The Metaverse is a far reaching concept being discussed in many different spheres of business. However, much confusion still exists in the lending, borrowing and insolvency spaces as to “what is the Metaverse?” and what are its implications?
Essentially, the Metaverse is a next generation Web 3.0 concept that is intended to supplement and potentially replace the present Web 2.0 internet we currently use in our day-to-day lives. The Metaverse provides a virtual space allowing users to do many things, including purchasing digital assets such as digital land, buildings, and art. As a result of the digital nature of assets in the Metaverse, traditional legal concepts in lending, taking/providing contractual security, owning and selling assets, and enforcing security have quickly become far more complicated than in the traditional physical universe. Given the likelihood of certain physical assets being supplemented or even replaced with digital assets in the future, the Metaverse will likely require modification of borrowing relationships between lenders and borrowers. Additionally, court officers acting in insolvency scenarios will need to understand the nature of digital assets to be able to take control of such assets and assist in selling them in an insolvency proceeding. Before being able to take any of those steps though, lenders, borrowers and court officers alike will need to have a basic understanding of the Metaverse and digital assets.
This first insight on the Metaverse and digital assets as part of an ongoing series will provide a general overview of the Metaverse and digital assets, the legal nature of digital assets as personal property, and how secured positions in digital assets can be taken and initially protected.
What is the Metaverse?
The Metaverse allows individuals to interact with one another within virtual worlds or spaces through digital, virtual or augmented reality technologies. A common misconception is that the Metaverse is a single overarching virtual world, however, the Metaverse is not a solitary online space and numerous platforms currently and will exist which are all considered their distinctive “Metaverse”.
The possibilities for a Metaverse are currently limitless and the investments being made in new Metaverse-related technologies and platforms have grown immensely over the last 12 months. For example, some large cap technology companies are spending tens of billions of dollars purchasing global gaming brands, while others are spending billions of dollars in research and development creating new technologies and infrastructure for their Metaverses. Furthermore, investors and businesses are spending millions of dollars purchasing digital land in popular Metaverses to create virtual business spaces where consumers are sold goods, services or entertainment. In this regard, the first ever “mortgage” loan for digital land (to be discussed in further detail below) was recently granted in early 2022.[1]
With all of the potential that exists, lenders and investors are seeking opportunities to capitalize on new Metaverse markets and digital assets which are estimated to be worth over US$1 trillion in the future.[2] Borrowers are also seeking out financing for projects which would not otherwise have existed just a short time ago. When insolvencies arise, which will inevitably occur as they do in any business sector, court officers will also need to be involved in Metaverse and digital asset related matters.
What are digital assets?
All of the above leads to the next question: “What exactly is a digital asset?” Understanding a “non-fungible token” (NFT) is the starting point. An NFT is unique data coding which can be visually represented by a digital asset, for instance a virtual building. When an NFT is purchased, a private digital key password for the NFT can be created or generated for the purchaser which can be used to certify that the specific digital asset is owned by the purchaser. The private key in turn gives the owner of the NFT the ability to transfer and sell the digital asset. An NFT for a digital asset in a Metaverse will be recorded on the specific blockchain associated with that specific Metaverse. For example, the highly popular Decentraland Metaverse is stored on the Ethereum blockchain which records NFT digital asset transactions for Decentraland.
Since digital assets are not physical, the next question that exists is what definition of legal property should digital assets fall under. Like other types of intangible intellectual property, such as trademarks, copyrights and patents and the legal rights therein,[3] digital assets and NFTs should arguably fall under the meaning of an “intangible” under personal property security legislation since digital assets are not tangible (i.e., physical) personal property.[4] Notwithstanding the above, it is likely that specific legal reforms may need to be made in the future to personal property security legislation to create additional legal and commercial certainties as legal issues in the digital asset space develop. Such reforms may include creating specific legal definitions for digital assets, and specific legislative sections and regulations pertaining to them.
Personal property security rights in digital assets
When providing loans for digital assets, lenders should ensure that appropriate language is used in security agreements to properly capture digital assets as collateral. Borrowers should also understand that when granting security, they may be pledging their digital assets as collateral if appropriate language exists in the security documents they sign with a lender. Court officers should understand whether digital assets fall under the scope of the debtor-creditor security relationship when acting in a pre or post insolvency scenario.
As referenced above, the first ever “mortgage” loan with respect to digital land was granted by a Canadian company in early 2022.[5] The basic terms of the loan appear to be that (a) the digital land was purchased by the lender, and (b) the NFT (and associated digital land) would remain stored on the blockchain in the lender’s name as “owner” until the loan was paid in full by the borrower.[6] At face value, the security granted by the borrower is not a legal “mortgage”, which provides a security interest against physical land with title being in the name of a borrower. The “mortgage” terms for the digital land appear to be akin to a traditional conditional sale wherein title is held by a lender until payment is made in full by a borrower. Generally Canadian provincial personal property security legislation applies to every transaction that in substance creates a security interest, without regard to its form and without regard to the person who has title to the collateral.[7] Furthermore, the legislation applies to a conditional sale that secures payment or performance of an obligation.[8] Accordingly, it remains to be seen how the concept of ownership in “mortgaged” digital land will be interpreted by Canadian courts in light of personal property security legislation where the principles of ownership and security interests are separate legal rights. In other words, will Canadian courts allow lenders to hold legal title to digital assets and concurrently possess them as collateral under their security agreements?
In order for a lender to maintain the priority of their security interest against a digital asset, it is important for lenders to properly register their security interest in the appropriate provincial personal property security registry. It is generally also standard for court officers in an insolvency scenario to determine if a security interest has been properly registered as part of their engagement. Most provincial personal property security legislation provides that the validity and perfection of a security interest in an intangible is generally governed by the law of the jurisdiction where the borrower is located at the time the security interest attaches.[9] Personal property security legislation in different provinces will enumerate different factors to consider when determining the location of a debtor. However, certain challenges can easily arise in registering against digital assets where borrowers have multiple offices in multiple jurisdictions. Accordingly, lenders should have a firm understanding of the location(s) of a borrower when being granted security over their digital assets and ensure that their security interest(s) is registered in the appropriate jurisdiction(s). Borrowers should also ensure that they provide proper reporting to their lenders in the event that they move to a different jurisdiction to avoid any breaches of covenants under their security agreements. Court officers should also obtain a firm understanding of the location(s) of a borrower when an insolvency scenario arises to determine the appropriate legislation which governs the digital asset aspects of an insolvency proceeding.
Additional steps can also be taken by lenders to help mitigate against a loss of their collateral in addition to properly registering against digital assets. Generally, two options are available: (1) the borrower can provide the lender their private key password which provides the lender the ability to directly enforce against a digital asset in the event of a default in their lending relationship; or (2) the private key password can be provided to an escrow agent which holds the private key pursuant to an escrow agreement negotiated between the parties.
If a breakdown occurs in a lending relationship and enforcement by a lender could arise, specific legal issues should be carefully considered by lenders, borrowers and professionals in the insolvency space (if they are already engaged) and their professional advisors should be consulted before any substantive steps are taken by them to ensure they are acting in accordance with their legal rights and the applicable legislation.
Conclusion
Limitless opportunities exist for businesses to capitalize on opportunities in the Metaverse. Furthermore, digital assets can now form an integral part of a business’ capital portfolio. Lenders, borrowers, and professional advisors in the insolvency space should ensure that they have a firm grip of the legal issues which exist when making decisions regarding the Metaverse and digital assets.
Dentons Canada can provide specific advice to these parties, amongst others, on the Metaverse, digital assets and personal property security to help guide them through their precise business, legal and other needs.
This article was written by Sam Gabor of Dentons Canada LLP. Sam is a Senior Associate in Dentons’ Restructuring, Insolvency and Bankruptcy Group in Calgary, Alberta and its National Intellectual Property Group. Sam is formally licensed to practice law in Alberta, Saskatchewan and Manitoba. His practice focusses on personal property security, security enforcement, bankruptcy, receiverships, and restructuring law. Sam acts as counsel to lenders, debtor companies, creditors, purchasers, monitors, receivers and trustees in bankruptcy, receivership and restructuring proceedings. Sam further practices in the area of intellectual property and provides advice regarding intellectual property rights, the Metaverse, digital assets, trademarks, copyrights and other aspects of intellectual property. Sam has represented and advised various types of clients, operating in a wide range of industries, including finance, professional services, technology, software, real estate, agriculture and transportation.
This article was originally published by The Lawyer’s Daily (www.thelawyersdaily.ca), part of LexisNexis Canada Inc.
[1] https://markets.businessinsider.com/news/currencies/metaverse-mortgage-terrazero-decentraland-virtual-land-real-estate-crypto-finance-2022-2
[2] https://www.forbes.com/sites/greatspeculations/2021/12/20/the-metaverse-is-a-1-trillion-revenue-opportunity-heres-how-to-invest/?sh=7e2a5cf14df9
[3] Westlaw Edge Canada - § 2:62. “Intangible”—Commentary.
[4] See for example Section 1(1)(x) of the Personal Property Security Act, RSA 2000, c P-7;
[5] Supra footnote 1 above.
[6] Supra footnote 1 above.
[7] See for example Section 3(1)(a) of the Personal Property Security Act, RSA 2000, c P-7.
[8] See for example Section 3(1)(b) of the Personal Property Security Act, RSA 2000, c P-7.
[9] See for example Section 7(2) of the Personal Property Security Act, RSA 2000, c P-7.