Cryptoassets: a guide on key legal issues

Last month, in the case of AA -v- Persons Unknown and Others, Re Bitcoin, the English High Court granted an interim proprietary injunction over Bitcoin. In doing so, it gave detailed consideration to the legal status of the cryptocurrency, confirming in clear terms that “cryptoassets such as Bitcoin are property”.

The decision in Re Bitcoin follows hot on the heels of the “Legal Statement on cryptoassets and smart contracts” published in November 2019 by the LawTech Delivery Panel’s UK Jurisdiction Taskforce. The Legal Statement is the result of a collaboration by the UK Government, the English Judiciary and the Law Society, whose stated aim was to provide the “best possible answers” to key legal questions about smart contracts and cryptoassets.

It is significant that, within the space of two months, both the LawTech Delivery Panel and the High Court have concluded that cryptoassets are capable of fulfilling the definition of “property”, and if so, subject to English property law. The removal of the previously perceived uncertainty around the legal status of cryptoassets is expected to bring market confidence to the use of, investment in, and creation of new cryptoassets, particularly by institutional and regulated market participants. It is also likely to be followed by a spike in contentious cases and disputes involving cryptoassets relating to securitisation, insolvency, taxation, and succession as the legal community tests and refines the boundaries of this developing area of law.

The Legal Statement will have continued significance in both commercial and legal contexts. The analysis and Q&As set out within it will continue to be essential reading for commercial parties seeking to understand the legal framework applicable to investments and dealings in cryptoassets (particularly Bitcoin); and to the courts and legal representatives in resolving cryptoasset-related disputes.   

In their first article reporting on the Legal Statement Kate Allass (Farrer & Co) and Hazem Danny Al-Nakib (Sentinel Capital Group) summarise the answers reached by the LawTech Delivery Panel to the critical legal questions in this developing area. 

What is a cryptoasset?

To effect an electronic transaction in a traditional currency, parties must usually rely on third party financial institutions to execute and document the payment on their behalves.  Cryptoassets are used in alternative electronic payment systems which are underpinned by freestanding “cryptographic” proof of payment, rather than by trust in financial institutions.

Cryptoassets are the digital tokens which are or represent the assets being transferred between the parties. They can be hugely varied in form, ranging from purely notional payment tokens (such as Bitcoin (BTC)) to tokens which are “tethered”, linked/pegged to, or representations of conventional assets such as fiat currency, commodities, share capital, debt or land. 

The Panel identified that the distinctive features of cryptoassets are:

• intangibility: whilst cryptoassets may be linked to tangible assets, they are themselves virtual or digital in nature;
• cryptographic authentication: dealings in the cryptoasset require the use of a private cryptographic “key” to authorise the transaction. The person in possession of the key therefore has practical control over the asset (and it should therefore be kept secret);
• use of a distributed transaction ledger: dealings in cryptoassets are recorded on a digital ledger (such as Blockchain) which keeps a reliable history of transactions and prevents double-spending;
• decentralisation: the ledger recording the transactions is shared over a network, with no single individual or entity having responsibility for maintaining it. There is therefore no one central bank to regulate the system (or to step in if something goes wrong); and
• consensus rule: the rules governing dealings with the assets are understood by informal consensus, rather than through contract or other legally binding system.

What are the practical implications of cryptoassets being categorised as property?

1. Ownership: Cryptoassets can have an owner. Whilst the public ledger will usually reflect an asset’s ownership, it is not a definitive record of title as there can be a delay between a change in ownership and it being “broadcast” to the ledger. A more reliable indicator is therefore who has control of the private key relating to the asset; the person with knowledge of the key is generally understood to be its owner (although that may depend on the circumstances and the rules of the system). The Legal Statement supports this, suggesting that having the private key is tantamount to practical control or practical and physical ownership as opposed to legal ownership or title. The Statement also demonstrates, however, that so long as obtained legally, possession or knowledge of the private key may result in being considered the owner of the cryptoasset. As with conventional assets, that key may be held on trust or by an agent on behalf of others, and someone who has obtained the private key illegally (for example through hacking) would not be treated as the lawful owner.

2. Assignment: The ownership of cryptoassets can be transferred. Exactly how this happens will depend on the networked system’s rules (on which there are now many variations) but the Legal Statement considered the mechanics of assignment for two broad categories of transfer:

“On-chain” transfers: where the change in ownership is effected through the amendment of data contained on the transaction ledger (most commonly on the Blockchain). Typically, the transferor will amend the publicly accessible information about the asset on the ledger which creates a record of the transfer, including details of the transferee (their public key). That transaction is then authenticated using the transferor’s private key, and a new private key is generated which is linked to the transferee, giving the new owner effective control. When this happens a “new” cryptoasset is created in the case of Bitcoin, linked publicly and privately to the new holder of the private key with access to that cryptoasset, which is then broadcast on the public ledger as a transaction record.

“Off-chain” transfers: happens where parties enter into an agreement to transfer a cryptoasset but that agreement is not recorded in the transaction ledger. The Panel saw no reason why such an agreement, if drafted appropriately, would not be recognised and recorded, but recognised that this might cause practical difficulties – in particular that control of the private key would not effectively have been transferred rendering the cryptoassets inaccessible, creating an opportunity for the transferor to “double-spend” the asset by transferring it “on-chain” to a third party notwithstanding the existence of the “off-chain” agreement.

3. Governing law: The Legal Statement recognises the inherent difficulty of trying to allocate a governing law to intangible assets (which by their nature have no physical location) which are recorded and traded on decentralised systems specifically intended to have no single or fixed base and which operate across multi-jurisdictionally and digitally. It concluded that the normal rules should not necessarily apply and that the complex questions of governing law and jurisdiction will need to be addressed through legislation following international cooperation.

Until that happens, when considering whether English law applies, the courts will attempt to apply the normal rules by looking at whether there has been any agreement between the parties that a particular law will apply to the transaction, and the locations of (a) any off-chain assets or transfers; (b) any centralised control of the asset or the networked system; and (c) the location of the individual with control of the cryptoasset in question (or the location of the private key). This can become more complicated as changes to the governing consensus rules are made and novel forms are created, decentralisation is proven to not necessarily exist, and rehypothecation of cryptoassets of various forms becomes much more widespread.

4. Grant of security: The Legal Statement concluded that security can be granted through the creation of a mortgage or equitable charge over cryptoassets (in the same way as for other intangible assets). However, since cryptoassets cannot be physically possessed given they are virtual-only in nature, they cannot be the object of a pledge or lien. This is the case for cryptoassets which exist as a digital store of value such as Bitcoin, as opposed to, for example representation of share capital in the form of a transferrable token.

The Panel cautioned that, in order for true security to be created, it would be necessary for there to be a grant of a proprietary interest in the underlying asset. This may not be achieved by the grant of merely “functional” or “quasi” forms of security, which are sometimes used to provide creditors with factual control over the asset (and other rights) pending payment of the debt. Care should therefore be taken to ensure that simulated security achieves the desired effect in substance, particularly when the cryptoasset exists only digitally.

5. Insolvency: The Legal Statement concludes that “Since cryptoassets can be property at common law, we have no doubt that they can be property for the purposes of the Insolvency Act” and would therefore fall to be governed in accordance with the usual insolvency principles.

6. The Sale of Goods Act 1979: The Panel interpreted the language of the Sale of Goods Act as requiring “goods” to be capable of possession. Their conclusion was therefore that cryptoassets are not “goods” for the purposes of this legislation and are not subject to the protections created by that Act.

7. Bailment: The law of bailment governs what happens when there has been a temporary transfer of possession – but not ownership – of an object (such as leaving a coat in a cloakroom). Because cryptoassets are purely virtual and cannot physically be transferred, the Panel concluded that they cannot be the object of a bailment. This applies only in so far as the cryptoasset, such as Bitcoin, is digital only, and does not represent any non-network native or off-chain asset, such as the cloak.

The Panel’s rationale: why is a cryptoasset “property”?

Given the significant differences between cryptoassets and traditional property, there has been some uncertainty as to the extent to which laws relating to property rights are applicable to cryptoassets. The Legal Statement provides a clear answer to this question, concluding that cryptoassets, as the Statement defines them, are to be considered property and therefore that English property law should apply to them.

In reaching this conclusion, the Panel first considered whether cryptoassets possess the key features of property. Whilst there is no one definition of property, it has been said that for a right or interest to be treated as property it would need to be definable and identifiable by third parties and have some degree of permanence, certainty, exclusivity, control and assignability.

The Panel took the view that cryptoassets are capable of fulfilling each of these requirements. 

• They saw no issue with definability or certainty, because identifying information about cryptoassets (such as its practical ownership, value and transaction history) is stored or referenced within a “public data parameter” which is accessible by all participants in the particular payment system being used to trade or exchange the asset (or in some case, by the world at large).
• The requirements for control and exclusivity were thought to be satisfied by the cryptographic authentication process which allows only the holder of the private key to deal with the asset (eg, transfer or exchange the asset), to the exclusion of others.
• The Panel also saw no reason to doubt that cryptoassets are in their nature capable of being acquired by third parties – and indeed designed with the aim of being transferable – and therefore assignable (even if some of the methods of assignment may be novel and even where identifying the owner may not always be straightforward).
• The requirement for permanence was also thought to be satisfied, in that cryptoassets are as permanent as other conventional financial instruments which may exist only until they are cancelled, redeemed or repaid. Even though it was highlighted that, upon transfer, the cryptoasset received is a new cryptoasset (the previous cryptoasset of which no longer exists, in the case of Bitcoin) the value remains the same.
• The only criterion which appeared to give the Panel pause for thought was the requirement of stability. The Panel noted that – because of the consensus driven rule set which governs the networked system and the related ledger on which cryptoasset dealings are recorded – there may be periods during which a consensus has not yet been established or may be subject to change, overridden, or taken over. A change in the consensus may also lead to a hard or soft fork in the system and the generation of multiple rule sets, cryptoassets and networks, some of which may survive, others may fall out of use and operation. Even so, the Panel concluded that (even without resolving those issues) cryptoassets are sufficiently permanent and stable to be treated as property.

The Panel also considered whether cryptoassets might be disqualified from the category of property because the courts are generally reluctant to treat “mere information” as property and cryptoassets are largely defined by data, such is the nature of, for example, of Bitcoin itself being little more than lines of code in essence. 

Here, the Panel noted that the commercial value of a cryptoasset (and the data representing it) lies in what that data allows you to do. By itself, the data representing the cryptoasset does not convey anything of interest, similarly with a public or private key; however, the person possessing the private key and thereby access to the Bitcoin or cryptoasset is able to use it as a token within the networked  system to effect and authenticate transactions due to the rules of the system. Therefore, and in combination, the characteristics and components constitute something more than “mere information” alone. This contrasts with other information-based assets, such as databases and digital photographs, where the value lies in the information itself which they contain. On this basis of this distinction the Legal Statement concludes that cryptoassets are not “pure information” and do not fall foul of this principle.

By contrast, the private cryptographic keys used to authenticate transactions are considered mere information, and cannot be treated as property in and of themselves. For example, the hypothetical nonexistence of Bitcoin would render a corresponding private key, if there would be one, as mere information, given it would be nothing more than an alphanumeric line in a database.

A slight difficulty, however, in this approach, is the fact that cryptoassets are being analysed as they stand today. If Bitcoin were to have been analysed in the same way ten years ago, when the value of Bitcoin was less, and it were more difficult to assign a value in fiat money to any one Bitcoin, it is questionable if commercial value would easily have been ascertained. The premise that a Bitcoin is more than something just created out of thin air is central to the Panel’s conclusion that it has value due to the utility it permits its users in conduct such as in trading, being invested in, being priced against fiat currencies, or being bartered against priced goods and services. 

Does it matter whether cryptoassets are “things in action”?

This question is relevant because of a 19th century decision of the House of Lords in which it was said that the law would only recognise as property “things in action” or “things in possession”, and nothing else. Cryptoassets are not “things in possession” because they are not tangible and cannot be possessed. The Panel therefore gave detailed consideration to the question of whether they could fall within the definition of a “thing in action”.

The term “thing in action” is generally used to mean a right of property that can be enforced by court litigation, or action, such as a debt or contractual right. This does not sit on all fours with the concept of a cryptoasset, which may be merely linked to legal rights but will not necessarily itself embody a right capable of being enforced by action. Furthermore, given that the networked system may be decentralised (and the Legal Statement assumes this as a prerequisite of cryptoassets) the participants in the networked system do not assume legal obligations to one another in participating in the system. However, there is a broader and less formal understanding of the term “thing in action” as a catch all to cover any property which is not a “thing in possession” as opposed to an enforceable right or obligation alone.

The Panel acknowledged that cryptoassets may not fall within the narrower definition of “things in action”. However they were reluctant to treat a 19th century decision as limiting the scope of what constitutes property in the 21st century. They also noted that the courts have had no difficulty in accepting other novel types of intangible assets as property (for example EU carbon emissions allowances) and that various statutes define property as including “things in action “and other intangible property””.

Against this background, the Legal Statement concludes it is neither necessary nor useful to try to fit cryptoassets within the traditional definitions, and that the fact that cryptoassets may not be “things in action” in the narrow sense and thus should not be a bar to them being treated as property or “things in action” in the broader sense.

However, the main reason why cryptoassets such as Bitcoin cannot be considered a “thing in action” is due to one of the characteristics which the Legal Statement identified as a necessary constituent element: namely decentralisation. In a decentralised networked system it would not be possible to identify the jurisdiction in which for example the Bitcoin is necessarily recoverable, or where rights and obligations would to be enforced. 

Yet, it is critical to note that many networked systems have various consensus rules and architectures, which may not be decentralised and are often intended to be quasi-centralised through consortium or other structures, or veiled forms of centralisation. Alternatively, the networked system may well be taken over by a select group of “miners” and/or “node operators”. In these cases, it may be possible for those cryptoassets in non-decentralised networked systems still to be governed by some consensus rules and also to constitute a thing in action in the traditional and narrower sense. And it may also be possible for a decentralised networked system to become a centralised one, once again rendering the cryptoasset, a thing in action in the traditional and narrower sense.

Conclusion

There remain some areas of uncertainty in this quickly developing area of law – not least in relation to establishing the governing law and jurisdiction applicable to dealings in cryptoassets.

However, the resounding message from both the Law Tech Delivery Panel and the High Court is that cryptoassets will be recognised as “property” and the courts will do their best to grapple constructively with the complexities presented by this novel type of property. In adopting such a positive stance, they have reinforced the rights of those investing in, using, dealing with and creating cryptoassets and encouraged a consistent approach to legal dealings in them. 

Growth in the development and use of these assets – which was already rapid – is likely to gather even more pace. The malleability of the English common law to expand and contract in response to the changing contours of new technologies and scenarios is a crucial characteristic to its position as both a financial and technology centre and a technology-friendly jurisdiction. And although the Legal Statement, when analysed, assesses primarily the case of Bitcoin, it is a positive step for other types of cryptoasset such as those assets with real-world connections, or new forms of asset classes that exist only digitally.

If you require further information about anything covered in this briefing, please contact Kate Allass, or your usual contact at the firm on +44 (0)20 3375 7000.

This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.

© Farrer & Co LLP, February 2020