The Law Commission for England and Wales has published its recommendations for reform of the law on “digital assets”, covering digital files, digital records, email accounts, domain names, in-game digital assets, digital carbon credits, crypto-tokens/cryptocurrencies and non-fungible tokens (NFTs).

The Law Commission’s project reflected concerns that some digital assets do not fit readily within traditional categories of personal property and that there should be a new “third category” of personal property.

The Law Commission report suggests a three-part approach:

1. Common law: rely on the flexibility and resilience of the common law as the principal mechanism for law reform. The Law Commission considers that the law of England and Wales has proven itself capable of recognising many digital assets as things to which personal property rights can relate, but that statutory intervention would be required in a few highly nuanced and complex areas;

2. Targeted statutory intervention: to address those areas of residual uncertainty the Law Commission recommends targeted statutory law reform. This would include:
   • the establishment a new category of personal property to accommodate digital assets that are not easy to place within traditional categories of things to which personal property rights can relate. This new category would be distinct from a ‘thing in possession’ (e.g., a car) or a ‘thing in action’ (e.g., a debt) and would become a third category thing (e.g., a crypto-token); and
   • 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.”

3. Industry guidance: the Law Commission recommends that the Government creates or nominates a panel of industry-specific technical experts, legal practitioners, academics and judges to provide non-binding guidance on the complex and evolving factual and legal issues relating to control involving certain digital assets (and other issues relating to digital asset systems and markets more broadly). The Law Commission’s view is that such detailed and technology-specific guidance would facilitate clear, logical and consistent applications of legal rules and reasoning over time.

“Third category” things or “digital objects”

The Law Commission report recommends statutory confirmation that a thing will not be deprived of legal status as an object of personal property rights merely by reason of the fact that it is neither a thing in action nor a thing in possession. While that statute would confirm that a “third category” thing is capable of being an object of personal property rights, it would not define the hard boundaries of what falls within that third category. Instead, the common law would determine whether a particular thing properly can (and should) be regarded as a “third category” thing.

Crucially, the “third category” would not necessarily be limited to digital things and could include things like milk quotas or certain carbon emissions allowances. Consequently, the Law Commission refers to digital things falling within the third category as “digital objects”.

Proposed reform of the Financial Collateral Arrangements (No 2) Regulations 2003 (FCAR)

Although falling outside the project’s direct scope, the Law Commission recommend statutory amendment of the FCARs:

• to clarify the extent to which, and under what holding arrangements, crypto-tokens, cryptoassets and/or mere record/register tokens can satisfy the definition of cash, including potentially by providing additional guidance as to the interpretation of “money in any currency”, “account” and “similar claim to the repayment of money”;
• to 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
• to 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.

Key conclusions on current law

In addition to its recommendations for law reform, the report sets out conclusions stemming from the Law Commission’s analysis of the law relating to digital assets. Those conclusions are:

• factual control (plus intention) can found a legal proprietary interest in a digital object. We conclude 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;
• it is possible (with the requisite intention) to effect a legal transfer of a crypto-token offchain by a change of control or onchain by a transfer operation that effects a state change;
• a special defence of good faith purchaser for value without notice applicable to crypto-tokens can be recognised and developed by the courts through incremental development of the common law. This reasoning can also be extended to other third category things;
• under the law of England and Wales, crypto-token intermediated holding arrangements can be characterised and structured as trusts, including where the underlying entitlements are:
  • held on a consolidated unallocated basis for the benefit of multiple users, and
  • potentially even commingled with unallocated entitlements held for the benefit of the holding intermediary itself.
• 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;
• 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; and
• that it would be constructive for the courts to develop specific and discrete principles of tortious liability by analogy with, or which draw on some elements of, the tort of conversion to deal with wrongful interferences with third category things.

Next steps?

It is now for the UK Government to decide whether it intends to take our recommendations forward. By way of encouragement, the Law Commission points out that its recommendations for reform and common law development “aim to create a clear and consistent framework for digital assets that will provide greater clarity and security to users and market participants”. The recommendations also support the Government’s goal of attracting technological development to cement the position of England and Wales as a global hub for crypto-tokens and crypto-assets.

Disclaimer: While every effort has been made to ensure that the information contained in this article is accurate, neither its authors nor Squire Patton Boggs accepts responsibility for any errors or omissions. The content of this article is for general information only, and is not intended to constitute or be relied upon as legal advice.