On 28 July 2022, the Law Commission published a consultation paper on digital assets. The outcomes of the consultation will inform the programme for law reform in England and Wales and may therefore result in the tabling of legislation designed to implement the Law Commission’s proposals for adapting the law to better suit this asset class.
The consultation is designed to provide greater clarity and certainty around the question of the status of digital assets as property but, by the Law Commission’s own reasoning, the common law of England and Wales has already shown itself to be ‘sufficiently resilient, flexible and iterative to accommodate digital assets’. This is borne out by successive judgments, in which the status of digital assets as property has already been considered and established. This consultation will, however, potentially inform the development of the common law, whether or not primary legislation will follow. It will doubtless be scrutinised by those currently involved in litigation involving digital assets. It will also inform the development of regulation.
What follows are some of our key takeaways for the treatment of digital assets and, particularly, crypto-tokens as property. We have not covered every element of the consultation paper, but rather have summarised what we believe are the key aspects that are likely to matter most to the digital assets industry.
What is the Law Commission and why does their opinion count?
The Law Commission has a legal remit to propose and promote law reform. It is comprised of legal figureheads from practice, the judiciary and academia. Its duties are set out in statute and it is accountable to the Lord Chancellor. The latter must put programmes for reform created by the Law Commission before Parliament. In short, what the Law Commission publishes and proposes will impact the way in which the law is developed in the UK.
Background to the Digital Assets Consultation
In March 2020, the Law Commission was tasked with undertaking two related projects: one being, to consider the application of the law to the growing body of things people have started to group together as digital assets, including cryptoassets. It conducted a call for evidence in 2021 and the current consultation, ongoing until 4 November 2022, is designed to set out and test some of the conclusions it has reached, in light of that exercise. The current consultation does not change the law it merely outlines how (in the Commissioners’ opinion) it can be said to apply to digital assets and where change to the law of England and Wales might be necessary to provide greater certainty and predictability in this area. The goal is to bring the legal ecosystem of England and Wales up to date and ensure it is properly capable of dealing with issues such as the rules around ownership of digital assets as well as everything ancillary to that, including resolving disputes.
Is the law out of touch with digital assets?
The short answer is yes. So much is clear from the opening gambit of the consultation, in which the Law Commissioners explain that digital assets don’t easily fit within the two traditional categories of personal property (things in possession and things in action) and so, for the purposes of express clarity and legal certainty, a new category needs to be recognised. This third category “data objects” should represent or embody obligations enforceable by legal rights.
Data objects as a third category of personal property
- are composed of data represented in an electronic medium, including in the form of computer code, electronic, digital or analogue signals;
- exist independently of persons and of the legal system; and
- are rivalrous: this means that their capacity for use is limited and people must compete for it or its use as a resource by one person excludes another using it at the same time in the same way.
Data objects by this definition are distinguishable from pure information, which should not, in the Law Commission’s opinion, attract property rights. To protect information, people must instead rely on intellectual property law, confidentiality and data privacy, security and protection norms. This distinction is particularly relevant in the context of digital assets as, in the vast majority of cases, when we are talking of digital assets we are describing strings of information.
The Law Commission goes on to consider specific examples of digital assets and give provisional opinions as to whether or not they should be treated as property or pure information. A selection is set out below:
- Media files and program files - will fall outside of our proposed third category of personal property (although the same is not true of the physical storage medium on which it is recorded, which would fall under the traditional category of a thing in possession). The Law Commission did say it thought it would be possible in future to see media or program files structured so as to satisfy the criteria;
- Digital records - do not qualify but it is possible for some data objects to be used for record keeping purposes;
- Email accounts and in-game digital assets - are unlikely to satisfy the criteria as they are structured, generally, so that only the player or account holder has contractual rights in respect of them against the service provider. Email accounts are tied to email addresses and mailboxes. These can be thought of as data represented in an electronic medium, they are rivalrous, and exist independently. They’re not usually divestible. Email accounts are more properly categorised as things in action (rights against the provider). In-game digital assets can’t be separated from the information or the hardware where they are stored and from where they are interpreted and presented. Access is limited via licenses so they don’t exist independently of the legal system. They only exist on the proprietary ecosystem owned by the game developers. However, in future, the Law Commission envisages that these types of digital assets will test the boundaries of whether ownership is properly categorised as contractual or data-object based;
- Domain names – these also don’t exist independently of the legal system instead they’re dependent on the contractual obligations between the registrant and registry, so they won’t satisfy the criteria. Despite this, they can be extremely valuable. Emerging technologies mean that there are new ways of implementing domain names which potentially would satisfy the criteria of independence and so these could become categorised as data objects at some stage.
- Carbon emission allowances created under trading schemes – again, they don’t exist independently of the legal systems but, like IP rights, are dependent on legislation for their continued existence and function thing;
- Voluntary carbon credits - do potentially satisfy the criteria, to be determined on a case by case basis. They are most likely to operate like a certificate or token representing the holders right to certification that it has removed or reduced the equivalent of a tonne of carbon dioxide from the atmosphere. VCCs structured in this way exist (and have meaning in the eyes of market participants) independently of the legal system and their value ultimately derives from the finite nature of the resources represented by them;
- Crypto-tokens – do potentially satisfy the criteria with some caveats.
How should crypto tokens be treated in terms of property ownership?
The term crypto-token is used by the Law Commission to describe an instance of a thing constituted of data strings or data structures that exists within a crypto-token system, and not any exogenous thing, right, or asset that might be linked to it. In the Law Commission’s opinion, such crypto-tokens don’t exist solely as a technical construct or as pure data or information. They achieve functional reality as a result of the system in which they exist and because they are governed in accordance with a particular set of protocol rules. Their functionality derives from the way in which users interact with them and system. If the presence of the crypto-token in its system can’t be replicated and the protocol rules set out how it is rivalrous, the criteria for a particular crypto-token to be treated as a data object will be satisfied. By contrast, a private key should be treated as pure information, not capable of attracting property rights. Crypto-tokens can also be linked to an external dataset stored elsewhere e.g. to give effect to them being linked to an equity or debt security or land. Although this information is recorded either externally or internally to the crypto-token, the exogenous part and any legal rights in respect of it aren’t part of the data object.
Where crypto-tokens satisfy the criteria of the Law Commission’s proposed third category of property, they should be capable of attracting property rights.
According to the Law Commission, the concept of control – rather than possession – is more appropriate for this form of personal property. This means the person in control of the data object at any moment in time is able to:
- exclude others from it;
- use it;
- pass control of it; and
- identify themselves as the person who can do these things.
The Law Commission suggests that the concept of control as the primary means of asserting property rights should be developed through the common law rather than codified in statute.
The Law Commission’s view is that a crypto-token transfer typically involves the causal creation of a new, modified thing which is not the same as but is related to the thing disposed of by the transferor. The original thing is destroyed, replaced, modified, cancelled, or eliminated. Therefore, the law needs to evolve to keep up. Specifically:
- the law should clarify that a transfer operation which results in a state change is a necessary condition for legal transfer of crypto-tokens so contracts providing for change of ownership aren’t enough;
- the law should also recognise that transactions typically take the form of ledger entries that themselves follow or are impacted by prior entries and which may be accompanied by varying degrees of technical encumbrances;
- where transactions do follow this structure, they should be characterised as involving the acquisition of a new thing by the transferee and should be considered as effecting a change in control;
- this notwithstanding, the law should also leave room for parties to characterise a transaction as the transfer of a persistent thing – it should allow for contractual freedom and flexibility. This includes the flexibility to facilitate parties’ express recognition of the distinctiveness of a particular crypto-token, and its ability to be tracked in some manner.
The Law Commission’s characterisation of what happens to crypto-tokens on transfer could have serious consequences depending on how the law treats the transfer of title. If, by transferring a crypto-token, superior legal title is always automatically lost, it means that some of the remedies which protect those who have been defrauded or had their property stolen from them would be unavailable. The Law Commission therefore recognises that the legal rules on derivative transfers of title can apply to crypto-tokens and that a transferee will generally acquire no better title than the transferor. In conjunction with this, however, the Law Commission recognised that the law would also need to develop a special defence of good faith purchaser for value without notice (an innocent acquisition rule) for crypto-token transfers. This should apply to both “fungible” and “non-fungible” tokens but not (automatically) to things linked to a crypto-token. According to the Law Commission, this would be better implemented via primary legislation.
The second consequence of recognising derivative transfer of title in respect of crypto-token transfers is that the superior legal title might be different from what is evident on the distributed ledger or structured record. Therefore, it follows that neither should be regarded as a definitive record of (superior) legal title but merely evidence of title, which could be shown to be incorrect. This means that disputes over title can be resolved by developing the common law and commonly understood principles.
Crypto-tokens are the main type of data object for which custody arrangements are currently an issue with various market participants already offering arrangements of different natures to crypto-token owners. The Law Commission considered to what extent the law should contain a presumption of trust in respect of a direct custody arrangement, which could be displaced by, for example, express contractual wording. On the one hand, this would mean that the beneficial interest will remain in the cypto-token and, for example, safeguard against the insolvency of the custodian. On the other, the custodian trustees would be subject to legal duties and obligations they might not understand or be aware of, plus the law already allows for the creation and recognition of trusts where appropriate. The Law Commission predicts that the courts would take a purpose-based and commercially responsive approach and therefore there is no need to create a new interpretive principle.
Some of the positions taken by the Law Commission may take the market by surprise. There is no cause for immediate concern, however. As the Law Commission itself recognises, the law is already flexible enough to have dealt with the various challenges that have been thrown at it in terms of resolving disputes involving crypto-assets. Indeed, despite the need as identified by the Law Commission to recognise a wholly new category of property, existing principles have been applied effectively to unwind competing claims and treat cryptoassets as the objects of property rights without the need for extensive legal analysis of the basis on which that is the case. Should such a dispute arise pending reform in this area, the position taken by the Law Commission will inevitably weigh into the arguments and it will be for the judiciary to how to treat any applicable opinions set out in this document. We remain interested to see how this area of law will develop.