The Law Commission, a statutory, independent body charged with reviewing the law of England and Wales, has published a 549 page consultation paper examining the law of personal property as it applies to digital assets. The consultation recommends a number of reforms to ensure that the law keeps pace with society and technology.
Digital property rights in the metaverse and beyond
It follows the announcement in April 2022 that the UK government wants the UK to be “a global hub – the very best place in the world to start and scale crypto-companies”. While some of the initiatives promised have yet to materialise (such as the Royal Mint NFT), progress has been made in some areas. For example, last month HMRC issued a call for evidence to address concerns about its guidance on the taxation of Decentralised Finance (DeFi) transactions, a whiplash turnaround given the guidance was only published in February.
The Law Commission’s consultation paper builds on this momentum and makes further strides towards developing a strong, sensible and flexible UK framework to accommodate the innovative potential of digital assets.
Although the ongoing ‘crypto winter’ has set back many investors, individual and institutional, as well as creators operating in the digital economy, the optimism of those who see blockchain technology as a fundamentally positive innovation for many areas of society, technology and finance appears undimmed.
One such area is the metaverse, a broad concept understood to represent the next generation of the internet, combining digital and physical worlds in an immersive way. In some iterations of the metaverse, digital property such as NFTs will be key to how we transact and interact with each other. If we are to build meaningful digital worlds in which we can create and share value, a clear understanding of our digital property rights is crucial.
The proposed reforms
To summarise just some of the many key findings and recommendations made by the Law Commission:
A new category of property
- The law should be reformed to include a new category of personal property known as ‘data objects’. According to the Law Commission’s criteria, the data object category would include most crypto-tokens but not certain other categories of digital property such as media files and domain names. Explicitly recognising a third category of digital property would allow the law to deal with the special characteristics of objects that are ‘new, emergent and idiosyncratic’, rather than having to shoehorn such objects into restrictive categories which predate the internet.
- A definition of the new term ‘crypto-token’ is offered for discussion (feedback can be provided here). To paraphrase, a crypto-token is defined as a specific data structure that exists and behaves according to the protocol rules of a distributed ledger-based system.
Control vs Possession
- One of the special characteristics of crypto-tokens that the proposed legal reforms would recognise is the way in which they are ‘controlled’ rather than ‘possessed’ (unlike the way that, say, a ring worn by its owner would be possessed). Although the Law Commission acknowledges that the concept of control here is nuanced, broadly speaking it thinks it should be an ‘important constituent element’ when analysing complex legal mechanisms involving crypto-tokens. This, together with the creation of a new category of personal property, may be one of the most disruptive aspects of the legal reform, capable of having infinite ramifications. It will be interesting for example to see whether this influences UK tax policy, particularly the current rules which determine the location of crypto-tokens for tax purposes as the place where the beneficial owner is tax resident, which may not be the same place in which the private key is stored (ie where the control is). This approach has been widely criticised for causing uncertainty for UK residents who are claiming the remittance basis, as it appears that HMRC treat crypto-tokens differently to other forms of property. Talking about control rather than possession will also have ripple effects on the way in which legal and beneficial ownership, in the traditional sense, of the data object is going to be transferred in non-commercial transactions. Think for example of succession matters and estate administration, or division of assets on divorce. International considerations and the impact of conflict of law rules will also need to be completely rethought, to fit with these new concepts. Here too, it will be interesting to follow closely the position that other jurisdictions will take.
Legal ownership and legal transfers
- The state of the distributed ledger should not be regarded as a definitive record of legal title to a given crypto-token. The ledger offers a factual account of control rather than a legal one.
- However, in order to legally transfer title to a crypto-token, the Commission concluded that it should be necessary for there to be a ‘transfer operation that effects a state change’; in other words, any change of legal ownership should be reflected at the level of the blockchain ledger. It is provisionally proposed that the law be reformed to confirm that a state change is a necessary, but not sufficient, condition for a legal transfer of a crypto-token.
Tokenisation
- There is no legal reform needed to accommodate crypto-tokens (including NFTs) which are linked to other assets (ie tokenisation). The Commission’s view is that, over time, accepted ways of creating these links will develop organically through market practice, contract law and common law, with modifications for the type of asset that is being linked. Parties should have the freedom to design their own bespoke arrangements. For example, a crypto-token linked to a physical object might require a trusted custodian to store the object in order to maintain the link between the object and the token. Crypto-tokens which only create a record of or title to an object (for example, an NFT which acts like a certificate of authenticity) are considered unlikely on their own to confer legal title to the underlying asset, without specific legislation to the contrary. The discussion raises an interesting possibility, namely whether it is possible have a crypto-token which splits legal title and beneficial ownership over an asset, creating a trust or nominee-like arrangement.
Custodianship
- The Commission identifies principles of trust law which already protect users of certain crypto-token custody services that become insolvent or steal customers’ tokens. Crypto-token custodians and custodial exchanges are relied on heavily by users: according to research by HMRC in February 2022, 46% of UK customers surveyed use centralised exchanges to hold their crypto-tokens. However, the Commission concludes that reforming the law to enforce a trust in all custodial relationships would go too far and potentially disrupt legitimate commercial arrangements. This leaves users dependent, ultimately, on the particular terms of the custodian. The Commission notes that regulatory reform may be a more appropriate way to protect customers in this area.
- It was noted that the nature of the legal relationship between a customer and a crypto-token exchange is akin to a traditional banker-customer relationship. Again, this analysis could have implications for tax policy as there are specific rules which determine the location of assets held at a bank.
The consultation also includes technical explanations of a wide range of digital assets, including crypto-tokens, from their inherent characteristics to the many ways in which they are deployed in virtual systems. The Commission’s substantial work in this area should encourage English lawyers and non-English lawyers alike to develop their knowledge of the technological aspects of “data objects” and other digital assets, to better serve their clients.
Looking ahead: a global framework?
The Law Commission’s work should be seen as hugely significant for the UK’s development as a “global hub”. It is also an opportunity for other jurisdictions to consider their own legal frameworks to ensure, so far as possible, that the development of digital property rights happens evenly, given the ‘borderless’ nature of many digital transactions today. We look forward to seeing where this consultation leads.
For further information, please contact:
Alessia Paoletto, Partner, Withersworldwide
alessia.paoletto@withersworldwide.com
Lauren Rapeport, ,Associate Withersworldwide
lauren.rapeport@withersworldwide.com
