Law Commission report positions UK as a centre for digital asset disputes

At the end of June 2023, the Law Commission published its long-awaited report on digital assets.  At some 300 pages, it's not light reading but its conclusions set out a strong vote of confidence for the flexibility and creativity of the English legal system and its ability to address most legal issues arising in relation to digital assets. It is also a firm statement of intent for the inclusion of digital assets in the economy, describing them as "fundamental to modern society".

Digital-asset report digested

The five main takeaways from the Law Commission's report can be summarised briefly, but their impact is likely to be significant:

• The creativity and flexibility of English common law is sufficient to address most digital asset issues. Indeed, that flexibility and its approach of incremental, iterative development means it is a better legal tool than legislation to keep up with developments and remain "technology neutral".
• Limited statutory intervention is recommended to clarify potential uncertainties in the common law position. However, this would largely be to codify the existing developments in common law – such as to confirm and support the development of a third category of personal property rights.
• Digital assets are property but fall outside the traditional categories of "chose in action" (that is, rights) and "chose in possession" (that is, physical things). That "third category" thing should be recognised by statute to provide definitive, parliamentary authority to the existing view at common law.
• A new defence of ''good faith purchaser for value without notice'' specific to crypto tokens (and ''things in possession'') more generally should be introduced. This would bring the defence in-line with other property types. This will be of particular relevance to crypto exchanges whose wallets are involved in the tracing of fraudulently taken digital assets.
• The government should establish a new panel of cross-industry sector-specific experts.

Strength of common law, supported by statute

The report continues to demonstrate that England is a leading jurisdiction for digital assets, including crypto. English courts have been willing to show flexibility and creativity to deal with digital asset-related issues in the recent past. It is the flexibility of the English common law system that the Law Commission believes should remain at the forefront of the development of law in relation to digital assets.

Nonetheless, the Law Commission does recommend that Parliament place certain aspects on a statutory footing, legislating to make the law more certain.

In particular, the report recommends the recognition of a new category of ''thing'', the so-called ''third-category thing'' to sit alongside ''thing in action'' and a ''thing in possession''. This would make clear that this category can attract property rights (and thus benefit from all the rights which attach to property).  

While this is already the case at common law, the Law Commission recommends placing this on a statutory footing. In doing so, it was at a pains to state that this new category should not be limited by strict definitions. It also makes clear that the ''thing'' no longer need to consist of data, which is a welcome and pragmatic development.

Secondly, the report recommends the development of a new regime for collateral arrangements which involve digital assets, and specifically, crypto-tokens and assets.

It recommends that the government create a cross-industry panel of industry experts (technical experts, legal practitioners and the judiciary) to produce non-binding guidance. In doing so, it hopes to better facilitate crypto arrangements at every stage of transaction through to enforcement.

New crypto-exchange defence

Crypto exchanges will no doubt be pleased to see the recommendation that a new common law special defence of ''good faith purchaser for value without notice'' applicable to crypto tokens (and third category things more broadly) should be developed. The timing of this will be particularly welcome in light of a host of recent case law.

In relation to this more generally, industry practice amongst crypto exchanges is to pool crypto assets on a non-designated basis. In a recent decision of the English High Court, the crypto exchange, Binance successfully challenged an injunction, which had been ordered against it on an interim basis, by arguing that it was a "bona fide" purchaser of the transferred assets and, therefore, had no liability to the claimant.

While this was no doubt a welcome development on the part of crypto exchanges, it's not clear how this method, in the event of an insolvency of the exchange, could adequately protect consumers.  In the absence of proprietary rights, customers will rank as unsecured creditors; but, even where co-mingled assets are held on trust for multiple customers, there is legal uncertainty as to how many "shortfall" should be allocated.

Perhaps with an eye to this, the Law Commission has drawn a distinction between “custodial intermediated holding arrangements”, “non-custodial intermediated holding arrangements” and “non-holding arrangements” based on the legal consequences of such arrangements. In doing so, it highlights the potential risk faced by ''users of intermediated holding arrangements'' in the event that a crypto exchange were to enter insolvency proceedings.

In an attempt to address this risk, it considered – but did not recommend – a general pro rata shortfall-allocation rule in respect of commingled unallocated holdings of crypto tokens or crypto-token entitlements held on trust by a custodial holding intermediary that enters insolvency proceedings.  That is, the shortfall should be borne by all customers, in proportion to the overall size of their claim in insolvency.

While this is a practical and pragmatic approach to resolving these issues, in the absence of legal clarity, it is also not clear that such an approach would, in practice, provide adequate protection to retail consumers.

Osborne Clarke comment

The government will need to consider the report and decide which recommendations to take forward – but the time period for this remains uncertain. However, the report is thorough in its analysis and, as with the UK Jurisdiction Taskforce's Legal Statement on the Status of Cryptoassets and Smart Contracts, published in 2018, it is likely to hold significant sway with the courts (or provide an essential tool to those making submissions in those courts!)

The recommendation of the creation of a panel of industry experts to help guide the government and judiciary is welcome.  At the core of this analysis must be the question of how co-mingled cryptoassets are dealt with when crypto exchanges enter into insolvency. While the ''general pro rata shortfall'' would provide a level of certainty and ease of practical application, further consideration will be required to ensure it is consistent with the law and adequately protects consumers. It will be interesting to see how regulators and the government responds to this recommendation.

If you have any questions or issues relating to the legal status of, or disputes over, digital assets, speak to one of our experts.