New recommendations for reform and development of the law on digital assets

On 28 June 2023, the Law Commission of England and Wales published its report (the Report) on digital assets, detailing the conclusions and recommendations for law reform in this area. While it is acknowledged that the digital asset market and the technology in question is continually evolving, the common law system in England and Wales has been deemed a coherent and globally relevant regime to sufficiently accommodate this emerging area.

The report marks the culmination of two years of consultation with market participants and experts. It supersedes the Consultation Paper (the Paper) published in July 2022, a summary of which is available by clicking on our previous blog here. The report follows a request from the Government to the Law Commission to carry out a first ever rigorous common law analysis, demonstrating how the law in England and Wales is able to respond to this kind of emerging technology.

Overall, the report makes markedly few recommendations for law reform, adopting a ‘tripartite’ approach:

1. It concludes that the common law is, in general, sufficiently flexible to accommodate digital assets and therefore any reform should be through further common law development where possible;
2. It recommends targeted statutory law reform only to confirm and support the existing common law position, or where common law development is not realistically possible; and
3. It recommends that the Government creates or nominates a panel of experts to provide non-binding guidance on the complex and evolving factual and legal issues in this area.

In doing so, the report sets out four recommendations for legal reform on digital assets, namely:

1. Legislation to confirm the existence of a distinct third category of personal property under the law which can better recognise, accommodate and protect the unique features of digital assets;
2. Creation of a panel of industry-specific technical experts, legal practitioners, academics and judges to provide non-binding advice to courts on complex legal issues relating to digital assets;
3. Creation of a bespoke legal framework that better facilitates the entering into, operation and enforcement of collateral arrangements relating to crypto-tokens and crypto-assets; and
4. Statutory law reform to clarify whether certain digital assets fall within the scope of the Financial Collateral Arrangements (No 2) Regulations 2003.

We set out further detail on each of the recommendations and the conclusions below. It is now for the Government to decide whether it intends to take forward the Law Commission’s recommendations. 

Personal Property Rights

Recommendation 1:  Statutory confirmation that a thing will not be deprived of having personal property rights merely by it not being a “thing in action” nor a “thing in possession”, through the recognition of third category things.

The Report recommends using legislation to restate the already existing position in common law that treats digital assets as being capable of having personal property rights, despite not fitting into either of the established two categories. While statutory confirmation is deemed necessary to remove debate surrounding things that are neither in possession nor in action, it is not considered appropriate to define a hard boundary, in statute, for this third category. Rather than asserting determinative exclusionary criteria, the Law Commission instead provides criteria to act as indicia to allow for analogical, incremental categorisation.

Digital ‘things’ falling into this third category are coined ‘digital objects’. Contrary to the provisional three-part criteria (indicia), suggested in the Paper, there is no longer a criterion of ‘being composed of data represented in an electronic medium’, which was thought to focus too much on conceptualisation of the thing and creates unnecessary rigidity. The second and third criteria suggested in the Paper, that the thing ‘exists independently of persons and exists independently of the legal system’ and is ‘rivalrous’, have been confirmed and reiterated.

As endorsed by the Court of Appeal in the Tulip Trading case, a thing is rivalrous ‘if the use or consumption of the thing by one person (or a specific group of persons) necessarily prejudices the use or consumption of that thing by one or more other persons’.

Control

Recommendation 2: Formation of a panel of industry experts including specific technical experts (particularly experts in the crypto-token markets), legal practitioners, academics, and judges to provide non-binding guidance on the factual and legal issues relating to control involving third category things (and other issues relating to digital asset systems and markets more broadly).

The report describes, but does not define, the factual concept of “control”, i.e. in essence the ability to exclude or permit access to a digital object and put it to use. It notes that the concept of control is considered likely to be appropriate for the vast majority of digital objects, but should not be considered part of the definition.

The common law has developed the principles of possession and factual control over time in response to market developments and legal challenges and it is similarly able to do so in the context of digital objects. The common law is therefore seen as the appropriate and principal driving force to develop accurate jurisprudence concerning control, which also ensures consistency with the analogous but distinct concept of possession.

The courts may however encounter difficulties when making complex findings of fact where control works differently for digital objects and through different technological implementations. As such the Report makes the recommendation for a technical expert panel to offer guidance on these evolving factual and legal issues relating to control of digital objects and other third category things.

As a supplement to this recommendation the Report makes the following conclusion:

Conclusion 1: A legal proprietary interest in a digital object can be founded by factual control (plus intention), and this can be separated from a superior legal title.

In the context of crypto-tokens, a person who has control may not be recorded by the state of the crypto-token system as having control, may not be the person with superior legal title, and may have exercised some level of joint, split or otherwise encumbered ‘factual control’. These scenarios may give rise to disputes as to the legal consequence of a person having factual control over a crypto-token, some of which may need to be resolved by reference to title. 

Transfers of data objects

Conclusion 2: It is possible to effect a legal transfer of a crypto-token offchain by a change of control, or onchain by a transfer operation that effects a state change.

When transferred onchain, a crypto token undergoes a transition whereby the chain of cryptographically validated transactions in the distributed ledger or structured record is updated. Every transaction of that token adds to its chain and therefore the crypto-token received is not exactly the same crypto-token that was transferred.

There is debate as to whether a transfer operation that effects a state change, creates a new post-transfer object of personal property rights (extinction/creation analysis), or whether the rights persist through the transaction (‘persistent thing’ analysis). The Report concludes that both could be accurate.

Where the law needs clarity, however, is whether a transfer operation that effects a state change is a necessary condition for a legal transfer of a crypto-token or if ‘change of control’ could apply as a wider condition. Recognising change of control, the second conclusion of the Report more accurately reflects the current use of crypto-tokens in the market and supports offchain transfers. Further, the technical expert group, under recommendation 2, will cumulatively develop practical, technology-specific guidance to develop certainty on what is required in a ‘change of control’ for the transfer of title.

Conclusion 3: Incremental development of the common law will allow courts to recognise the special defence of good faith purchaser for value without notice, applicable to crypto-tokens.

The Report also discusses how the common law special defences of good faith purchaser for value without notice with regards to money and to negotiable instruments should apply to crypto-tokens and other third category things. This existing body of law provides useful conceptual scaffolding to develop an analogous special defence, without requiring cryptoassets to necessarily fit into the existing law of negotiable instruments nor be legally characterised as ‘money’.

The Report concludes that the application of this special defence to crypto-tokens, and other third category things, can be recognised and developed by the courts through incremental developments of the common law. The Report differs from the Paper, however, in that, following conclusion 2, this special defence would not in principle be limited to situations involving an onchain transfer, but could also apply to a transfer of a crypto-token made offchain through a change of control. 

Intermediated holding arrangements

Conclusion 4: Crypto-token intermediated holding arrangements can be characterised and structured as trusts, under which, the interests of the beneficiaries are rights of co-ownership in an equitable tenancy in common.

The Report notes that effective and versatile legal frameworks already exist for intermediated holding arrangements, namely contract-based full title transfers or trusts. It confirms that, under the law of England and Wales, crypto-token intermediated holding arrangements can be structured as trusts, including where the underlying entitlements are held on a consolidated unallocated basis for multiple users; or commingled with unallocated entitlements held for the benefit of the holding intermediary itself. Despite reaching the same outcomes, the courts have not, however, been unanimous in their approach. This risks potential legal uncertainty but does not warrant statutory intervention. Instead, the Report establishes that these specific crypto-token entitlements are best characterised as rights of co-ownership in an equitable tenancy in common.

Conclusion 5: A control-based legal proprietary interest could provide an additional and alternative legal structure for custodial intermediated holding arrangements, in addition to trusts. This could take the form of holding intermediaries acquiring control based proprietary interest in held crypto token entitlements subject to a superior legal title retained by users.

An alternative structure to contract and trusts, based on holding intermediaries acquiring a control-based legal proprietary interest in held assets, would enhance flexibility of the common law but does not necessitate statutory law reform. This will parallel the existing law of bailment but be conceptually distinct (similar to the distinction between control and possession). This, therefore, will not distort any existing principles but will also allow the courts to be responsive to the idiosyncrasies of digital objects. 

Collateral arrangements

Recommendation 3: Statutory amendments to the Financial Collateral Arrangements (No 2) Regulations 2003 (FCAR) to clarify and confirm:

1. what holding arrangements crypto-tokens, cryptoassets and/or mere record/register tokens can satisfy the definition of ‘cash’ (with potential additional interpretational guidance).
2. that the characterisation of an asset which satisfies the definition of a financial instrument or a credit claim will be unaffected by the mere recording or registration of that asset by a crypto-token within a blockchain or distributed ledger technology (DLT) based system.
3. that where an asset which satisfies the definition of a financial instrument or a credit claim is tokenised and effectively linked or stapled to a crypto-token forming a distinct object of personal property rights, the linked or stapled token itself also satisfies the relevant definition.

 A review of the relevant laws applicable to UK companies to assess the merits of reforms that would validate and expand the use of crypto-token networks for the insurance and transfer of equity and other registered corporate securities. Any such review should consider how the laws support the use of public permissionless ledgers for the issuance and transfer of legal interests in equity and other registered corporate securities.

The current FCARs do not provide a comprehensive regime with regards to crypto-tokens, cryptoassets and record/register tokens. Not least because it is uncertain whether or where they fall within the regulations since they do not clearly satisfy the definition of ‘cash’ nor therefore ‘financial collateral’ as required by the FCARs. Despite this interpretative uncertainty, the Report recognises that the dynamic nature of the cryptoasset market, and likelihood of substantive change in a relatively brief period, make any rigid characterisations inappropriate. Therefore, instead, the recommendation is for clarificatory statutory amendments to deal with any residual uncertainty, starting with what meets the definition of ‘cash’.

To comply with s 113 of the Companies Act 2006 regarding maintenance of members (and other) registers, UK companies are constrained as to the extent they might use tokenised equity or other corporate securities. The Law Commission supports the view of the UK Jurisdiction Taskforce (UKJT) that these statutory requirements can only be met with a ledger operated by a permissioned blockchain network, smart contract, or DLT-based system. A ledger within a public, permissionless crypto-token system would not satisfy the requirement that an issuer must maintain centralised discretionary control over updates to the ledger. In light of other jurisdictions reforming their corporate laws to allow for a broader use of these technologies in the issuance and transfer of securities, it is recommended that UK laws governing this are similarly reviewed. Alongside the proposed reforms to the FCARs this would ensure UK financial markets remain internationally competitive, harnessing the full potential of these innovative technologies.

Recommendation 4: Formation of a multi-disciplinary project to implement a bespoke statutory legal framework to better facilitate the entering into, operation and enforcement of certain crypto-token and certain cryptoasset collateral arrangements.

With the decision against an extension of the FCARs to formally encompass crypto-token collateral arrangements, the Law Commission instead makes the final recommendation for a bespoke statutory legal framework to more precisely fit crypto-token and cryptoasset collateral arrangements. This would require consideration of how this legal framework would interact with the existing FCARs. Although beyond the parameters of the Report, attention was given to the potential legal issues regarding the scope of this proposed bespoke regime and the associated complex policy-related issues.

Above all, this final recommendation is consistent with the Government’s policy objective to become a global hub for crypto-token and cryptoasset technology and investment, by offering both clarity and flexibility to encourage increased participation and engagement in this space. 

Causes of action and associated remedies

Conclusion 6:  Specific and discrete principles of tortious liability should be developed by the court similar to the tort of conversion to deal with wrongful interferences with third category things.

There exists a balancing exercise between limiting the risk of imprecise wholesale application of existing torts to digital assets and the affect any new regulation may have on the still nascent and evolving digital assets market. Much of the current law concerning causes of action and associated remedies can encompass third category things without law reform, including in the context of breach of trust or contract and vitiating factors. The law of England and Wales rarely distinguishes between the categories of personal property. Therefore, there is no need to address the addition of this proposed third category of things. Rather, the courts can continue to recognise the nuances in this area and apply existing legal principles as appropriate.

The Report does however identify a potential gap in the law where a superior legal title holder may be prevented from pursuing a cause of action. These situations may only arise in limited situations where a claim based on unjust enrichment or proprietary restitution cannot be made out. This small gap should be addressed through the incremental development of specific and discrete principles of tortious liability – analogous to the tort of conversion – to address wrongful interferences with third category things such as digital objects.

This differs from the approach taken in US law which simply extends the tort of conversion to apply to third category things including intangible objects of personal property rights. This has seen victims, who have had their crypto-tokens misappropriated through fraud or hacks, base their claim on the tort of conversion. The Law Commission contends that the US approach leaves uncertainty in the scope of the extended tort. Instead, it concludes that to develop specific principles is the optimal way to limit scope and effect and be more sensitive to the specific issues applicable to third category things.

 

 

*this post was originally published on our Digital TMT and Sourcing Notes blog