The Law Commission of England and Wales’ proposals would mark a significant step in the legal status of digital assets and a radical departure from centuries of legal precedent
The Law Commission of England and Wales has published a consultation paper (the Paper) on the recognition and protection of digital assets. The consultation, which ends November 4, 2022, focuses on the legal treatment of digital assets and recommends reform to create a third category of personal property – referred to as “data objects” – beyond things (or “selections”) owned ( z as physical objects) and things in action (like contractual rights).
The paper marks an important development in the field of digital assets, particularly in relation to its proposals regarding ownership and the transfer of data objects. In a recent speech, Master of the Rolls Sir Geoffrey Vos identified six key pillars a legal system must have to lay the foundation for distributed ledger technology (DLT). These are:
- legal certainty
- A dispute resolution process that takes into account how on-chain transactions take place.
- Procedural capacity of a legal system to handle disputes over digital transactions.
- A private law background that allows for the issuance and transfer of securities via DLT.
- Industrial and government familiarity with smart contract use cases.
- An appropriate regulatory environment. The Legislative Commission paper takes a step toward beginning addressing items one and four.
English law has demonstrated its flexibility in dealing with issues relating to digital assets in recent years. However, more targeted reforms that could bring additional legal certainty will be welcomed by the industry and will be an important step in the government’s broader strategy to make the UK a global hub for digital assets and related services.
How does the paper define data objects?
As mentioned above, the paper proposes the creation of a third category of personal property – data objects. The definition of data objects in The Paper is intentionally broader than cryptoassets (which it refers to as crypto tokens). To identify a data object, the paper proposes the following three criteria:
- Consists of data represented on an electronic medium, including in the form of computer code, electronic, digital or analog signals. A data object must be electronically recorded in some way. While data objects are stored on or transmitted through physical objects that are owned, the publication treats them separately from the objects through which they are stored or made available.
- Exist independently of persons and exist independently of the legal system. The paper proposes to distinguish data objects as things in action, since they exist, can be used and manipulated as long as the blockchain or other system on which they exist remains active (theoretically outside the formal scope of any legal system).
- Be rival. Something is said to be “competitive” if it cannot be used in an equivalent way by others at the same time. This is not to imply that it is unique or non-fungible. A key innovation of blockchain technology is finding a way to make electronic data competitive when it can otherwise be reproduced almost indefinitely at near-zero marginal cost.
The Law Commission has also proposed a definition of crypto tokens as a subset of data objects, which it has made available for comment on its GitHub page (as well as in the paper itself).
While the paper suggests either legislative or civil intervention for most of its other proposals, the Legal Commission on the subject has outlined the pros and cons of each approach without drawing a preliminary conclusion.
From ownership to control – what distinguishes data objects from other types of ownership?
The key concept for owning more traditional, tangible objects is “possession”. Though nuanced, possession involves elements of both control and intent over a physical object. Ownership of things in action (e.g. contractual rights) relies on the legal system for enforcement.
The paper suggests that this model does not fit data objects, where control in many cases is determined by control over cryptographic keys – hence the emergence of adages like “not your keys, not your bitcoin”. Rather than legislate what “control” means for data objects, the Legal Commission proposes that common law will be the primary ground for appropriate prominence, with courts possibly asking a multidisciplinary panel for assistance.
What does the paper say about rights associated with NFTs, stablecoins and other crypto tokens?
While the paper acknowledges that NFTs and cryptoassets sometimes purport to confer, prove, or embody rights off-chain or in the physical world, it notes that the tokens themselves cannot do so for legal reasons. These rights or representations are decisions in action that may be associated with the crypto token, such as a copyright license expressed from time to time for the benefit of the holder of a particular crypto token, rather than being data objects themselves.
There are several ways to create such a link. The strength and implications the paper suggests are likely to depend on a mix of market practice, contractual arrangements and common law developments. In the absence of other contractual, statutory or other arrangements, the paper suggests that crypto tokens used to create registers or records of external items are likely to be useful only as evidence and confer no rights themselves without legal intervention.
The Legal Commission considers this two-track structure to be sufficiently established and flexible and does not propose any reform in this area.
Transfers of Data Objects
Since the legal system is external to crypto token systems, the Legal Commission believes that the state of the relevant system (such as a distributed ledger or structured record) does not necessarily determine the (overriding) legal entitlement to a crypto token . Part of the reason for this is that such systems provide a factual rather than a legal record.
Another element of this distinction is that the system may not be able to display as many states as the legal system. Changing the mapping of a crypto token from one public key address to another may be contingent upon or derived from the full or partial transfer of a prior legal interest.
As a result, the Law Commission has tentatively ruled that existing ownership transfer rules can be applied to on-chain transactions, even if that transaction results in the creation of a new, modified, or related crypto token. The paper therefore proposes no legislative reform in this area, other than recommending that the law state that “equity’s darling” – the defense available to bona fide buyers against value and without notice – remains in place in relation to data objects.
Adopt security via data objects
Given the Legal Commission’s view that data objects cannot be owned, the paper asserts that ownership arrangements – such as pledges – cannot be used for crypto tokens. Conversely, crypto token holders can provide non-possessory collateral or enter into ownership transfer agreements such as mortgages and encumbrances. However, the Law Commission is examining whether it can make sense to develop tailor-made legal regulations for collateral agreements in relation to crypto tokens. As this would be a significant piece of work, the Legal Commission at this stage is only pointing out the problem and making no concrete proposal.
Bankruptcy of cryptoasset custodians
After the recent price falls of a number of crypto assets – and on a number of previous occasions due to hacks – crypto token custodians were sometimes left with insufficient crypto assets to meet their liabilities to users. How the remaining user assets are distributed among the users in such an insolvency situation depends on the financial situation under English law.
If the custodian holds the users’ crypto-assets on a purely contractual basis, ie without any trusteeship over these assets, then the users are unsecured creditors. These types of arrangements are common in yield farming and other arrangements where a custodian lends users’ cryptoassets for a consideration, while cryptoasset exchanges could also use this approach when acting as a custodian of user assets. This depends on the respective terms and conditions.
If a trust exists over the crypto tokens held by the custodian and the users’ claims are assigned individually (rather than a trust established over pooled assets), then the users whose property has been lost – through a hack, a bad debt or otherwise – bears the full damage.
The paper, meanwhile, suggests that legislative reform would be beneficial to clarify and simplify how losses fall when a trust exists across pooled or commingled tokens held by an insolvent custodian. The paper elaborates on whether and how such a trust might arise, considering several options and tentatively determining whether the rights of users should be spelled out in such an agreement as an equal shared tenancy.
Giving courts the power to award sums denominated in crypto tokens
Although English courts can make awards in government-issued currencies, they are not yet able to make awards denominated in cryptoassets. In certain situations, such as B. the insolvency of a crypto-asset custodian, the issuance of such an award may be more representative of a claimant’s loss. Given the fungibility and liquidity of cryptocurrencies and relatively low storage and delivery costs compared to commodities, the paper proposes reforming the law to give courts discretion in awarding “monetary” rewards based on specific crypto tokens ring.
What does the paper say about rights associated with NFTs, stablecoins and other crypto tokens?
For more information on rights attached to NFTs, see our IP in NFTs blog series.
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