New Developments in the World of Secured Lending Due Diligence
The due diligence process is an essential component of secured lending. It is one of the most significant preliminary steps before proceeding with any business transaction and identifies potential risks and opportunities, ensuring it is beneficial to all parties involved. The secured lending industry is constantly evolving, and as we move into 2024, it is important to stay up-to-date with the latest trends for due diligence.
Two areas where lenders are seeing changes that impact due diligence practices are cryptocurrencies/ digital assets (CDAs) and cannabis-related businesses.
In this article, we will explore these trends in greater detail, discuss the issues facing secured lenders, and how they are shaping the future of the secured lending industry.
Cryptocurrency/ Digital Assets
CDAs are a fast-growing asset category used as a medium of exchange and store of value in personal and commercial transactions and investments.
The value of all existing cryptocurrency is around $1 trillion, with about $508 billion of that amount attributed to Bitcoin as of mid-2023. Total global payments revenue is expected to exceed $3 trillion by 2026.
While CDAs are used widely as a medium of exchange and store of value, they have no intrinsic value, and unlike fiat currencies, e.g., U.S. dollar or Swiss Franc, they are not issued or backed by any government. They are, however, recognized as legal tender in certain countries.
CDAs have no physical presence, existing only in the digital world as non-fungible tokens (NFTs) on a digital ledger called a blockchain. Crypto-wallets keep CDAs safe and accessible, allowing holders to send and receive cryptocurrencies.
CDAs include cryptocurrencies such as Bitcoin, Ethereum, Tether, and other types of NFTs.
Issues Facing Secured Lenders in Transactions Involving CDAs
CDAs are increasingly being used as collateral for secured lending transactions. Some of the challenges facing lenders include:
- Method of attachment: CDAs are not tangible assets, so how can a lender attach a UCC-1 security interest and take possession of CDAs? There is a lack of physical possession which makes it difficult to ensure dominion.
- Asset group classification: Cryptocurrency and digital assets are not exactly money/ cash. They previously may have been considered an intangible however they don’t really fit that category. The concern becomes, would filing a UCC-1 cover cryptocurrency or digital assets as intangible assets?
- Prior liens or claims: How would a lender know if there is a prior lien or claim on CDAs?
- Perfection of a security interest: Filing a financing statement may not be enough to perfect a security interest in CDAs.
- Priority of security interest: How is a lender to know the priority of its security interest if a crypto-wallet has multiple parties that have access to the wallet? Having a UCC-1 without access to a crypto-wallet is worthless and access by too many parties creates uncertainty.
- Take-free rules: The take-free rules of UCC-9 allow “qualifying purchasers” to take priority over an earlier security interest, even if perfected.
These issues have been the driving force behind changes that address the issues lenders face in transactions involving CDAs.
New Developments Affecting Security Interests for CDAs
The Uniform Commercial Code (UCC) streamlines rules for common commercial transactions with secured lending. A new Article 12 and changes to the language in Articles 1 and 9 have addressed some of the issues with CDAs.
- Article 12: The new Article 12 creates another category of assets known as Controllable Electronic Records (CERs). CERs are defined as “a record stored in an electronic medium that can be subjected to control under Section 12-105.” The new Article 12 governs certain transfers of CERs and has already been introduced in over 29 states.
- Article 9: The language changes in Article 9 address the perfection of security interests for CERs. Lenders may perfect their security interest in CERs either by establishing control or by filing a financing statement.
- Article 1: Some lenders treated CERs as general intangibles, while others described them as investment property. The change in language clarifies the description of CERs on a UCC-1 financing statement.
These amendments have been enacted in seven states: Alabama, Colorado, Indiana, Nevada, New Mexico, North Dakota, and Washington. These changes clarify a number of issues facing lenders and establish with certainty the enforceability of UCC filings. There may continue to be other issues with possession and UCC filings however that will work itself out in the courts and through different statutes.
Secured lending services for cannabis-related businesses is a relatively new phenomenon and a hot topic. The cannabis market in the U.S. was valued at $13.2 billion in 2022 and is expected to grow at a compound annual growth rate (CAGR) of 14.2% from 2023 to 2030. Cannabis is now legal in some form in 37 states.
Given the size of the cannabis market and projections for further rapid growth, it is not surprising that lenders are clamoring to have the opportunity to provide financing to this market. The U.S. Department of The Treasury’s Financial Crimes Enforcement Network (FinCEN), has reported over 800 banks have filed to be allowed to work with cannabis businesses.
Lenders will need to address a number of very sensitive issues if they want to participate in the growth of the cannabis industry.
Issues Facing Secured Lenders in Transactions Involving Cannabis
State and local governments regulate and license the production, distribution, and sale of cannabis, and there may be varying requirements among them. Cannabis remains classified as a Schedule 1 drug and is still illegal in the eyes of the Federal Government as a controlled substance.
The cannabis industry has limited access to capital, with banking services not available because of legal and regulatory issues, which makes cash flow management difficult. Other issues confronting growers, distributors, retailers/ dispensaries and other supporting services include taxes, security of doing business, operations, adequate anti-money laundering practices and so forth.
There are a large amount of lenders and financial institutions looking to service this market however they must implement adequate risk management tools. All transactions in the cannabis industry are deemed high-risk so the risk tolerance is outside the threshold for most traditional banking institutions.
Currently, there are federal banking restrictions on cannabis companies and the majority of lenders have not spent the time or resources to understand federal laws. They have instead adopted a “wait-and-see” approach when it comes to regulation. Lenders fear consequences that can arise without thorough due diligence on cannabis-related businesses.
New Developments Affecting Secured Lending to Cannabis Businesses
In order to deal with the issues facing the cannabis industry, lenders are enhancing due diligence with: in-depth investigation of the business and ownership, extended monitoring and use of “seed-to-sale” software to track operating information, and in-house cannabis experts and due diligence programs that can identify changes that may need further investigation. There is also a push to reclassify cannabis from a Schedule I to a Schedule III drug potentially making it safer for all parties involved in the transaction cycle.
Adopting enhanced due diligence practices and understanding the legal challenges will help lenders gain confidence in their ability to provide secured lending to cannabis businesses.
Due diligence has always been a part of business transactions. How it is conducted will continue to evolve to facilitate the flow of capital for new products and services. Due diligence helps lenders decide if a business opportunity or transaction is worth pursuing. Having experience and in-depth knowledge of the due diligence process will help to ensure the best possible outcome for clients and lenders.
Capstone is a private commercial finance company which focuses on accelerating client cash flows and providing creative business funding solutions to growing companies. We have been engaged in the industry for over 30 years providing client-specific solutions through Factoring Services, Purchase Order (PO) Financing, and Domestic and International Trade Financing. Our services offer results to construction trades, service companies, distributors, suppliers, and wholesalers.