New UKJT legal statement on digital securities under English law
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What are digital securities?
The UKJT legal statement considers three types of digital security: digital debt securities (aka digital bonds); digital proprietary securities (e.g., GBP10 tokens representing a fraction of an interest in land); and, digital equity securities (aka digital shares). For each, the statement analyses how they can work under existing English law and identifies the potential gaps, if any.
A bit of history
Traditional bearer bonds are readily tradeable debt obligations. Historically this stems from their being “negotiable”: i.e., they can be transferred by physical delivery and the person who has the bond can, generally, assume they have a good title to it.
Bearer bonds acquired negotiable status by mercantile custom (effectively being treated as such over a prolonged period). Normally you can’t transfer to another person a better title than you have yourself (a rule which clings on to its Latin label nemo dat). Since bearer bonds are negotiable, under the common law, this normal rule does not apply, provided certain conditions are met. The ability, generally, to take the title at face value was an important part of the success of the Eurobond markets that Allen & Overy helped foster by documenting the first issue (for Autostrade) in 1963.
For some reason, bearer bonds always make me think of the 1980s classic, Die Hard, and the arch baddie Hans Gruber who is trying to steal them from the vault of Nakatomi Plaza, only to be outfoxed by a white vest-sporting goodie John McClane.
With registered bonds, a designated person keeps a register and transfers are effected by the register being updated.
These days bearer bonds and registered bonds alike are usually “immobilised” (stuck in a vault) with a custodian, and participants trade in contractual or equitable rights to them.
How does this map to digital bonds?
If digital bonds simply entail the use of blockchain technology while the bonds are still effectively centrally managed registered bonds then, as the legal statement notes, the analysis is relatively straightforward.
The position requires more thought where the blockchain is decentralised and where the token on the blockchain can give rise to property rights separate from a contractual right to payment. The decoupling risk does not arise with bearer bonds where the debt is embodied in the physical document and the physical document is negotiable. The question is therefore how the same effect can be achieved where you are dealing with a decentralised digital bond.
The legal statement proposes the following, multi-layered approach:
- Make the digital bond a deed poll.
- Have the terms of the digital bond state, e.g., that:
- it is control, not proving good title, that matters for enforcement of the bond debt;
- the bonds are intended to be treated as if they are “negotiable”, and that no earlier controller of the token can assert a better legal title against a later controller;
- the person who has control of the token and can transfer it for redemption, can require the issuer to pay them, and payment will operate as a complete discharge of the debt.
- Structure the digital bonds so that (and analyse their structure as if) what actually happens on a “transfer” of a token is not that the same thing is “transferred” but rather that there is:
- a cancelling of the original token and the creation of a new token;
- a change of control from the transferor to recipient;
- a change to the distributed ledger.
A deed poll is a unilateral promise, binding from the moment it is made, which does not need consideration. Anyone who is intended to benefit from the promise can sue to enforce it. It can be expressed to be irrevocable. The classic deed poll is the one used to change your name. The designation refers to the fact that the paper the promise was written on used to be cut or polled.
A deed poll, like any deed, must be in writing and signed. Both these requirements can be achieved electronically. A deed poll can be executed by a UK company by the electronic signature of two authorised signatories. This avoids the need for the signatures to be witnessed (which would be problematic in a wholly digital platform). It's even simpler for foreign companies, from an English law perspective at least.
Using this multi-layered approach goes a long way towards achieving negotiable-like status and side-stepping the nemo dat rule so that there’s no need to investigate title:
- Using a deed poll, the legal statement argues, means there’s no assignment needed to transfer rights. You don’t have to worry about the formalities of assignment, nor are you “stepping into the shoes” of the assignor (and so taking subject to their rights).
- If the “transfer” of a token on the blockchain involves the creation of a new thing and the extinguishing of the old, then the legal statement contends that the nemo dat rule is irrelevant. The Law Commission takes a different position on this point arguing that rules of derivative transfer of title still apply to a transfer of a token. This is why they advocate an explicit clarification that the common law mechanism that allows negotiable instruments, generally, to be taken at face value, applies to crypto-tokens.
There does remain a risk that a digital bond would not operate in the same way as a fully negotiable bearer bond in relation to a third party acquiring an equitable interest, but that would only be relevant if that third party managed to acquire it in good faith and without notice of any competing interest (otherwise they just take subject to any earlier equitable interest in the normal way).
Digital proprietary securities
For digital proprietary securities, the legal statement proposes simply that you use a declaration of trust in place of a deed poll so the person who controls the token gets a beneficial interest in trust property.
There is a provision in the Law of Property Act which requires that a “disposition” of an equitable interest must be in writing and signed by the person making the “disposition”. There are arguments about whether this provision would be engaged but even if it is, the legal statement takes the view that the signatory requirement could be met by a private key and the code that would be produced would be in writing (this last bit goes further than the Law Commission‘s view from a while back that code which is not intended to be read by humans would not be “in writing”).
The challenges for digital shares are: the statutory requirements for registration; certification; and, transfer. The need for certification can be dispensed with in the company’s articles. The other two elements cannot be.
Currently any digital share platform needs to generate a “proper instrument of transfer” as required under the Companies Act because of the need to give something to HMRC for stamping. So, there are certain limits for the moment on how a system could be designed.
A permissioned blockchain system could work for a register of members (provided it could generate hard copies) but a permissionless one would be unlikely to since it would lack sufficient control.
What is a “legal statement”, anyway?
Sir Geoffery Vos MR had a clear precedent in mind when he first proposed that the UK Jurisdictional Taskforce (of the LawtechUK Panel set up by the Secretary of State for Justice) should publish a legal statement on the status of cryptoassets and smart contracts under English law in 2019.
The concept of “true and fair” has long been central to accounting in the UK but lacked a statutory definition. In the 1980s Leonard Hoffmann QC and Mary Arden QC gave legal opinions on the point. Over time, and by the courts adopting them, these opinions effectively became the law.
The original 2019 UKJT legal statement on cryptoassets has certainly delivered. It was first cited, a month after publication in a judgment which described the analysis as “compelling” and relied on it to decide that a proprietary injunction could be granted over a cryptoasset. Since then, it has made it as far as New Zealand.
Let’s hope the UKJT is just as successful with this very welcome second statement.