Digital assets and English private law: the highlights of our response to the Law Commission’s consultation
The Law Commission of England and Wales has been consulting on a wide range of proposals concerning the private law treatment of digital assets. Its aim is to foster a legally certain and facilitative environment in which the use of digital assets can flourish. The project is hugely welcome across the industry, and the consultation paper itself has already served the market by enhancing legal certainty. In this piece, we highlight ten key points shaping our response to the consultation.
This summer, the Law Commission published its long-awaited consultation paper on digital assets (CP). It was worth the wait. The CP comprises over 500 pages of detailed legal summaries and analysis on a range of private law issues concerning digital assets. As well as expressing a view on the existing law, the CP invites comments on various proposals for law reform, in some cases by way of statutory intervention. The deadline for input is 4 November 2022.
The CP follows the Law Commission’s previous reports on smart contracts and electronic trade documents, as well as an initial call for evidence on digital assets. It also builds on the UK Jurisdiction Taskforce (UKJT) legal statement, which provided influential authority that certain crypto-tokens, such as bitcoin, are objects of property, and which has been endorsed in courts in England and Wales as well as other jurisdictions.
The Law Commission is also undertaking two further related projects, on conflicts of laws relating to digital assets and decentralised autonomous organisations (DAOs), which are also highly anticipated.
We agree with much of the analysis in the CP. In relation to the proposals, the key points shaping our response are outlined below. An overriding theme in our response is that, in most cases, we believe that the development of the law in this area is best supported by the evolutionary process of commentary from experts and adoption by the courts, as opposed to statutory intervention.
The Law Commission has already made an extremely valuable contribution in this regard, as the courts will likely give significant weight to the CP and (once published) the final report. In this respect, we expect the Law Commission’s findings to inform the development of English law, even in the absence of pursuing some statutory proposals. We also expect the CP to influence the development of regulatory policy internationally, and it has already been referred to in cases in other jurisdictions.
In our view, statutory intervention, other than in very targeted areas, creates a significant risk of boundary issues and risks unintended consequences.
10 key points
- Crypto-tokens are already capable of qualifying as property, though the precise boundaries are unclear. We have no doubt that the English courts already recognise crypto-tokens (broadly, as described in Appendix 4 of the CP) as objects of property under English law. There will inevitably be boundary issues, and the property status of specific crypto-tokens will depend upon the particular features of the relevant system. Some of the Law Commission’s proposals for statutory intervention (e.g. an innocent acquirer rule, as described in point 8 below) could imply a need for a statutory definition of crypto-tokens. We believe that the boundaries of this concept should evolve under the common law, which is capable of adapting and responding to evolving technology and market practice.
- Statutory intervention to establish a third category of property is unnecessary. The CP proposes that English law should recognise a third category of property (beyond things in possession and things in action, the two categories of property contemplated in Colonial Bank v Whinney). It also invites views as to whether this would best be achieved through common law development or statutory reform. The courts have already recognised as property many intangible things that are not things in possession or things in action (in the strict sense). In our view, this points to a third category that comprises such property. Some commentators consider that a third category is unnecessary, as the category of things in action is already of a residual nature. We consider that Colonial Bank v Whinney is not authority for asserting that crypto-tokens which qualify as property are things in action to which all the rules applicable to things in action (in a strict sense) apply (see, for example, point 5 below). We think that the better view is instead that there is a third category of property encompassing intangible things which qualify as property but which are not things in action (in the strict sense). This third category is not limited to data objects. It follows that statutory intervention to create a third category of property is unnecessary. It is also likely to be problematic, with a high risk of unintended consequences, particularly if the statute seeks to define the boundaries of that third category.
- Defining the parameters of intangible assets can be challenging. The CP seeks to define the third category of property as “data objects”, which poses certain challenges. Among other things, the proposed criteria require that such assets are “composed of data in an electronic medium”. We expect that an intangible asset will need to be composed of more than mere data in order exhibit rivalrousness (another of the Commission’s criteria). However, for some intangible things, identifying precisely what the asset is remains elusive. For crypto-tokens, we view the asset as the power to effect a state change within the crypto-token system, as instantiated in that system (as described in paragraphs 4.8 and 4.9 of Appendix 4 of the CP). This power is derived from the combination of certain data (including cryptographic keys) and the system protocol (including the embedded cryptography), which ensure that the “crypto-token” cannot be double spent. In this way, the asset is composed of a myriad of factors, including, but not limited to, data.
- The legal characterisation of a crypto-token transfer is likely to be system-dependent. The CP suggests (and we agree) that the factual nature of the transfer will depend on the precise features of the system. For many (but not necessarily all) crypto-tokens (whether layer 1 or layer 2 based), the power to effect a state change will be destroyed through an on-chain transaction (while a new power is created). In our view, this necessarily informs the legal characterisation of an on-chain transfer.
- Legal mechanisms for transferring crypto-tokens do not mirror those applicable to things in action (in the strict sense). One reason why we favour the view that crypto-tokens are not things in action is because the legal mechanisms for transfer are not those applicable to things in action (in a strict sense), as discussed in Chapter 13 of the CP. We agree that crypto-tokens cannot be novated, as there is no counterparty to a crypto-token. Whether or not a crypto-token can be assigned, there is in practice no debtor to provide notice to (meaning that the requirements for a legal assignment cannot be met). It is also possible to transfer legal title to a crypto-token other than by way of assignment, with no formalities.
- A legal concept of Control for crypto-tokens, with direct legal consequences, can and should be developed by the courts. The CP considers a concept of factual control in the context of crypto-tokens, but generally does not propose pinning any direct legal consequences to it. We believe that in order to support the recognition of crypto-tokens as property it will be necessary for the courts (with the support of market commentators) to develop jurisprudence around a concept of control that is to crypto-tokens what possession is to tangible things. We refer to that concept as “Control”. We believe that, as is the case for possession, intention should be a necessary element of Control, to avoid unintended consequences. Control may, but will not necessarily, coincide with legal title. In this sense, it should be possible to have Control-based proprietary interests that fall short of legal ownership. Similarly, it should be possible to gain “constructive” Control of crypto-tokens, and to transfer legal title through a transfer of Control. The development of the concept of Control will provide the most effective legal framework to recognise and characterise many effects of smart contracts and DeFi arrangements.
- Legal title to crypto-tokens may be transferred on-chain and off-chain. The CP contemplates that a transfer operation that effects a state change is a necessary (but not sufficient) condition for the transfer of (superior) legal title to a crypto-token. In our view, legal title can also be transferred off-chain, albeit that title from such a transfer is susceptible to being defeated by a subsequent (and conflicting) on-chain transfer in certain circumstances. Assuming a Control concept is developed, we believe a transfer of legal title to a crypto-token may be effected (i) on-chain, through a transfer operation that effects a state change coupled with a change of Control; and (ii) off-chain, through a change of Control. We also agree with the CP that it is possible to declare a trust over a crypto-token.
- A satisfactory form of innocent acquirer rule may already exist for many crypto-tokens. The CP proposes introducing, by way of legislation, an “innocent acquirer rule” that applies to on-chain transfers of crypto-tokens. This would allow bona fide purchasers for value to take free of any defects in title of the transferor. For transfers of crypto-tokens involving a destruction and creation, an innocent acquirer rule already exists (in the sense that, all else being equal, a bona fide purchaser will take good legal title to a fresh asset, free from equitable remedies). For transfers of crypto-tokens involving the passing of a continuous thing from transferor to transferee, in our view there are strong legal grounds for asserting that they are capable of acquiring negotiable status (and therefore an innocent acquirer rule would apply) through mercantile custom, where such a custom can be demonstrated. We believe such custom is highly evident in the case of many frequently traded crypto-tokens. We acknowledge that this will require some development of the law (since historically only tangible things have been able to acquire negotiable status through mercantile custom), but we believe that there is strong legal authority for such development. In summary, that reduces the need for statutory intervention only to crypto-tokens where there is the passing of a continuous thing where the rules relating to negotiable instruments do not apply. It is not clear to us as a matter of policy that an innocent acquirer rule (which prefers the transferee) should apply in that case. In any event, the benefit of statutory intervention would appear to be limited.
- There is a case for both Control-based security interests and a financial collateral type regime for crypto-tokens. We agree with the CP that title transfer arrangements and security interests in the form of charges and mortgages can be created over crypto-tokens that qualify as property. However, we also believe that there is considerable merit in supporting other forms of possessory-style security (notably pledges), to enhance the flexibility of English law and provide legal grounding to existing practices. Such security interests should be capable of being recognised by the courts if a Control concept is developed, as contemplated in point 6 above. There is also a need for a targeted statutory intervention to enable crypto-token markets to benefit from the financial collateral protections available in the traditional financial markets. On balance, we believe an extension of the existing Financial Collateral Arrangements (No. 2) Regulations (FCARs) is preferable to creating a bespoke regime for crypto-tokens, at least in the short term.
- Contractual and other rights may be linked to crypto-tokens through a range of legal mechanisms. It is in our view possible to link contractual rights to a crypto-token so that they accompany legal title to the crypto-token. The linking of other assets to crypto-tokens is complex and may not survive a transfer of the crypto-token in all cases. It is also possible to link rights or interests to data that is not itself an object of property (even if described as a crypto-token). In this regard, we broadly agree with the Law Commission’s analysis.
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Our full response will be submitted in due course. If you would like to find out more, please don’t hesitate to get in touch.