By Guest Contributor
The author Michael Whalen is the co-lead of Goodwin Proctor’s FinTech practice. Goodwin specializes in FinTech alternative lending and funding products and arrangements, including lending on the blockchain and virtual currency secured loans. Mike and other members of Goodwin’s FinTech team will be at LendIt April 9-11 in San Francisco, CA. The article was originally published on Goodwin’s site.
The most frequently asked security question around virtual currency has shifted from “Is it secure?” to “Can it be used as security?” Yes, it can, and we’re seeing break-through lenders making loans to ICO platforms and others flush in virtual currency, but shy on cash, using their virtual currency as security on the loan. It makes sense to leverage virtual currency in this way, particularly if the borrower is having challenges exchanging virtual currency for fiat, believes that gains in virtual currency will outpace interest paid on the loan, or tax consequences make selling its virtual currency not a good option.
Naturally, the terms of a virtual currency secured loan must be tailored to the unique characteristics of its security. For example, the loan-to-value ratio of the loan proceeds to the starting value of the virtual currency as security should be high enough to withstand big drops in the virtual currency’s price. It’s a good idea to consider a call for more security if the price drops significantly.
The table below is a skinny term sheet of some of the major business terms that should be considered for inclusion in a virtual currency secured promissory note. There’s more to it, but the chart should give you a good feel for key issues.
The regulatory issues presented by this class of loans are outside the scope of this article. As a general rule, business loans made to business entities have 1/10th the regulatory drag of consumer loans. So, consider starting with business purpose loans to companies, but keep in mind you do not get a regulatory free pass with business loans. For example, lenders that make secured or unsecured business loans to California residents (e.g., company borrower is organized and headquartered in California) must obtain a California Finance Lender license. In New York, lenders that make business loans of $50,000 or less with an interest rate greater than 16% must be licensed. Also, a handful of federal lending laws apply to business loans, including the Equal Credit Opportunity Act, Servicemembers Civil Relief Act and Fair Credit Reporting Act (if consumer reports are pulled on principals), as well as Office of Foreign Asset Control rules.
VIRTUAL CURRENCY SECURED PROMISSORY NOTE TERMS
The lender should leave itself some leeway on the virtual currency it will accept as collateral. Consider defining “virtual currency” in the note as “virtual currency accepted by the Lender from time to time, which may include, for example, Bitcoin and Ether.”
Collateral; LTV; Security Interest
The note should condition disbursal of the loan proceeds on the borrower first delivering virtual currency as collateral to a wallet designated by the lender. The lender should not consider the virtual currency delivered until it is reflected in a sufficient number of blockchain updates (e.g., 3 for BTC, 50 for ETH). The lender should take into account the volatility of the virtual currency price in setting the collateral amount. It may make sense to set the loan-to-value ratio (LTV) as a multiple of the loan amount (e.g., 200%).
The note should go on to provide that the borrower pledges to the lender as security for its payment obligations and grants to the lender a continuing first-priority security interest in, lien on, right to liquidate, and right of set-off against, the virtual currency collateral.
Consider the usury laws of the state that govern the note for purposes of interest. For example, per annum interest on business loans is generally limited to 25% in New York, except for loans of $2.5 million or more which do not have an interest limit. California’s usury ceiling is lower for business loans, limiting annual interest to 10% unless the lender is a licensed Finance Lender or other regulated financial institution (e.g., bank). Unless applicable law provides otherwise, origination fees should be considered interest and added to the numerical interest rate for purposes of evaluating usury.
Payments can be structured as either interest only with a balloon payment at maturity or principal and interest during the term. Payments can be made in fiat or the borrower may direct the lender to sell the virtual currency held as collateral for fiat to make payments. If the lender exchanges virtual currency for fiat to make payments, the note should provide that the borrower is responsible for exchange costs from the proceeds of the sale.
Call and Liquidation Triggers
The note should protect its security from big drops in collateral value. Consider a call for additional collateral triggered by a drop in the virtual currency price by a certain percent from the start price at origination. The call would require the borrower to send more virtual currency to the lender’s wallet to maintain the required LTV. If the borrower doesn’t satisfy the call requirement in short order, the lender should have the authority to sell all the collateral, pay off the loan and return the remaining proceeds to the borrower. If the borrower meets the call and the price of the virtual currency held as security later rises back to the starting value at origination, consider returning the additional virtual currency delivered on call as a customer accommodation.
Also consider including a liquidation trigger, permitting the lender to liquidate all of the virtual currency collateral and pay off the loan if the price drops further to a set percent without permitting the borrower to send additional currency to maintain the required LTV. This would be the lender’s doomsday protection.
Events of Default; Remedies
The lender should spend some time thinking about the different permutations that should be covered as events of default. Upon the occurrence of an event of default, the lender should be permitted to accelerate the loan, sell the collateral, pay off the loan and the lender’s costs and expenses, and return the remaining proceeds. Events of default may include: failure to comply with a call trigger, failure to make timely monthly and maturity date payments, bankruptcy, suspending business, sale of all or substantially all of the borrower’s business, government action, or a material adverse change in the borrower or a material adverse effect, generally.
Risk of Loss
Virtual currency has its risks, including hacking and theft. The lender should disclaim risks to the fullest extent possible. The note should make clear that the lender’s wallet is not insured and that the borrower assumes risk of loss.