The Law Commission’s consultation paper on digital assets (corporate law aspects) – Part 2

29 September 2022

In July 2022, the Law Commission for England and Wales launched its consultation proposals inviting comments and recognition for protection of digital assets (such as crypto-tokens, cryptoassets and non-fungible tokens (NFTs)).

In Part 1 of this article we covered (1) the suggested creation of a third category of personal property, and (2) how the concept of control, rather than the concept of possession, should apply to data objects.

In this article, we provide our readers with an overview on where the Law Commission’s proposals apply from a corporate law perspective. Some of the key aspects discussed are:

(1) What are identified as digital assets of a company?

(2) How should the transfer of digital assets be managed?

(1) What are digital assets of a company?

In its broadest sense digital assets of a company could mean all of its data represented in an electronic medium, such as forms of computer code, electronic, digital or analogue signals. The Law Commission describes assets as “data” where they have the ability of unique instantiation such that it takes on characteristics or attributes that make them function much more like objects instead of pure information. The term ‘instantiation’ in computer science refers to the creation of an object. Normally all crypto-tokens, crypto-currency, NFTs and other similar kinds of data would be considered as digital assets of a company as they possess an element of ‘instantiation’. The other constituent elements of data would be “rivalrousness” and “divestibility”, each concept previously explained in Part 1 of this article.

Digital assets in their nature are neither tangible nor intangible and do not neatly fit within the traditionally recognised categories of personal property. This category of assets is intended to be wider than “cryptoassets” and could include anything from in-game avatars, electronic signatures, cryptography, smart contracts, and distributed ledgers to a company’s shares. Traditionally assets are considered as either things in possession or things in action, but the Law Commission now proposes creating a third category of assets to capture digital assets.

The criteria attaching to this third category are evolving and its definition was discussed in detail in Part 1 of this article. Relying on that interpretation, we think that any assessment on the identity of corporate digital assets should be a nuanced consideration of new, emergent, and idiosyncratic things which would not otherwise be captured as assets. As the law develops further, an analogy between things in possession or things in action, would be on a case by case basis to establish a settled position. There is sufficient flexibility within the suggested premises of the Law Commission paper to indicate that even where one of the technical features of a digital asset are limited or removed, they may still be classified as a “data object” and fall within the overall ambit of the law.

(2) How should the transfer of digital assets be managed?

Recent publications by UNCITRAL Model Law on Electronic Transferable Records, University of Cambridge papers, Lawtech Delivery Panel’s UK Jurisdiction Taskforce Legal Statement on crypto assets and smart contracts (November 2019) (the “UKTJ Statement”), UNIDROIT Digital Assets Working Group and various other international regulatory authorities have helped build an evolving consensus on the transferability issue. Collating various views, and now along with the Law Commissions’ paper, we have noticed a common theme emerge which we have discussed below.

To transfer any asset legally two critical elements would always need to be established by a transferor, i.e. title to asset and capacity to contract (discussed further below). Assuming that property rights in digital assets can be established (which in the UK they have been such since 2019), transfer of digital assets should be possible.

Currently there is no standardised method for transferring an electronic record of a digital asset, so developments in that area may be built on the equivalent existing framework of transferable instruments (e.g. stock transfer forms, title documents, acquisition agreements etc.).

Like assets documented on paper, a transfer instrument for a digital asset may mirror similar legal obligations e.g. smart contracts transferring a digital asset may entitle a transferor to cash/non-cash consideration, and a transferee to claim performance of an obligation (such as instantaneous updating of digital record). However, the Law Commission paper notes that crypto-tokens are transferred in an idiosyncratic manner so it’s not possible to have a one box fits all approach. We think that eventually digital assets may have different methods and instruments of transfer used to transfer legal title so as to capture all digitality associated with tangible and intangible assets.

Any method used to transfer digital assets would only be reliable if it (a) identified the “transferable” element of the electronic record associated with that digital asset, (b) identified the person who has control of that electronic record (from its creation until its transferred/ or ceases to exist) and (c) retains the integrity of that asset within that duration.

The Law Commission paper suggests that it is the element of “control” that may be possible to establish in legislation and currently common law per se already applies for determining control of data objects.

The transferable essence of digital assets is perhaps best captured by its characteristic feature of tokenisation. In computer science, a “token” means a programming object that represents the ability to perform an action in a software system. In law, the word usually connotes a tangible object. Cash is a “token-based payment system” because banknotes and coins are “tokens” of rights against the central bank. In a nutshell, tokenisation enables that economically and legally the most important features of an asset are recorded, and that a written record deals with the rights that embody the underlying asset. Conventional forms of asset securisation rely on the same concept for transfer of an asset.

Title to digital assets

The title requirement to contract is based on the basic rule in relation to title in English law that no one can give away what they do not have. This rule plays an important role with digital assets as their idiosyncratic nature of transfer affects their title differently from normal goods, meaning that for digital assets each on-chain transfer creates a new property with a new title and a new digital record.

With digital assets that are expressed as tokens their transfer of title occur by means of updating the relevant ledger, which is more analogous to existing systems for assets such as uncertificated (dematerialised, scripless) securities than to transfers of cash, which involve a change of physical possession.

The Law Commission paper proposes that a crypto-token–based register could also be established by legislation, which would determine the strength of the evidentiary power of the record and any transfer formalities.

Additionally the Law Commission also provisionally proposes an explicit clarification that the special defence of good faith purchaser for value without notice should apply to crypto-token transactions. This  common law defence was generally available only to cash money transactions (as it granted legal title to a transferee who purchases “property” for value in good faith without notice of any other party’s claim against that property). The characterisation of crypto-tokens as money is currently the subject of various other debates.

Capacity to contract for digital assets

A transfer made by a person who had limited legal capacity would be void or voidable, depending on the nature of the limited capacity. If it were void, the starting point would be that the transferor would retain their legal title to the thing. If it were voidable, then the legal title would pass to the transferee, but the transferor might be free to rescind the transfer and cause the (superior) legal title to the object to revert to them. Therefore the starting point for the acquisition of a digital asset would be to consider if the transferor has the capacity to transfer it at all, and then also under what form could this be done to allow for void/voidable aspects of the transfer to take effect if necessary. The complications arise at this stage, as digital asset records are permanent so the technology for undoing their transfers for want of limited legal capacity does not exist.

The Law Commission paper also draws on the explanations in the UKTJ Paper on smart contracts to suggest these can be used as contracts to record the transfer of a digital asset.

There is no precise definition of smart contracts so we have analysed various interpretations to simplify the meaning for our readers. A smart contract is a contract whose terms are recorded in a computer-readable form, i.e. in code. Its notable feature is that it is performed, at least in part, automatically and without the need for, and in some cases without the possibility of, human intervention.

Smart contracts are coded as embedded within a networked system so that when the requisite consents are in place, those contracts are automatically executed and performed using the coded techniques (like cryptographic authentication, distributed ledgers, decentralisation, consensus) as we discussed above under tokenisation.  This means there is strictly no need for a counterparty to either promise performance or to resort to the law to enforce a specific promise by another: the computer code will do as programmed.

We expect that over time the legal mechanisms for constituting smart contracts will gradually become more uniform as the crypto-token markets mature. In fact the Law Commission has already initiated a start on this, suggesting a relaxation in the rules in respect of transferring property to accommodate the transfer of crypto-tokens.

Comment

The Law Commission has taken a more open-minded approach focusing on solutions for digital assets, recognising that innovation may be necessary if the full range of digital assets and crypto assets are to be accommodated within the UK legal framework.

Eventually law reform will be needed to bring digital assets satisfactorily within a settled legal position. Although at this time the Law Commission concluded that no particular legislation be introduced, they have taken into account the evolving crypto technologies and made some meaningful suggestions to facilitate the natural adoption of digital assets in common market practices.

Market participants are encouraged to respond to the Law Commission’s consultation by Friday 4 November 2022. A full list of the Law Commission’s consultation questions is at pages 468 to 482 of the consultation paper here.

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