Law Commission’s final report on digital assets: What’s new?

Tripartite approach

 “... the law of England and Wales has proven itself sufficiently resilient and flexible to recognise some digital assets as capable of being things to which personal property rights can relate. We conclude that the law in this respect is now relatively certain and that most areas of residual legal uncertainty are highly nuanced and complex. That complexity remains, in part, because both the digital asset market and the technology in question is evolving and will continue to do so.” (para 1.7 of final report)

So, how should English law approach that residual complexity?

The Law Commission takes a tripartite approach, by:

1. Prioritising common law development;
2. Proposing targeted statutory law reform only to (i) confirm and support the existing common law position; or (ii) where common law development is not realistically possible; and
3. Recommending that the Government creates a panel of industry-specific technical experts, legal practitioners, academics and judges to provide non-binding guidance (since this hasn’t been created or named yet – we’ll coin and deploy the name Council of Crypto Elders in this article) 

A new third type of property

“The law has now moved on from the (arguably hollow) debate on categorisation of digital assets to answering substantive questions as to the legal principles applicable to those digital assets. It is entirely appropriate for the common law of England and Wales to take this approach.” (para 2.50 of final report)

In its consultation paper the Law Commission proposed a new category of property for “data objects”, listed the three criteria for that category, and asked whether this should be implemented through common law development or statutory reform.

In the final report this has evolved to the new category of property expanding (so it is no longer limited to “data objects”), the criteria are now indicia and the statutory reform is confirmatory.

Why the obsession with property rights? First, for historical reasons English law has distinguished between things “in possession” (eg a bag of gold) and things “in action” (eg a debt claim). Certain things (including digital assets such as crypto-tokens) risk falling between the two. Secondly, English law does not accept that there are personal property rights in pure information. Thirdly, property rights have valuable qualities. They can be asserted against the rest of the world in contrast to other personal rights which depend on people assuming a legal duty (eg you agree in a contract to do a certain thing, or the circumstances mean that you owe a duty of care). Property rights allow you to stop others interfering in your things, enable your things to be used as security or collateral and allow you to assert superior rights in an insolvency. Fourthly, most people instinctively know that there is something different between a Bitcoin and a Word document. In other words, people have legitimate expectations that digital assets have a quality of property-ness that should be met.

The Law Commission notes that 24 cases including, recently, the Court of Appeal in Tulip Trading now recognise crypto-tokens as distinct things which are capable of being objects of personal property rights (despite not necessarily being either a thing in possession or a thing in action). The common law has done its job. However, specialist and senior judges (among others) wanted some targeted confirmatory legislation to bolster the common law.

Accordingly, the Law Commission recommends express statutory confirmation that a thing will not be deprived of legal status as an object of personal property rights merely by reason of the fact that it is neither a thing in action nor a thing in possession.

This approach means there will be no statutory definition of a digital asset. The Law Commission felt any legislative definition would be too rigid, in contrast to the flexibility which the common law can offer. Therefore, what were hard criteria are now softer indicia, for the courts to run with, of what would be needed for a digital asset to attract property rights:

1. It is composed of (but more than) data represented in an electronic medium. This is primarily about distinguishing it from tangible things.
2. It exists independently of people and the legal system. A debt, for example, exists only because the law says so.
3. It is rivalrous. This criterion was adopted by the Court of Appeal in Tulip Trading. Essentially it means that the holding of the thing by one person necessarily prevents another from holding the very same thing at the same time.

Things that have these indicia are described by the Law Commission as “third category things”.

To illustrate how it works, let’s look at crypto-tokens:

• Indicia 1: The Law Commission describes them as “a notional quantity unit manifested by the combination of the active operation of software by a network of participants and network-instantiated data”. If your head doesn’t hurt at this point, you are clearly very smart. The difficult-to-express point is that like a GBP1 coin—which is more than a mere metal disc—a crypto-token is more than a string of data on a distributed ledger. It is a construct or “ideational thing”. 
• Indicia 2: Unlike a debt, contractual right or, say, an EU carbon emission allowance, a crypto-token would still be “there” even if the law did not acknowledge it.
• Indicia 3: Crypto-tokens are rivalrous by design. Bitcoin was conceived to address the double spend problem faced by digital assets (ie you don’t want more than one person being able to spend the same Bitcoin). As the Court of Appeal in Tulip Trading put it, “The signing of the hashed transaction record with users’ private keys in the first place, and the incorporation of these records into a hashed chain of blocks produced by the proof of work, solves the double spending problem”. The fact that you can have a “fork” in a crypto-token system also supports the idea that a crypto-token is rivalrous.

Possession vs Control

“... [C]ontrol is highly complex, composable and multi-faceted in the context of third category things; and different technology, products and services use control in different ways.” (para 5.3 of final report]

The Law Commission has stuck with its proposal that the concept of control is more appropriate for third category things than the concept of possession (which is relevant only to tangible things).

Control in relation to third category things is the factual concept that captures the ability to (i) exclude or permit access to a thing and (ii) put that thing to the uses of which it is capable. That sounds simple enough but digital assets have a habit of taking seemingly simple concepts and making them fiendishly complex (think mining and baking which have nothing to do with extracting precious metals or creating delicious treats). Control is no exception.

By way of illustration, the Law Commission previously provided the following broad description of control of digital objects in its consultation paper: where a person is sufficiently able to (i) exclude others from the object; (ii) put the object to the uses of which it is capable; and (iii) identify themselves as the person with the abilities specified in (i) and (ii). However, in its final report, the Law Commission recognises that control can be more complex than its broad description suggests. For example, in a multi-signature arrangement, multiple keys (which may be held by different persons) will be required to authorise a crypto-token transaction.

Because of this complexity, the Law Commission considers that defining the concept of control in statute would make it too rigid. Control (like possession) needs to be a flexible tool. The Law Commission therefore proposes that the concept of control be developed through common law.

Factual control has legal consequences. For example, as explained below, the Law Commission now considers that it is possible to transfer legal title to crypto-tokens by a change of control. The principal area of controversy regarding the legal consequences is whether control should have similar consequences for third category things as possession has for tangible things. In particular, whether the law should treat a certain level of control of a third category thing as giving rise to a legal proprietary interest in that thing (which can in certain circumstances be separated from and inferior to superior legal title). The Law Commission concludes that it can give rise to such an interest.

What next? The Law Commission envisages that the proposed Council of Crypto Elders will provide non-binding guidance on the complex and evolving factual and legal issues relating to control.

Transfer [no longer] means cancellation and creation

“We think that a more or a less data-centric approach to conceptualising a crypto-token can potentially give rise to different analysis when applying legal principles to transfers of crypto-tokens.” (para 6.17 of final report)

Analysis of transfer

There are two opposing ways to analyse the on-chain transfer of a crypto-token. In its consultation paper, the Law Commission previously analysed an on-chain transfer operation as typically involving the cancellation of the original crypto-token and the creation of a new crypto-token. This is referred to as the extinction/creation analysis.

We argued against the extinction/creation analysis long ago in our 2020 article which considered the UKJT’s adoption of that analysis in its legal statement. Our view was that whilst certain data might represent a crypto-token, that data is not itself the crypto-token (which is ultimately an imaginary or notional thing). Accordingly, a change in that data (following a transfer) does not entail a change in (ie cancellation of) the crypto-token itself.

In its final report, the Law Commission gives more prominence than it did previously to the persistent thing analysis. This analysis recognises that, whilst the crypto-token is manifested through different data before and after a transaction, the crypto-token is a notional quantity unit at the system level which persists through a transaction. 

The Law Commission ultimately considers that there is no single correct analysis. It just depends on whether the analyser chooses to focus on blockchain level data or the system level. However, the Law Commission does recognise that there are a number of arguments as to why the persistent thing analysis is more practically accurate. These include reflecting the expectations of users and strengthening the argument that the rules of derivative transfers of title apply to on-chain transfers.

Conditions for legal transfer 

In its consultation paper, the Law Commission provisionally proposed that a transfer operation that effects a state change of the ledger or record (ie an on-chain transfer) is a necessary but not sufficient condition for a transfer of legal title.

However, in its final report, the Law Commission accepts that it is also possible (with the requisite intention) to effect a legal transfer of a crypto-token off-chain by a change of control. This means that, by way of example, a transfer of physical control over a private key or a Layer 2 transaction (eg on the Bitcoin Lightning Network) can be sufficient to effect a legal transfer of a crypto-token. This is significant as it reflects what market participants often do in practice.

Common law defence of good faith purchaser for value without notice

The common law defence of good faith purchaser for value without notice (not to be confused with the equitable principle) currently only applies in respect of money and negotiable instruments. Crypto-tokens are neither of these. So, if Alice steals Bob’s GBP1 coin and uses it to buy sweets from innocent Chuck, then Chuck will have a fresh, indefeasible, legal title to the GBP1 coin (even though Alice as a thief did not). But if you replace the GBP1 coin with a Bitcoin in that scenario, then Chuck will not have a fresh, indefeasible, legal title to the Bitcoin.

So should crypto-tokens enjoy a privileged proprietary status like money currently does?

In its consultation paper, the Law Commission proposed that there be an explicit statutory clarification that the common law defence of a “good faith purchaser for value without notice” should apply to on-chain crypto-token transfers.

In its final report, the Law Commission instead concludes that an equivalent defence applicable to on-chain and off-chain crypto-token transfers can be recognised by the courts through incremental development of the common law (and that reasoning can be extended to other third category things). The reason for opting for common law development rather than statute is because the Law Commission has not recommended a hard definition of third category things on which to base a statutory rule.

What happens when a crypto custodian fails?

“... [I]ntermediary insolvency risk is evidently elevated across crypto-token markets, at least as they currently exist. This strengthens the need to approach intermediary insolvency in careful and comprehensive terms.” (para 7.93 of final report)

If I trade my Bitcoin on an exchange, that exchange might use a single network address to collectively hold the crypto-tokens of a number of users. So what happens if that exchange becomes insolvent? To answer that question, we need to understand the arrangement that is in place.

In its consultation paper, the Law Commission distinguished direct custody arrangements (ie arrangements that involve the holding of crypto-tokens by an intermediary) from non-holding arrangements. However, the term ‘custody’ in regulated financial services (as opposed to the crypto world) refers to the situation where an entity holds assets for its client but the client retains ultimate title to the assets.

To ensure consistency, the Law Commission therefore proposes the following refined terminology in its final report: 

• Custodial intermediated holding: These are arrangements under which clients retain superior legal or equitable title to the crypto-tokens. This affords more effective protection for clients in the event of an insolvency since their assets will not be available to meet the claims of the intermediary’s general creditors. Whilst these arrangements will most likely be structured as trusts, the Law Commission also considers that (with further development of the common law) they might include facilities in which the intermediary acquires a control-based legal proprietary interest in the assets (ie the same type of interest discussed above).
• Non-custodial intermediated holding: These are arrangements under which the holding intermediary acquires superior legal title to the crypto-tokens and the clients merely have personal contractual claims to the return of equivalent assets. Clients would therefore rank as unsecured creditors in an insolvency.
• Non-holding services: These are other technology-based services that relate to the administration or safe-keeping of crypto-tokens but do not involve the service provider holding the tokens.

The Law Commission makes the following observations in its final report regarding crypto-token intermediated holding arrangements. 

First, it concludes that intermediated holding arrangements, under current law, can be structured as trusts (provided the three certainties are established) including where the crypto-tokens are (i) held on a consolidated unallocated basis for the benefit of multiple users; or (ii) potentially even commingled with unallocated entitlements held for the benefit of the holding intermediary. It considers that the best way to understand the beneficiaries’ interests in these trusts is as rights of co-ownership in an equitable tenancy in common.

Second, it maintains its position that a presumption of trust should not be introduced as a new interpretative principle. Whilst a presumption might strengthen user protection and/or encourage clearer terms of use and service agreements, the Law Commission considers that it is more appropriate for regulators to consider these issues.

Third, it confirms that it remains in favour of a general pro rata shortfall allocation rule (rather than the application of traditional tracing rules) in respect of commingled unallocated holdings of crypto-tokens held on trust by an intermediary that enters insolvency proceedings. However, it no longer proposes the express statutory rule recognising this that it provisionally proposed in its consultation paper. This is because these situations must be considered within wider regulatory and policy frameworks. In this regard, HM Treasury’s consultation on a potential future financial services regulatory regime for cryptoassets will consider user rights on insolvency.

Collateral: bespoke statutory arrangements?

“We conclude that the introduction of bespoke collateral regime applicable to crypto-tokens and cryptoassets is consistent with the Government’s stated policy objective of making the UK a global hub for crypto-token and cryptoasset technology and investment.” (para 8.153 of final report)

The Law Commission reiterates that security which does not involve taking possession—mortgages and charges—works perfectly well for crypto-tokens. Equally because, as a matter of English law, you cannot possess an intangible thing, security which requires possession—pledges and liens—will not work for crypto-tokens. However, the Law Commission observes that the common law could, possibly by analogy with a pledge, coherently develop a control-based security interest in respect of crypto-tokens. That security interest is conceptually linked to the control-based proprietary interest referred to above.

The Law Commission then goes on to consider the applicability of the Financial Collateral Arrangements (No 2) Regulations 2003 (FCARs) to (i) unbacked crypto-tokens (eg Bitcoin and Ether), (ii) cryptoassets (ie crypto-tokens such as Central Bank Digital Currencies (CBDCs) and stablecoins which are linked to a legal right/interest in another thing) and (iii) mere record/register tokens. The FCARs aim to facilitate the provision of financial collateral by exempting financial collateral arrangements from certain formality requirements and insolvency provisions.

Many unbacked crypto-tokens are likely to fall outside scope of FCARs. However, at least some cryptoassets and mere record/register tokens may fall within scope. The Law Commission recommends law reform to clarify the scope of the FCARs.

However, even if the scope is clarified, the Law Commission does not consider the FCARs to provide a satisfactory regime for collateral arrangements in respect of crypto-tokens and cryptoassets because (i) certain crypto-tokens and cryptoassets will be excluded from the FCARs’ scope and (ii) the application of the FCARs’ “possession or control” requirement for security based financial collateral will be problematic.

The Law Commission therefore recommends that, as a matter of priority, the Government sets up a multi-disciplinary project to formulate and put in place a bespoke statutory legal framework for certain crypto-token collateral arrangements.

Crypto litigation 

“… [W]hat is required is that the courts continue to recognise the nuances or idiosyncrasies of third category things (including their distinct functionality and technical characteristics) and apply existing legal principles to such things as appropriate.” (para 9.2 of final report)

The Law Commission’s conclusion is that the English courts are more than able to help protect rights in crypto-tokens. Indeed, much of the case law to date demonstrates them doing just this. The potential gaps or anomalies include the following:

• An obligation to pay crypto-tokens would be classified as a claim for damages for failure to deliver a thing rather than a monetary debt. So you would get your recompense in pounds not the crypto-token. The Law Commission thinks the current position is appropriate.
• Burning a crypto-token (ie permanently removing it from circulation by sending it to an inaccessible address) without consent might be something for which there is currently no adequate remedy. For various reasons, proprietary restitutionary claims at law (no subsisting right held by defendant), unjust enrichment (the defendant is not enriched), and the tort of conversion (does not apply to things which cannot be possessed) may not quite get you there. The Law Commission hopes that the common law can develop specific and discrete principles of tortious liability by analogy with, or which draw on some elements of, the tort of conversion to deal with wrongful interferences with third category things such as digital objects.

Conclusion

The approach taken is one akin to key-hole surgery. It is very targeted and largely leaves the common law to do its job. However, the Law Commission hasn’t finished its to-do list. It still has conflict of laws and distributed autonomous organisation to contend with. Cue music: dum dum dada...