Making a Difference – The Digital Assets Consultation Paper

“To recognise and protect the rights of users and maximise the potential of digital assets.” – The Law Commission

On 28 July 2022, the Law Commission of England and Wales (the “Commission”) published a consultation paper on digital assets (available here, the “Paper”) signalling the need for law reforms in several areas.

The Commission invites interested parties to submit responses to the questions posed by the consultation (at Chapter 20 of the Paper) by 4 November 2022.

The proposed reforms will be of broad interest to crypto-exchanges, platforms, token issuers and market participants, and include issues such as: ownership, the legal effect of transfers, collateral arrangements and custody arrangements (a particularly hot topic in the wake of recent liquidity and insolvency events surrounding a number of platforms and exchanges).

For those short on time to read all 549 pages of the Paper, we set out a snapshot of the key areas of proposed reform below.

Data Objects: A New Third Category of Personal Property

The central proposal for reform in the consultation is the establishment of a third category of personal property, provisionally called “data objects.”

Historically, the legal system of England and Wales has recognised two categories of personal property: (1) “things in possession” i.e. physical assets such as gold; and (2) “things in action” i.e. property conferring legal rights such as a debt claim. However, digital assets do not easily fit into either of the existing categories and the Commission strongly advocates for a third category of personal property so that the law is able “to take a principled, nuanced, and idiosyncratic approach to the legal treatment of new technology… without being fettered by legal rules developed specifically by reference to categories that are no longer exhaustive.”

The Commission proposes three key criteria in order for a “thing” to be characterised as a “data object”¹:

1. The object must be composed of data which is represented in an electronic medium such as computer code, electronic, digital, or analogue signals which is essential to distinguish between the third category of data objects and the first category of “things in possession.”
2. The object must exist independently of persons and exist independently of the legal system (so as to be distinguished from a “thing in action” and which the Commission consider would be excluded as a data object even if in digital form, e.g. a debt claim in electronic form).
3. The object must be rivalrous, meaning that the use of the data object by one individual would prejudice the ability of others to make equivalent use at the same time. This is a key distinguisher from mere information (which does not attract personal property rights) that can be reviewed by many simultaneously.

The Commission has provisionally concluded that while crypto-tokens would satisfy the proposed criteria for a “data object,” media files, program files, digital records, email accounts, in-game digital assets, (DNS) domain names, Carbon Emissions Allowances and most Voluntary Carbon Credits (VCCs) would not.²

Other Key Areas of Proposed Reform

The Paper also considers a wide range of other potential issues and proposals for reform concerning crypto-tokens, and we highlight some of the critical questions posed by the Commission below:

• Determining ownership of a data object³
  • Should ownership of a data object be determined by the concept of possession, or is the notion of “control” more apt? The Commission favoured the latter view, concluding that “control” would present greater sensitivity to the idiosyncrasies of data objects.
• The legal effect of transfers of crypto-tokens⁴
  • Is it possible to separate legal title from the state of the distributed ledger and/or factual control over a crypto-token? The Commission’s view is that the state of the distributed ledger should not necessarily be regarded as a definitive record of (superior) legal title to a crypto-token and that the concept of control will be an important factor in the overall analysis on whether a legal transfer has taken place.
  • Should crypto-tokens be treated as analogous to “goods” pursuant to existing consumer rights legislation?
  • When does title to a crypto-token transfer pursuant to a contract of sale?
• Custody arrangements for crypto-tokens⁵
  • Is it appropriate to distinguish between direct custody services (i.e. holding crypto-tokens on behalf of or for the account of other persons and having capacity to exercise, coordinate or direct the exercise of factual control) and custodial or other technology-based services that do not involve a direct custody relationship?
  • Should crypto-token custody arrangements be characterised and structured as trusts, even where the underlying entitlements are (i) held on a consolidated unallocated basis for the benefit of multiple users, and (ii) potentially even commingled with unallocated entitlements held for the benefit of the custodian itself?
  • How should beneficial interests in crypto-tokens be treated?
  • Is there a need to provide for a general pro rata shortfall allocation rule in respect to commingled unallocated holdings of crypto-tokens or crypto-token entitlements in a custodian insolvency?
• Causes of Action and Remedies⁶
  • Can existing causes of action (e.g. breach of contract, breach of trust, following and tracing, equitable wrongs, proprietary restitutionary claims and unjust enrichment) extend to data objects?
  • Do remedies such as injunctive relief require reform for data objects?
  • Can existing methods of enforcement be usefully developed and if so, how?

Areas Outside the Scope of the Consultation

While the consultation is comprehensive, there are several notable areas that are not presently covered, though regulation and/or legal reform is in the pipeline:

• The regulation of Stablecoins (i.e. cryptocurrencies that peg their market value by reference a particular asset, typically fiat currency such as the USD or GBP) is currently the subject of separate proposals in the Financial Services and Markets Bill that is currently going through the House of Commons.
• Conflict of laws: The global and decentralised nature of crypto assets gives rise to novel issues of jurisdiction and applicable law that will be the subject of a separate project by the Law Commission.
• DAOs (Decentralised Autonomous Organisations): the Law Commission has confirmed they will be the subject of a separate 15-month scoping study.

Blockchain participants and users operating in the EU will be mindful of the proposed EU reforms, namely (1) the Transfer of Funds Regulation, which proposed to extend anti-money laundering regulations to the transfer of crypto assets and; (2) the Regulation on Markets in Crypto Assets (MiCA), which seeks to bring crypto-assets, crypto-assets issuers and crypto-asset service providers under a single regulatory framework.

Comment

While the courts of England and Wales have been willing to apply existing legal principles flexibly to accommodate digital assets (including in numerous recent crypto-fraud cases), the nuanced nature and novelty of digital assets means that the existing legal system does not in all cases provide users with necessary protection or certainty. That said, a careful balance must be struck so that law reforms do not stifle important development and innovation in this area. The Commission has emphasised its aim of creating “a strong legal framework that offers greater consistency and protection for users and promotes an environment that is able to encourage further technological innovation.”⁷ Given the significant and rapid innovation in the crypto-sphere and the broad diversification of digital assets and novel concepts, interested parties are encouraged to respond to the consultation in order to have their say and help shape the law in this area.

In our view, the areas outside of the scope of the consultation will also be critical issues to resolve, particularly surrounding conflict of laws and uncertainty as to jurisdiction given issues arising as a result of the global and decentralised nature of digital assets. However the Commission’s proposal to create a separate categorisation for digital assets is a welcome and necessary step in the right direction.

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¹ Paragraph 4.101 of the Paper
² Ibid, paragraphs 6.52, 6.62, 6.68, 7.31, 7.59, 8.26, 9.22 and 9.45.
³ Chapter 11 of the Paper
⁴ Chapter 13 of the Paper
⁵ Chapter 16 of the Paper
⁶ Chapter 19 of the Paper
⁷ Professor Sarah Green, the Law Commissioner for Commercial and Common Law: https://www.lawcom.gov.uk/law-commission-proposes-reforms-for-digital-assets-including-crypto-tokens-and-nfts/