The Law Commission of England and Wales has published a consultation paper (the Paper) on the recognition and protection of digital assets. The consultation, which closes on 4 November 2022, focuses on the legal treatment of digital assets and recommends law reform to create a third category of personal property – referred to as “data objects” – beyond things (or “choses”) in possession (such as physical objects) and things in action (such as contractual rights).
The Paper is an important development in the digital assets space, in particular its proposals in respect of property rights and transfer of “data objects”. The Master of the Rolls, Sir Geoffrey Vos, identified in a recent speech six key pillars that a legal system must have in order to provide the foundation for DLT. Those are: (i) legal certainty; (ii) a dispute resolution process that accounts for how on-chain transactions happen; (iii) procedural ability for a legal system to deal with disputes over digital transactions; (iv) a private law backdrop allowing the issue and transfer of securities via DLT; (v) industrial and government familiarity with smart contract use cases; and (vi) an appropriate regulatory environment. The Law Commission Paper goes some way towards beginning to address points (i) and (iv).
English law has over the last several years shown its flexibility in dealing with issues connected with digital assets (see for example the recent grant of a freezing injunction for non-fungible tokens (NFTs) alleged to have been stolen). However, more targeted reform that may lead to additional legal certainty will be welcomed by the industry and will be an important stepping stone in the wider UK government strategy of making the UK a global hub for digital assets and related service, in particular if it helps to position English law as the established first choice of law underpinning the use of DLT.
How does the Paper define data objects?
As mentioned above, the Paper proposes the creation of a third category of personal property – “data objects”. The Paper’s definition of data objects is intentionally broader than cryptoassets (which it terms crypto-tokens). To identify a data object, the Paper proposes the following three criteria:
- be composed of data represented in an electronic medium, including in the form of computer code, electronic, digital or analogue signals
A data object must be recorded electronically in some way. While stored on or transmitted via physical objects, which are things in possession, data objects are treated in the Paper as distinct from the objects by which they are stored or made available.
- exist independently of persons and exist independently of the legal system
The Paper suggests that data objects be considered as distinct from things in action in that they can exist, be used and be operated on as long as the blockchain or other system on which they exist remains active (theoretically outside the formal scope of any legal system).
- be rivalrous
Something is considered to be “rivalrous” when it cannot be used by others in an equivalent way simultaneously. This is not intended to mean that it is unique or non-fungible. Finding a way to make electronic data rivalrous, when it can otherwise be reproduced near-infinitely at close to zero marginal cost, is a key innovation of blockchain technology.
The Law Commission considered and dismissed a potential fourth criterion of “divestibility” – being capable of being transferred or disposed of – which characteristic they determined to be common but not critical among data objects. Excluding divestibility from the criteria would keep non-transferable objects, such as the “soulbound” tokens proposed by Ethereum co-founder Vitalik Buterin, within the scope of data objects.
The Law Commission has also proposed a definition of crypto-tokens as a subset of data objects, which it has made available for comment on its GitHub page (as well as in the Paper itself).
While the Paper suggests either legislative or common law intervention for most of its other proposals, on this topic the Law Commission has outlined the pros and cons of each for approach without expressing a preliminary conclusion.
Moving from “possession” to “control” – what distinguishes data objects from other types of property?
The key concept for the ownership of more traditional, tangible objects is that of “possession”. While nuanced, possession involves elements of both control of, and intention in respect of, a physical object. The ownership of things in action (e.g. contractual rights) relies on the legal system for enforcement.
The Paper suggests that this model does not fit data objects, where control is determined in many cases by control over cryptographic keys – hence the advent of sayings like “not your keys, not your bitcoin”. Rather than legislating for what “control” means for data objects, the Law Commission suggests that the common law will be the principal driver of an appropriate meaning, with the courts perhaps looking to a multidisciplinary panel for assistance.
What does the Paper say about rights linked to NFTs, stablecoins and other crypto-tokens?
While the Paper acknowledges that NFTs and cryptoassets sometimes purport to confer, evidence or embody rights off-chain or in the physical world, it notes that the tokens themselves cannot do so as a matter of law. Those rights or representations are choses in action that may be linked to the crypto-token, for example a copyright licence expressed to benefit – or stablecoin issuer’s liability to redeem an amount of fiat currency for – the holder of a given crypto-token from time to time, rather than themselves being data objects.
There are different ways to create such a link, the strength and consequences of which the Paper suggests are likely to depend on a mix of market practice, contractual arrangements and developments in common law. In the absence of other arrangements made by contract, statute or otherwise, the Paper suggests that crypto-tokens used to create registers or records of external items are likely only to be useful as evidence, conferring no rights themselves without statutory intervention.
Viewing this dual-track structure as sufficiently established and flexible, the Law Commission does not propose any reform in this area.
Transfers of data objects
As the legal system is external to crypto-token systems, the Law Commission takes the view that the state of the relevant system (such as a distributed ledger or structured record) does not necessarily determine (superior) legal title to a crypto-token. Part of the reason for this is that such systems provides a factual, rather than legal, record.
Another element of that distinction is that the system may not be able to show as many states as the legal system can – changing a crypto-token’s association from being with one public key address to another may be dependent or derivative on the whole or partial transfer of an earlier legal interest.
As a result, the Law Commission has provisionally concluded that existing rules on transfers of title can apply to on-chain transactions, even if that transaction results in the creation of a new, modified or related crypto-token. The Paper therefore does not propose any law reform in this area, save to recommend that the law make express that “equity’s darling” – the defence available to good faith purchasers for value and without notice – persists in relation to data objects.
Taking security over data objects
Given the Law Commission’s view that data objects cannot be possessed, the Paper asserts that possessory security arrangements – pledges, etc. – cannot be used for crypto-tokens. Conversely, owners of crypto-tokens can grant non-possessory security or enter into title transfer arrangements, such as mortgages and charges. The Law Commission is, however, considering whether developing bespoke statutory provisions for collateral arrangements in respect of crypto-tokens may be beneficial. As this would be a significant piece of work, at this stage the Law Commission is only flagging the issue and not making a specific proposal.
Insolvency of cryptoasset custodians
Following the recent fall in the prices in a number of cryptoassets – and on a number of earlier occasions due to hacks – crypto-token custodians have sometimes been left with insufficient cryptoassets to meet their liabilities to users. In English law, how the remaining pool of user assets is allocated among the users in such an insolvency situation depends on how the assets are held.
If the custodian holds users’ cryptoassets on a purely contractual basis, i.e. without there being a trust over those assets, then users will be unsecured creditors. These types of arrangements are common in “yield farming” and other arrangements where a custodian will lend users’ cryptoassets out for a return, while cryptoasset exchanges might also adopt this approach when custodying user assets. This will depend on the relevant terms of business.
If a trust exists over the crypto-tokens held by the custodian, and users’ entitlements are individually allocated (rather than a trust existing over pooled assets), then the users whose property was lost – to a hack, a bad debt, or otherwise – will bear the full loss.
The Paper suggests, meanwhile, that there would be a benefit to law reform to clarify and simplify how losses fall where there is a trust over pooled or commingled tokens held by an insolvent custodian. The Paper goes into some detail on if and how such a trust might arise, considering several options and provisionally settling on framing users’ rights in such an arrangement as an equitable tenancy in common.
Giving courts power to award sums denominated in crypto-tokens
Although English courts are able to make awards in state-issued currencies, they are not yet able to make awards denominated in cryptoassets. In certain situations, such as the insolvency of a cryptoasset custodian, making such an award might be more representative of a claimant’s loss. Given the fungibility and liquidity of cryptocurrencies, and the relatively low storage and delivery costs compared to commodities, the Paper proposes reforming the law to give courts discretion to award “monetary” awards denominated in certain crypto-tokens.
For further information, please contact:
Marina Reason, Partner, Herbert Smith Freehills