Law commission

UK – Law Commission on digital assets: five key takeaways | Allen & Overy LLP

1. A new property type

Much of the Law Commission’s analysis focuses on property law. The great advantage of property rights is that they can be invoked against the rest of the world. In contrast, personal rights, such as those in a contract, exist only between the parties who have assumed them. Property rights come to the fore in adversity, such as insolvency, fraud, or any circumstance where otherwise unconnected people claim rival rights to something. An unsecured creditor with a personal contractual claim will rank behind the claim of a secured creditor with an patrimonial claim.

English law has evolved piecemeal in terms of what is and what is not personal property, and therefore what things get those rights enhanced. While English law has been remarkably adept at doing this, the Law Commission now proposes to clarify certain issues.

For historical reasons, there are currently two types of personal property in English law called archaically:

  • possessions (i.e. anything the law considers possessible, for example a £10 note or a bag of gold); and
  • things in action (i.e. anything that gives rise to legal action, for example contractual rights).

Neither category fully covers digital assets. As a result, the Law Commission is proposing a new, third category: “data objects” (perhaps they thought choosing in data didn’t have the same resonance). Data objects would include “crypto-tokens”, the Law Commission’s preferred term.

The elements proposed to constitute a “data object” are that:

  • it is composed of data represented on an electronic medium;
  • it exists independently of people and the legal system; and
  • it’s a rival.

These require unboxing. The first element is to distinguish this type of personal property from things you can touch, and also to emphasize that the information-carrying bit is important. The second element takes on its full meaning if we consider that contractual rights only exist because the law says so. On the other hand, Bitcoin, at least as a data structure, exists no matter what the law says.

The third element “rivalry” is easier to understand than to pronounce: if at any given time Alice has a thing, then it should alter Bob’s ability to have that same thing. For traditional property rights, it is mainly about keeping others physically at a distance. If the gold is in Alice’s safe, it’s hard for Bob to get it. This all becomes more conceptual for “data objects”.

Additionally, but not as a defining characteristic, the Law Commission speaks of the importance of surrender. Alice must be able to transfer something to Bob in such a way that Alice no longer has it, and Bob does. Likewise, there must be some limit to how something can be used by different people at the same time.

This is the central proposition. The Law Commission then examines other areas where greater legal certainty could be achieved through law reform.

2. Transfer means cancellation and creation

Normally, the transfer of a thing from one person to another does not change the thing itself. However, crypto-tokens are unusual: a transfer leads to a modification of the data of the crypto-token (in particular the public and private keys with which it is associated).

The Law Commission notes the following factual consequences of a crypto-token transfer:

  • the cancellation of the original crypto-token and the creation of a new crypto-token;
  • a change of control from the assignor to the recipient; and
  • a modification of the distributed ledger.

What then are the legal issues that arise from this qualification of transfer?

First, if Alice is listed as the owner of a crypto-token on a distributed ledger, is she the legal owner? The Law Commission’s view is that the distributed ledger is not necessarily a definitive record of legal title (unless, for example, a statute provides otherwise), but rather records the factual situation (i.e. the transactions that took place in the crypto-token system). . However, it can provide strong proof of legal title.

Second, even if a transfer results in the cancellation of the old crypto-token and the creation of a new crypto-token, the Law Commission considers that the rules of the derivative transfer of ownership apply. In other words, if Alice transfers her crypto-token to Bob, Bob’s new legal interest depends on or derives from the transfer of Alice’s legal interest, instead of being a new and original interest. This differs from the UK Jurisdiction Taskforce’s analysis in its 2019 legal statement on crypto-assets and smart contracts which considered Bob’s interest to be an original interest in these circumstances.

Third, and following up on the second point, the Law Commission proposes that there be explicit clarification that the common law defense of “good faith purchaser for value without notice” should apply to transactions cryptographic tokens. This common law defence, which is distinct from the principle of equity that applies with respect to equitable interests generally, currently applies only with respect to money and negotiable instruments. Crypto-tokens are neither. So if Alice steals Bob’s £2 coin and uses it to buy sweets from innocent Chuck, then Chuck will have a new unassailable legal title to the £2 coin (even if Alice as thief does not did not).

Finally, the Law Commission notes that control of a crypto-token will play an important (but not determinative) role in analyzing the legal effect of a transfer of a crypto-token. For example, it provides rebuttable evidence as to the legal (superior) holder of a crypto-token.

3. What happens if a crypto custodian fails?

The recent turmoil known as the “crypto winter” has raised many concerns, including: what happens to crypto tokens held by a custodian if that custodian becomes insolvent?

The Law Commission observes that the allocation of losses among the users of a depositary depends on the legal nature of the place of custody and the rights granted to these users:

  • If the facility is contractual, the users will have no ownership rights and will be treated as general unsecured creditors.
  • If the facility is trust-based and the crypto tokens are held on an individual basis, any loss affecting a particular interest will be borne by the beneficial owner of that interest.
  • If the facility is trust-based and the crypto tokens are held on an unallocated co-mingled basis, there is some uncertainty as to the correct approach under English law (i.e. whether losses in these circumstances must be allocated on a proportional basis or according to traditional tracing rules). The Law Commission sees this uncertainty as unnecessary and proposes targeted statutory intervention, in particular a statutory rule providing for allocation on a proportional basis.

4. Collateral: tailor-made statutory arrangements?

Crypto tokens are increasingly being used as collateral, for example as a form of recourse, which can be accessed to cover payment obligations.

One of the ways of giving a guarantee is to effect an outright transfer of title. The Law Commission believes that this method should work like any other personal property.

The guarantee which involves the creation of a surety is a little more complicated. There are only four types that English law recognises:

  • a pledge where Alice hands over possession but not ownership to Bob (think a pawnbroker);
  • a contractual privilege where Alice, the lawyer, can keep the papers of Bob (her client) if the fees are not paid;
  • a mortgage involving transfer of ownership but subject to restitution upon extinction of the guaranteed obligation; and
  • a charge without transfer of title but which results in the creation of a specifically enforceable right of recourse to the thing encumbered if the debt is not paid.

The Law Commission indicates that types that do not require possession (a mortgage and a charge) can be granted on crypto-tokens. For types that require possession (a pledge and a contractual lien), the Law Commission accepts that security cannot be granted on cryptographic tokens (since they cannot be possessed), but does not consider this to be a problem and therefore does not recommend reform.

The formal treatment of financial collateral agreements under the law, and whether this could or should apply to crypto-tokens, notes the Law Commission, is problematic. In what the Law Commission recognizes to be important work, rather than changing existing rules, it offers the possibility of two new frameworks to address this issue:

  • One for “off-chain” crypto token collateral agreements where crypto token rights are represented by traditional ledger entries in a ledger.
  • Another for “on-chain” crypto token collateral agreements that rely on the technical characteristics of the network in which the relevant crypto token collateral is created.

5. Crypto Dispute

And what about “rival” parties seeking to enforce their rights? Well, the Law Commission has some helpful suggestions on that front:

  • The misdemeanor of conversion is what you are looking for if someone has your thing (think of it as the civil equivalent of the criminal concept of theft). For now, this can only apply to things that can be physically possessed. The proposal is to extend it to data objects.
  • No reform is needed regarding the property injunctions and freezing orders that the English court has already granted in connection with various crypto frauds.
  • The question remains whether the methods of enforcing court orders relating to digital objects need to be reformed.
  • The Court should be able to make orders denominated in certain types of crypto-token.

Obviously, in distilling such a comprehensive and thoughtful document into five key points, it was impossible to take into account all aspects of the Law Commission’s analysis. We will continue to digest but will conclude with the following observation. On the Rotten Tomatoes site, the critics’ consensus for Top Gun: Maverick says it delivers “a belated sequel that tops its predecessor in wildly entertaining style.” The Law Commission’s consultation paper was released almost two and a half years after the UKJT’s legal statement. We consider the consensus of critics to apply here as well.