UK: Law Commission Publishes Final Report On Digital Assets

On 28 June 2023, the Law Commission of England and Wales published its highly anticipated final report on digital assets following its consultation with industry stakeholders (see this summary of the final report). The comprehensive and wide-ranging report stresses that 'digital assets are fundamental to modern society and the contemporary economy', 'used for an expanding variety of purposes' and 'in growing volumes'. It makes few recommendations for actual law reform, concluding that the common law developed through individual cases is sufficiently flexible and able to accommodate most of the legal complexities posed by digital assets (which the report recognises is a very broad term covering very different assets and technologies). The Commission hopes that the analysis in the report will inform the development of the common law.

The Commission takes a three-pronged approach, proposing:

1. Common law development where possible.
2. Targeted statutory reform, which should be designed to confirm and support existing common law or address matters where common law development is not realistic.
3. The creation of a panel of industry-specific experts (expert panel) tasked with issuing nonbinding, technology-specific guidance to support the development of both common law and statute.

Below we summarise the report's key conclusions and recommendations for businesses operating in the digital asset space, with a particular focus on proposals that affect the crypto world.

What, legally, is a digital asset? A 'third category of thing'

As the report notes, '[p]ersonal property rights are vital to social, economic and legal systems'. The law of England and Wales traditionally recognises two categories of personal property rights:

• 'Things in possession' (i.e., tangible things – such as a car).
• 'Things in action' (i.e., legal rights or claims enforceable by action – such as a debt).

Most digital assets do not fall squarely within one of these two existing categories, meaning it is not always clear that these digital assets can be 'things' to which personal property rights can relate and attach. This can be relevant to rights and obligations in various legal contexts.

To resolve this issue, the report recommends that legislation should confirm digital assets as a third category of 'thing' that attracts personal property rights. However, the report contemplates that the boundaries of what falls into this new third category will be developed through case law. The Commission's fear is that attempting to legislate for a precise definition would mean that the law could not adapt to changing technological developments.

Control

The report considers the concept of 'control' of digital assets. Factual control means the ability to exclude or permit access to a digital asset – and to put it to use. The legal consequences of control are complex and varied. As this is highly technology-specific, the Commission recommends that the common law should be developed to govern the variety of possible ways in which assets are controlled. The Commission also recommends that the proposed expert panel should issue guidance on the complex and evolving factual and legal issues relating to control of digital assets, as well as guidance on how to transfer ownership effectively.

Transfer

When a crypto-token is transferred on-chain, what the transferee receives is not (technically) exactly the same thing as the transferor transferred (i.e., there has been a 'state change'). The report considers two opposing views as to the legal characterisation of such a transfer:

• 'Extinction/creation analysis': This concept recognises that what the transferee receives is not the same thing as what was transferred, because the record within the crypto-token system (i.e., the blockchain) is updated to reflect the transfer, creating a new factual state of affairs. A unit of the relevant digital asset, or sometimes a digital asset, is effectively extinguished and recreated.
• 'Persistent thing analysis': This concept asserts that exactly the same crypto-token persists through transactions (regardless of the changing recorded data).

The applicable concept can be highly relevant to legal rights and remedies arising in relation to digital assets. The Commission concludes that neither concept is the single 'correct' analysis – rather, both analyses are accurate in their own ways.

The report notes that it also is possible for legal transfers of crypto-tokens off-chain to be effected by a change of control (i.e., a change of factual control of crypto-tokens to another person).

The Commission concludes that the precise formalities for effective transfers of control should be addressed in relevant guidance from the expert panel noted above.

Intermediated holding arrangements

Intermediaries, such as cryptocurrency exchanges, often have custody of crypto for users. The report notes the lack of clarity within the crypto space regarding the meaning of the term 'custody'. The precise legal relationships can have a significant impact on the risks to which users can be exposed when using third parties to hold crypto. For example, who is the legal owner of an asset? That can matter enormously, for example, when a custodian of digital assets becomes insolvent. Can 'owners' claim digital assets to the exclusion of all other creditors, or are they available to satisfy the debts owed to all creditors? The Commission distinguishes between two types of arrangement:

• An 'intermediated holding' by a 'holding intermediary' (such as an exchange), which can be further subdivided into:
  • 'Custodial intermediated holdings' by custodial holding intermediaries – Here, users retain ownership of crypto-tokens held on their behalf by intermediaries (i.e., superior legal title and/or equitable title), likely because the assets are held on trust by the intermediary for the user.
  • More commonly, 'non-custodial intermediated holdings' by 'non-custodial holding intermediaries' – Here, the intermediary acquires superior legal title to the crypto-tokens that they hold on behalf of users, typically pooling them with the crypto-tokens of other customers in omnibus accounts, with users retaining no ownership rights to specific assets but instead having a contractual right to the return of assets equivalent to those held on their behalf.
• Non-holding services – i.e., other technology services related to the safeguarding or administration of crypto-tokens that do not involve a service provider holding the crypto-tokens on behalf of or for the account of others.

The precise legal arrangement will depend on the circumstances, with the contract governing the relationship between user and custodian being of particular importance. The report concludes that there should not be a presumption that crypto-assets are held on trust. Although such a presumption might strengthen user protection and encourage more precise terms of use and service agreements, the Commission considers that it is more appropriate for this to be dealt with in a regulatory framework.

The Commission suggests that the best way to understand the interests of two or more beneficiaries under trusts is that they have proportional entitlements to crypto-tokens at the relevant network addresses.

Disputes and remedies

With one key exception, the Commission considers that the existing law provides an adequate framework to deal with disputes arising in relation to digital assets:

1. Contracts. Many relationships between entities dealing with digital assets are governed by contracts. Long-standing contractual concepts can be applied and developed to interpret and enforce such contracts, as well as issues arising in relation to the creation and operation of contracts.
2. Equity and trusts. Where digital assets are held on trust, the principles of equity developed by the common law are sufficiently flexible to be applied to issues and disputes that arise. For example, those holding assets on trust will owe fiduciary duties to users and can be subject to claims for breach of those duties. The Commission concludes that the common law should be able to evolve in a logical and clear way to apply to digital assets.
3. Claims arising from the misappropriation of digital assets, fraud or insolvency. There have been a significant number of claims against exchanges and entities within the crypto landscape arising from fraud or insolvency, as well as against fraudsters themselves. These cases have been exploring what causes of action are available and the circumstances in which claims can succeed. Key issues include:

• Following and tracing: Victims of fraud often need to 'trace' or 'follow' misappropriated assets as, for example, they are transferred between accounts (stolen funds) or converted from one form to another (a car that is stolen and sold for cash or exchanged for other assets).
  • Banks usually have a defence to similar claims in relation to fiat transactions – unless they were on notice of the underlying fraud because they are a 'bona fide purchaser for value without notice of the fraud'.
  • The Commission notes that a similar defence applicable to crypto-tokens should be recognised and developed by the courts through the development of common law. One of the important questions will be the extent to which recipients of crypto-assets are required to undertake due diligence on their source – and the scope of that due diligence.
• Types of claims: Causes of action often deployed in fraud claims – such as restitution, knowing receipt and dishonest assistance – will often apply in the context of digital assets.
  • However, the Commission concludes that claims for conversion (interfering with the personal property of another) are unlikely to succeed in at least one very material circumstance – namely, where a claimant's crypto-token is 'burned' without consent (i.e., sent to an inaccessible public address to which the private key is unknown and removed from circulation.) The Commission recommends that this gap in the law should be addressed.

Collateral arrangements

The Commission summarises the circumstances in which crypto-tokens can be used as collateral (or security) under the existing law:

The Commission defines the three categories of crypto-goods as:

• Crypto-token is a 'composite thing which exists as a notional quantity unit manifested by the combination of the active operation of software by a network of participants and network-instantiated data'. Probably the most well-known crypto-token is bitcoin.
• Crypto-asset is a crypto-token that is '"linked" or "stapled" to a legal right or interest in another thing'. These are commonly called 'stablecoins' and will tie the value of the crypto-asset to a currency or other asset.
• Mere record/register tokens are crypto-tokens that act as a 'part of a register or record of entitlements to an underlying asset'.

The Commission concludes that crypto-tokens can be used as collateral in common law structures of collateral arrangements which do not rely on possession. Crypto-tokens are not considered things in possession (tangible), and therefore the asset being provided as security will not qualify under security arrangements which require possession. The Commission speculates that the 'third category of thing' concept, discussed above, might be sufficient to fulfil the legal requirements of a pledge.

When considering how crypto-tokens, crypto-assets and mere record/register tokens fit within existing UK collateral regulation, the Commission focuses on the Financial Collateral Arrangements (No. 2) Regulations 2003 (FCARs) which implemented the European Union Financial Collateral Directive and were meant to provide a system of categorising collateral arrangements based on security interest to allow for swift enforcement of any collateral interests.

Generally, the Commission concludes that crypto-tokens will likely fall outside the scope of FCARs, but it recommends legal reform to clarify whether crypto-assets and register tokens will be included within FCARs scope. Regardless of scope, the Commission concludes that FCARs are not an appropriate regulation for crypto-based collateral agreements.

The Commission makes recommendations for changes to FCARs that would remedy the issues of scope and seeks clarification of the term 'financial collateral' to take account of the variety of different crypto technologies, as well as the concepts of 'control' and 'possession' and how they apply in the crypto context. The Commission recommends this be done, as a matter of priority, through a governmental multidisciplinary project to create a statutory legal framework for crypto-token collateral arrangements.

The Commission suggests that the creation of a statutory legal framework for crypto-token collateral arrangements is necessary as a matter of priority.

Conclusion

As the digital landscape rapidly evolves, the Commission's report represents an important step toward addressing the challenges posed by the rapid evolution of digital assets. While the conclusions and recommendations seek to strike a balance between legal certainty and the flexibility to adapt to developing technologies, it remains to be seen whether they go far enough to resolve the complex issues that have arisen – and will continue to arise – in this area. The Commission's 'light-touch' approach to law reform will clearly be tested in the coming months and years with the growing number of disputes in the crypto space.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.