In case you were wondering what to add to your summer reading list, the Law Commission yesterday published its final report on digital assets. The full report weighs-in at a hefty 304 pages, accompanied by a shorter 21 page summary. We outline the key points in this Crypto View special.
The final report follows the wide-ranging consultation paper published by the Law Commission last summer. Generally, the final report makes relatively few recommendations for statutory reform, with the Law Commission preferring instead to rely on the flexibility of English common law (supported by non-binding guidance from a proposed panel of technical experts). The report is testament to the progress made in English private law in recent years, with several important issues now appearing relatively settled. There are notable exceptions, though, particularly the proposals to amend the Financial Collateral Arrangements (No 2) Regulations 2003 (the 'FCARs') and the broader need to further investigate collateral arrangements involving digital assets.
So, what does the final report say? Our highlights are set out below:
1. Digital assets are a 'third category' of personal property, but statutory clarification is recommended
The Law Commission maintains its view that, under English common law, digital assets are capable of being things to which personal property can relate. However, digital assets do not easily fall within the two pre-existing categories of personal property -- namely 'things in possession' (tangible objects) or 'things in action' (capable of being enforced by legal action). As such, the final report confirms that digital assets should be considered a 'third category thing'.
The Law Commission nevertheless recommends statutory reform in this area, albeit only to support the existing common law position. The nature of any reform is intended to be limited, aiming only to confirm that a thing will not be deprived of legal status as an object of personal property rights merely be reason of the fact that it is neither a thing in possession nor a thing in action. This is designed to avoid 'hard boundaries' that may arise if a specific definition is set out in legislation. The 'third category' may also capture non-digital items of personal property, such as carbon emission allowances.
2. The indicia of 'third category' things have been revised
The final report sets out the Law Commission's revised view of the indicia that must be met in order for a thing to fall within the new 'third category' of personal property. This modifies some of the indicia proposed in its earlier consultation paper, namely that a thing should be capable of falling within the proposed 'third category' if:
It is composed of data represented in an electronic medium, including in the form of computer code, electronic, digital or analogue signals;
It exists independently of persons and exists independently of the legal system; and
It is rivalrous.
In its final report, the Law Commission suggests that the 'composed of data' element need not be a criterion in itself, but has retained the other two indicia with certain clarifications (in light of the responses to the consultation paper).
3. Control remains a critical concept for digital assets, and a panel of technical experts should be convened to provide guidance
The Law Commission's earlier consultation concluded that the factual concept of control best describes the relationship between digital assets and persons. The final report describes factual control and its legal consequences in further detail, explaining some of the complexity that arises in a digital assets context. One of the key related conclusions drawn by the Law Commission is that:
"...factual control (plus intention) can found a legal proprietary interest in a digital object [and that] in certain circumstances such a control-based legal proprietary interest can be separated from (and be inferior to or short of) a superior legal title."
In light of the complexity associated with control, the Law Commission recommends that the Government establishes a panel of technical experts to provide non-binding guidance on factual and legal issues relating to control (and other issues relating to digital asset systems and markets more broadly).
4. The 'persistent thing' approach to transfers claims ground
On-chain transfers of digital assets may be conceptualised in two opposing ways: one referred to as the 'extinction/creation' approach (where, as a result of the transfer, the original digital asset is extinguished and a new digital asset is created) and another referred to as the 'persistent thing' approach (where the original digital asset continues to exist following a transfer).
In its final report, the Law Commission decided against siding with one approach over the other, instead suggesting that there is 'no single correct answer'. The final report does, however, outline a number of arguments (submitted by consultees) that suggest the 'persistent thing' analysis is more practically accurate. This seems to put both approaches on a more level pegging than in its earlier consultation paper, where the Law Commission preferred the extinction/creation approach.
5. An off-chain change in control can effect a legal transfer of digital assets
Another issue relating to the transfer of digital assets concerns whether a transfer operation that effects a state change on the relevant digital ledger was a necessary (but not sufficient) condition for a legal transfer of digital assets. This was the approach put to consultees in the Law Commission's earlier consultation paper, alongside an alternative wider condition based on the concept of a change of control.
In its final report, the Law Commission agreed with consultees that an 'on-chain' transfer should not be the only route to effecting a legal transfer. As such, the Law Commission concluded that it is possible (with the requisite intention) to effect a legal transfer of a digital asset 'off-chain', by a change of control. An example might include the physical transfer of control through handing hardware to the transferee.
6. The special defence of good faith purchasers for value without notice should apply to transfers of digital assets (but on a common law basis)
In its earlier consultation paper, the Law Commission provisionally proposed that a common law special defence of good faith purchaser for value without notice should apply to on-chain transfers (in the same way it applies to traditional money and negotiable instruments), and that such a defence should be codified in statute.
In its final report, the Law Commission changed tack, concluding that although a special defence should be possible:
It should be available to off-chain transfers involving a change of control, as well as on-chain transfers; and
It should be recognised and developed by the courts through incremental development of the common law, rather than being codified in statute. This is largely driven by the desire to avoid 'hard definitions' on which any statutory innocent acquisition rule could be based.
7. Terminology matters: Intermediated holding arrangements
Custody arrangements in respect of digital assets were one of the key themes in the Law Commission's earlier consultation paper. In its final report, the Law Commission refines the terminology it uses and draws a distinction between three different types of intermediated holding arrangements (based on the legal consequences of the different arrangements).
The three categories are:
Custodial intermediated holding: An arrangement under which users retain superior legal title or equitable title to the assets or entitlements to assets held on their behalf or for their account (most likely structured as trusts). In the event of the custodial holding intermediary entering an insolvency process, these entitlements would ordinarily not form part of the holding intermediary's estate and would not be available to meet the claims of its general creditors.
Non-custodial intermediated holding: An arrangement under which the holding intermediary acquires (or retains) superior legal title to the assets or entitlements to assets that they hold (or acquire) on behalf of or for the account of users. Under this model, users have primarily personal contractual claims to the return of assets equivalent to those held. In the event of a non-custodial holding intermediary entering insolvency proceedings, these claims would consequently rank as unsecured claims only and would give rise to no priority right of recourse to any specific crypto-tokens or token entitlements.
Non-holding services: Other technology and operational services related directly or indirectly to the safeguarding or administration of crypto-tokens or crypto-token entitlements that do not involve a service provider holding those crypto-tokens or crypto-token entitlements on behalf of or for the account of others
8. Intermediated holding arrangements in relation to digital assets can be characterised and structured as trusts
Another custody-related issue that arose in the initial consultation paper concerned how contract and trust law applies to intermediated holding arrangements in relation to digital assets. In its final report, the Law Commission concluded that certain intermediated holding arrangements can be structured as trusts under existing law (subject to meeting certain criteria), even where the underlying digital assets 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 holding intermediary itself. In line with its earlier analysis, the Law Commission concluded that the best way to understand the interests of beneficiaries under such trusts are as rights of co-ownership in an equitable tenancy in common.
Three related interventions that had previously been mooted were not carried forward as recommendations in the final report. Instead, the Law Commission concluded that:
A presumption of trust for intermediated holding arrangements involving digital assets is not necessary or appropriate (although this may be addressed by regulators separately).
While it remains in favour of a general pro rata shortfall allocation rule in respect of commingled unallocated holdings of digital assets or entitlements held on trust by a holding intermediary that enters insolvency proceedings, reform in this area should be dealt with separately (likely in the context of broader insolvency law reform).
Amendments to Section 53(1)(c) of the Law of Property Act 1925 (which prescribes certain formalities for the disposition of equitable interests) are no longer necessary, on the basis that any potential uncertainty has been addressed by the UK Jurisdiction Taskforce's recent work on digital securities.
9. . ...but other legal structures for intermediated holding arrangements may develop
Notwithstanding the view that trusts over digital assets are possible, the Law Commission leaves open the possibility that the common law will develop to support novel, alternative legal frameworks for custodial intermediated holding arrangements. The Law Commission concludes that:
"...recognition of a control-based legal proprietary interest could provide the basis for an alternative legal structure for custodial intermediated holding arrangements in addition to trusts. This could take the form of holding intermediaries being recognised as acquiring a control-based proprietary interest in held crypto-token entitlements that is subject to a superior legal title retained by users."
10. We need to talk about collateral
As expected, the Law Commission has confirmed in its final report that title transfer and non-possessory security interests (mortgages and charges) can be used in digital assets collateral arrangements without the need for reform. And by contrast, that possessory security interests pose problems in the context of digital assets, noting that it might be possible (and beneficial) for control-based security interests to be recognised and developed.
The Law Commission has, however, identified certain issues associated with collateral arrangements under English law, particularly when seeking to apply the FCARs to certain digital assets. The issue here is partly one of scope, as many digital assets are unlikely to fall within the definitions set out in the FCAR at present. The Law Commission recommends amendments to the FCARs to take account of this concern -- including changes to:
Clarify the extent to which, and under what holding arrangements, certain digital assets can satisfy the definition of cash; clarify the extent to which and under what holding arrangements crypto-tokens, cryptoassets (including CBDCs and fiat currency-linked stablecoins) and/or mere record/register tokens can satisfy the definition of cash;
Confirm that the characterisation of an asset that by itself satisfies the definition of a financial instrument or a credit claim will be unaffected by that asset being merely recorded or registered by a crypto-token within a blockchain- or DLT-based system (where the underlying asset is not "linked" or "stapled" by any legal mechanism to the crypto-token that records them); and
Confirm that, where an asset that satisfies the definition of a financial instrument or a credit claim is tokenised and effectively linked or stapled to a crypto-token that constitutes a distinct object of personal property rights from the perspective of and vested in the person that controls it, the linked or stapled token itself will similarly satisfy the relevant definition.
More pressingly, though, is the concern expressed by the Law Commission that the FCARs would not provide a satisfactory regime for collateral arrangements in respect of digital assets, even if its scope issues were addressed. The Law Commission consequently concludes:
"...that although the law of England and Wales does provide options for granting security in respect of crypto-tokens and cryptoassets, those options are not adequate. As such, we recommend 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 that better and more clearly facilitates the entering into, operation and enforcement of (certain) crypto-token and (certain) cryptoasset collateral arrangements."
11. Causes of action and associated remedies
The final report concludes that much of the current law concerning causes of action and remedies can be applied to 'third category' things without law reform. Instead, the Law Commission suggests that what is required is for the courts to continue to recognise the nuances and idiosyncrasies of 'third category' things, and to apply existing legal principles to such things as appropriate. Some nuances and improvements are identified, however (particularly given the unavailability of a claim for proprietary restitution, unjust enrichment or conversion following a defendant's burning of a claimant's crypto-token).
The final report will now be considered by the Government, which will consider whether and how to move forward with the Law Commission's recommendations.
Please do get in touch if you have any questions.
Note we have used the term 'digital assets' throughout the above for the sake of simplicity, but some of the Law Commission's analysis concerns crypto-tokens only (a more specific sub-category).
.jpg?crop=300,495&format=webply&auto=webp)
.jpg?crop=300,495&format=webply&auto=webp)
