that they do not expect SEC regulations to protect them.