The Law Commission of England and Wales has published a consultation document (the Paper) on the recognition and protection of digital assets. The consultation, which closes November 4, 2022, focuses on the legal treatment of digital assets and recommends legislative reform to create a third category of personal property – called “data objects” – beyond things (or “choices ”) in possession (such as physical objects) and things in action (such as contractual rights).
The document is an important development in the digital asset space, particularly its proposals regarding ownership rights and the 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 lay the foundations for DLT. These are: (i) legal certainty; (ii) a dispute resolution process that takes into account how on-chain transactions operate; (iii) the procedural capacity of a legal system to deal with disputes relating to digital transactions; (iv) a private law context allowing the issuance and transfer of securities via DLT; (v) industry and government familiarity with smart contract use cases; and (vi) an appropriate regulatory environment. The Law Commission document goes to some extent towards the beginning of the discussion of points (i) and (iv).
English law has in recent years shown its flexibility in dealing with issues related to digital assets (see for example the recent granting of a freezing injunction for non-fungible tokens (NFT) would have been stolen). However, more targeted reform which could lead to additional legal certainty will be welcomed by the industry and will be an important stepping stone in the UK government’s broader strategy to make the UK a global hub for digital assets and related services, particularly if it helps position English law as the established first choice of law underpinning the use of DLT.
How does paper define data objects?
As mentioned above, the document proposes the creation of a third category of personal assets – “data objects”. The document’s definition of data objects is intentionally broader than crypto-assets (which it calls crypto tokens). To identify a data object, the document proposes the following three criteria:
- consist of data represented in an electronic medium, including in the form of computer code, electronic signals, digital or analog A data object must be electronically recorded in some way. When stored on or transmitted through physical objects, which are things in possession, data objects are treated in Paper as distinct from the objects by which they are stored or made available.
- to exist independently of people and to exist independently of the legal system The paper suggests that data objects be considered distinct from things in action in that they can exist, be used, and operated as long as the blockchain or whatever system they exist on remains active (theoretically outside the scope of formal application of any legal system).
- to be a rival A thing is considered “rival” when it cannot be used simultaneously by others in an equivalent way. This does not mean that it is unique or not fungible. Finding a way to make electronic data rivalry, when it can otherwise be replicated almost infinitely at near-zero marginal cost, is a key innovation in blockchain technology.
The Law Commission considered and rejected a potential fourth criterion for “assignment” – transferability or disposal – a feature it determined to be common but not critical among data objects. Excluding assignment from the criteria would keep non-transferable objects, such as “soul-bound” tokens offered by Ethereum co-founder Vitalik Buterin, as part 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 document itself).
Although the paper suggests 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 of the approaches without expressing a preliminary conclusion.
Moving from ‘ownership’ to ‘control’: what distinguishes data objects from other types of ownership?
The key concept for ownership of more traditional tangible objects is that of “possession”. Although nuanced, possession involves both elements of control and intention with respect to a physical object. Ownership of things in action (eg contractual rights) relies on the legal system for enforcement.
The paper suggests that this model does not match data objects, where control is determined in many cases by control of cryptographic keys – hence the rise of sayings like “not your keys, not your bitcoin”. Rather than legislating what “control” means for data objects, the Law Commission suggests that the common law will be the primary driver for proper meaning, with courts perhaps turning to a multi-disciplinary committee to seek guidance. ugly.
What does the Paper say about rights related to NFTs, stablecoins and other crypto-tokens?
While the paper acknowledges that NFTs and crypto-assets sometimes claim to confer, prove, or embody rights off-chain or in the physical world, it notes that tokens themselves cannot do so in law. These rights or representations are choices in action that may relate to the crypto-token, such as an expressed copyright license for the benefit of – or the responsibility of the stablecoin issuer to redeem an amount of fiat currency for – the holder of a given crypto-token from time to time, rather than being data objects themselves.
There are different ways to create such a link, the strength and consequences of which, according to the document, will likely depend on a mix of market practices, contractual arrangements and common law developments. In the absence of other contractual, statutory or other provisions, the document suggests that cryptographic tokens used to create ledgers or records of external items are likely to be useful only as evidence, conferring no right themselves without legal intervention.
Considering this two-track structure to be sufficiently established and flexible, the Law Commission does not propose any reform in this area.
Data Object Transfers
Since the legal system is external to crypto-token systems, the Law Commission believes that the state of the relevant system (such as a distributed ledger or structured record) does not necessarily determine the (superior) legal title of a crypto token. This is partly because these systems provide a factual rather than a legal record.
Another element of this distinction is that the system may not be able to show as many states as the legal system can – changing the association of a crypto-token from being with a public key address to a another may depend on or derive from the total or partial transfer of a prior legal interest.
As a result, the Law Commission tentatively concluded that existing rules on ownership transfers can apply to on-chain transactions, even if that transaction results in the creation of a new, modified, or linked crypto token. The Cahier therefore does not propose any legislative reform in this area, other than to recommend that the law specify that “equity’s darling” – the defense offered to purchasers in good faith for consideration and without notice – persists relates to data objects.
Support data object security
Given the Law Commission’s view that data objects cannot be possessed, the document asserts that security arrangements with possession – pledges etc. – cannot be used for crypto-tokens. Conversely, owners of crypto-tokens can grant non-possessory security or enter into title transfer agreements, such as mortgages and encumbrances. The Law Commission is, however, considering whether crafting bespoke legal provisions for crypto-token collateral agreements can be beneficial. As this would be an important piece of work, at this stage the Law Commission is only pointing out the problem and not making a specific proposal.
Insolvency of crypto-asset custodians
Following the recent price crash of a number of crypto-assets – and on several occasions due to hacks – crypto-token custodians have sometimes found themselves with insufficient crypto-assets to meet their obligations to users. Under English law, how the remaining pool of user assets is distributed among users in such an insolvency situation depends on how the assets are held.
If the custodian holds the users’ crypto-assets on a purely contractual basis, i.e. without there being a trust over those assets, then the users will be unsecured creditors. These types of arrangements are common in “yield farming” and other arrangements where a custodian will lend users’ crypto-assets for a return, while crypto-asset exchanges might also take this approach when custodial of users’ assets. users. This will depend on the applicable commercial terms.
If there is a trust over the crypto tokens held by the custodian, and users’ rights are assigned individually (rather than an existing trust over pooled assets), then users whose ownership has been lost – due to hack, bad debt or otherwise – will bear the entire loss.
The paper suggests, meanwhile, that it would be beneficial to reform the law to clarify and simplify how losses fall where there is a trust on pooled or commingled tokens held by an insolvent custodian. The document explains in detail if and how such a trust could arise, considering several options and tentatively deciding to define the rights of users in such an arrangement as an equitable joint tenancy.
Give courts the power to award sums denominated in crypto-tokens
Although English courts are able to award awards in state-issued currencies, they are not yet able to award awards denominated in crypto-assets. In some situations, such as the insolvency of a crypto-asset custodian, an award of such compensation might be more representative of a claimant’s loss. Given the fungibility and liquidity of cryptocurrencies, and relatively low storage and delivery costs compared to commodities, the paper proposes reforming the law to give courts discretion to award rewards “ money” denominated in certain crypto-tokens.