Control is Key: The Key is Control

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Jacqueline Cook, Of Counsel and Luna Owen, Trainee of Sullivan & Worcester’s Trade & Export Finance team, comment on the “Digital Assets: Consultation Paper 256” published by The Law Commission.

1. Radical proposal to reform English property law

The Law Commission’s “Digital Assets: Consultation Paper” (Consultation) proposes a radical change to English law by suggesting there should be a new category of property assets labelled Data Objects for digital assets which do not seem to fit into the existing English law categories of personal property. Currently, digital assets may be recognised as rights, some intellectual property rights and others intangible contractual rights.

The digital assets workstream is part of a larger review of the legal landscape and its relationship with the virtual world. The Consultation goes hand-in-hand with the work on the Electronic Trade Documents Bill, to be known as the Electronic Trade Documents Act once it has received Royal Assent which is expected later this year.[1]

2. Complex legal concepts and the virtual realm

Over time, the English courts have set out certain characteristics to help identify an asset as an item of property, namely: identifiability; rivalrousness; excludability; separability; and value. [2] Many of these seem to be different aspects of what we would consider to be the key for asset ownership: control. English law has concepts for tangible assets, and now these are being adapted and tested for a new form of assets, digital assets.

The discussions in the Consultation around the complexities of demonstrating ownership, commercial viability, access to the rights for digital assets are not unfamiliar, as similar discussions were involved during the consultation for the Electronic Trade Documents Bill, covering the likes of electronic bills of lading and promissory notes.

3. Data Objects

The new radical category, Data Objects, aims to catch assets which do not fall neatly within the categories of ‘thing in possession’ (for tangible property, e.g. land or a commodity), or ‘thing in action’[3] (usually used for intangible assets such as rights enforced through the legal system e.g. a debt). The English courts have started to flex the meaning of ‘thing in action’ in an attempt to accommodate some digital assets with some success. However, the Law Commission proposes three criteria to identify a digital asset as a Data Object. The following criteria could be used for existing and future novel digital assets:

  • the data object must be represented in an electronic medium (intangibles held either by computer code, electronic, digital or analogue means);
  • the data object must have an independent existence (independent of both persons and a particular legal system, (i.e. the data may exist without the need to have someone who could enforce the Data Object); and
  • the data object must be rivalrous (i.e. it must be within the control of one person to the exclusivity of others).

Divestibility would be an indicator of whether a digital asset could be a Data Object but it would not be a strict requirement. The Consultation considers some of the following assets and whether they should constitute Data Objects; databases, crypto-tokens cryptocurrencies, non-fungible tokens, (NFTs), stablecoins, central bank digital currencies, digital finance and blockchain. Other examples explored include, milk quotas, EU carbon emissions allowances, export quotas and certain licences. However, in setting out its own analysis against the latter list of assets, the Law Commission has, in fact, taken the view that many of these do not meet the three criteria to qualify as Data Objects.

Effectively, Data Objects would mainly cover crypto-tokens. The term “crypto-tokens” according to the Consultation, encompasses cryptocurrencies, central bank digital currencies and NFTs. So, is it worth establishing a new category of personal property in law for a narrow class of assets? The proposal supports the UK government’s aim for the UK to be an international hub for digital assets. It is also supported by the Law Society, the City of London Law Society and the Financial Market Law Committee of the Bank of England as it would provide a principled, consistent approach with the knock-on effect that regulation, capital rules and tax provisions could follow by recognising that an increasing part of the UK economy is formed of virtual assets.

4. The Key is Control

Throughout the Consultation, the Law Commission flirted with the idea of adapting existing legal principles to cover the ownership of a Data Object, possession being the key principle. However, given the existing complexities relating to the principle of possession, and to avoid possession being a ‘jack of all assets and master of none’, the Consultation encourages mapping out a new concept for how a person can hold or have a Data Object. Therefore, as it turns out, the key to digital asset ownership is indeed control.

While control is an important feature of possession, it will be a key element in respect of Data Objects. According to the Consultation, in order to illustrate control over a Data Object, the asset must be capable of being sufficiently concentrated into a single person (or a group) and must be rivalrous. What this means in practice is that the person in control can (i) exclude others from the Data Object; (ii) put Data Objects to use, and (iii) identify as the person with the abilities in (i) and (ii).

How one excludes others from the Data Object is likely to be a digital solution in itself, for instance, by using a private key. Each platform or electronic system will have its own rules on how a private key is issued and if it is in fact transferred or re-issued, very similar to whether a Data Object is transferred or re-issued to a new owner or person having control. On the whole this will take the form of a code or an access code via portal.

5. What about collateral?

Both traditional lending and the newer decentralised financing (DeFi) could look at how NFTs, crypto-tokens and crypto-currencies could be harnessed as collateral to support borrowings, which the Law Commission recognises could be done under the current law to a point. What is crucial, in our view, is whether these assets would be financial collateral or not. If so, the Law Commission asks, whether Data Objects would fall within the current regime (which means such security interests do not need to be registered at Companies House), or whether there would need to be some amendment to the Financial Collateral Arrangements (No 2) Regulations 2003 to clarify the law.

The key again will be control: not control as the courts see it in relation to a fixed or floating charge, but control which is practical and identifiable in relation to Data Objects. Control from the point of view of the secured creditor may depend on the workings of the platform being used, or it may depend on access to the private key. Here, while title may not be transferred to the secured creditor on taking security, control over the Data Object would need to sit with the secured creditor as keeper of the private key to prevent any disposal of any kind or any other security interest being granted over it. Control should, therefore, exclude even the chargor from accessing the Data Object.

6. How will this be part of the future of trade finance?

The category of Data Objects it seems would not catch debt claims or receivables which would arise under contract, even if they are to be transferred or paid for by electronic means. The receivables will still be categorised as ‘things in action’ arising from a trading agreement between debtor and creditor. So, no change on that front.

But what would the position be if a crypto-currency is offered as a means of payment? What if NFTs are offered as collateral for short-term borrowings? What if a variety of crypto-tokens, e.g. central bank digital currencies, start to become an acceptable means of payment for commodities or are offered as collateral? Will English law provide the certainty needed to support trade and the trade finance market and to help it grow?

In our view, English law already has the flexibility to allow new digital products to develop, as some will be protected as intellectual property rights and others as intangible rights. Nevertheless, the proposals in the Consultation would certainly re-define English law by introducing a new category, Data Objects, and with it certainty and protection under the financial collateral regime.

7. Have your say!

Responses are sought by 4 November 2022, after which, the Law Commission will produce a report and any relevant draft legislation. You can access the Consultation online to submit your responses here.

[1] See the Sullivan & Worcester Trade & Export Finance team’s alert The Electronic Trade Documents Bill- it's on the agenda!

[2] See CP 256 for a summary of the current position under English law on how to identify a property object.

[3] Previously known as ‘chose in possession’ and ‘chose in action’.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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