The Law Commission's review of the law on digital assets and smart contracts:

Introduction

The world is moving rapidly towards a paradigm in which most commerce between commercial parties happens either partially or entirely digitally. On 21 September 2020, the Law Commission announced that it had begun work on two projects aimed at ensuring that “English law can accommodate two emerging technologies that could revolutionise commerce: smart contracts and digital assets.” These projects are aimed at finding gaps in the law and identifying necessary reforms to address them, to ensure that the law “allows the possibilities of technology to flourish”.

The Law Commission’s project on smart contracts began in December 2017 but was paused pending the outcome of work by the government-backed LawTech Delivery Panel’s UK Jurisdiction Taskforce (the “Taskforce”). The Taskforce had been asked by the Chancellor of the High Court (Sir Geoffrey Vos) to consider a number of areas of uncertainty arising out of the interaction between existing law and new technologies, specifically cryptoassets and smart contracts. In November of last year, the Taskforce published its report,¹ titled ‘Legal Statement on the Status of Cryptoassets and Smart Contracts’ (the “Legal Statement”).

The Law Commission’s work has now begun anew, with a broadened remit to consider cryptoassets and other digital assets, with the intention of building upon the conclusions in the Taskforce’s Legal Statement and to make proposals for legal change where required. The conclusions reached in the Legal Statement are therefore likely to foreshadow the Law Commission’s recommendations.

In this article we: (i) provide an overview of the Taskforce’s key findings in relation to cryptoassets and smart contracts; and (ii) conclude by assessing the nature of the recommendations the Law Commission is likely to make in light of the Legal Statement.

 

Cryptoassets

A cryptoasset is a particular type of digital asset. As the Legal Statement states, it is difficult to formulate a precise definition of a cryptoasset. However, a cryptoasset can generally be explained as a digital representation of an asset, secured by cryptographic authentication within its given system.

Functionally, a cryptoasset is represented by a public data parameter and a private data parameter. The public parameter is available to all participants on the given system and contains encoded information about the asset (such as its ownership, value and transaction history); the private parameter (also known as the private key) is known only to the owner of the cryptoasset and is used to authenticate transfers or dealings in the cryptoasset. Knowledge of the private key confers practical control of the relevant asset.

Dealings in cryptoassets are broadcast to the participants in the given system, and once confirmed as valid, is added to a digital ledger. The main function of the ledger is to keep a reliable history of transactions and so prevent inconsistent transfers. The ledger may be distributed and decentralised – i.e. it is shared across the system’s network, with no one individual having the sole responsibility or right maintain it. In this way, the distributed ledger technology eliminates the need to trust a central administrator (such as a bank or a state).

An important feature of many cryptoasset systems is that the rules governing dealings are established by the informal consensus of participants, rather than by contract. Consensus rules may also determine which version of the distributed ledger is definitive (such as Bitcoin’s “mining” process, for example, in which a valid “proof-of-work” verifies transactions and is rewarded with Bitcoin). The rules are self-enforcing, even if not legally enforceable, because only compliant transactions duly entered in the ledger will be accepted by participants as valid.

Taking into account the characteristics summarised above, the Taskforce determined that the novel elements of a cryptoasset are:

• intangibility;
• cryptographic authentication;
• use of a distributed transaction ledger;
• decentralisation; and
• rule by consensus.

The Taskforce then assessed these novel characteristics in the context of those areas of the law which it considered would be most problematic, to determine whether cryptoassets are capable of being legal property. The main conclusions in the Legal Statement were:

Whilst the question will need to be determined on a case by case basis, cryptoassets can in principle be treated as property, notwithstanding their novel characteristics. Equally, cryptoassets should not be disqualified from being property as pure information (which English law has historically refused to treat as property) because unlike information they have the characteristics of certainty, exclusivity, control, assignability and permanence.

A cryptoasset cannot be a “thing in possession” (because is intangible and cannot be physically possessed) and does not easily sit within the definition of a “thing in action” (a term which is generally used to mean a right of property that can be enforced, but which has also been used more broadly as a catch-all for any property which is not a thing in possession). However, the Taskforce concluded that cryptoassets are not precluded from being treated as property, even if they are not a thing in action on a narrow definition, and that they might be better thought of as a third type of property.

In terms of the law applicable to cryptoassets, to the extent that there is some sort of central control over the asset in a particular country, and particularly where the distributed ledger is merely a record of ownership of conventional real world assets, the law of that country might sensibly be said to govern the proprietary aspects of dealings in the cryptoasset. However, for a truly decentralised system there is a good argument that the normal English conflicts of laws rules should not apply, but it is difficult to say which rules should apply instead. It is likely that legislation will be required to resolve these issues, potentially requiring international cooperation across jurisdictions;

Certain types of security are capable of being created over a cryptoasset. Since cryptoassets cannot be physically possessed, they cannot be the object of a pledge or lien. However, if a particular cryptoasset is property, a mortgage or equitable charge can be created over it (in the same way as over other intangible property). Similarly, if a particular cryptoasset is property at common law, it can be considered “property” for the purposes of the Insolvency Act 1986 (and indeed the breadth of the definition of property in the 1986 Insolvency Act might also enable certain cryptoassets to be deemed as property under the Act even though they are not property at common law);

A cryptoasset cannot fall within the current definition of a documentary intangible or document of title, nor could it be considered as an “instrument” under the Bills of Exchange Act 1882 (such as a check or promissory note). Nor could cryptoassets be considered “goods” for the purposes of the Sale of Goods Act 1979, since they cannot be physically possessed. It is also worth noting that a distributed ledger cannot be treated as a definitive record of legal rights, unless it has been given binding legal effect by statute, and therefore a court will not be bound by the ledger when considering who owns a particular cryptoasset.

Recent cases have supported the Taskforce’s analysis with regards to the characterisation of cryptoassets as property:

In AA v Persons Unknown² , the English Court considered whether Bitcoin constituted property in the context of granting a proprietary injunction to recover stolen cryptocurrency following a malware attack. The Court specifically endorsed the Taskforce’s analysis and held that cryptocurrencies possess all the characteristics of property and are thus capable of being the subject of a proprietary injunction, even if they cannot strictly be said to be either a chose in possession or a chose in action.

In Ruscoe v Cryptopia Ltd (in liq)³, the New Zealand Court referred to the Taskforce’s analysis and held that digital assets of a cryptocurrency exchange constituted ‘property’ and were capable of being held on trust for accountholders on the exchange.

Smart Contracts

Smart contracts are performed, at least in part, automatically by algorithmic code and without the need for (or, sometimes, the possibility of) human intervention. They may be: (i) written in natural language and executed automatically by code; (ii) a hybrid, written in both natural language and code and executed by code; or (iii) fully written in, and executed by, code.

As with cryptoassets, the Taskforce conceded that a precise definition of a smart contract is difficult to formulate and unlikely to be useful in any event. Therefore, the Taskforce sought to identify the legally novel characteristic of smart contracts, which it determined to be “automaticity”.

The starting point for the Taskforce was that the ordinary rules of contract law should, in principal, apply to smart contracts. It then considered the characteristic of automaticity in the context of those rules. The conclusions of the Taskforce can be summarised as follows:

Smart contracts can, in principle, give rise to binding legal obligations and the analysis of whether a contract has been created should be done in the conventional fashion: was there offer and acceptance of sufficiently certain terms; did the parties to the smart contract intend to create a legally binding relationship; is the requirement for consideration satisfied? Depending upon the nature of the contract, answering these questions might require an analysis of the contract’s source code;

In terms of contractual interpretation where a smart contract is written wholly or in part in code, the English Court is likely to hold that the meaning of a smart contract will be what is expressed in the code. Indeed, code has the advantage, generally speaking, of being clear and unambiguous. Where it is not clear, the Courts will seek to determine the objective intention of the parties, including whether the code was intended to define the obligations of the parties or merely to implement them; and

A smart contract be a valid contract notwithstanding that the parties to it are anonymised; signature by private key is in principal likely to satisfy statutory signature requirements (as can other forms of electronic signature, provided the intention was to authenticate the document); and a smart contract can, in principle, fulfil a statutory requirement for a contract to be “in writing”, even if in code, provided it can be read.

While not involving a smart contract per se, the decision of the Singapore Court of Appeal in Quoine Pte Ltd v B2C2 Ltd⁴, in which it was decided that automated contracts for trades on a trading platform give rise to legally enforceable contractual rights and obligations, is instructive. The dispute involved an alleged fault in Quoine’s platform which caused orders to conclude at 250 times the going rate in the market. The Court was required to consider whether the contracts (i.e. the trades) were void or voidable for unilateral mistake in circumstances where they were executed by the parties’ respective algorithms. The majority (Lord Mance dissenting) held that the non-mistaken party would have had the requisite knowledge of the mistake if the programmer had actual or constructive knowledge when programming the algorithm that the relevant offer would only ever have been accepted by a party operating under a mistake and was acting to take advantage of such mistake. On this basis, the majority held there was no mistake. Similar issues are certain to come before the English courts in future in the context of smart contracts, as the used of deterministic algorithms increases.

What recommendations is the Law Commission likely to make in light of the Legal Statement?

The Taskforce analysed cryptoassets and smart contracts by reference to the existing legal framework, and concluded that, on the whole, English law is capable of dealing with these new technologies. Extensive reform therefore appears unlikely and the Law Commission is perhaps more likely to recommend clarification and incremental expansion of existing rules to increase certainty as to the effect of their application to digital assets and cryptocurrency. That said, certain lacunas remain, for example in relation to conflicts of law, and it will be interesting to see how the Law Commission tackles these areas, particularly since, given the nature of new technologies, international cooperation may be required.

The Law Commission is currently seeking initial views from businesses and the technology sector, with a view to publishing a call for evidence on smart contracts in late 2020 and a consultation paper on digital assets in the first half of 2021.

The concept of digital assets and their ability successfully to interact with the current legal is moving steadily to the forefront of the legal collective mind. Change isn’t just coming, it’s here, and lawyers need to embrace it or risk being left behind by their peers. Indeed, to quote the Chancellor of the High Court, Sir Geoffrey Vos, from his foreword to the Law Society’s recent report titled ‘Blockchain: Legal & Regulatory Guidance’ (7 September 2020):

“Lawyers face a steep learning curve. They will need to become familiar with [distributed ledger technology], smart legal contracts and cryptoassets – conceptually and functionally.”

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¹ Prepared by Lawrence Akka QC, David Quest QC, Matthew Lavy, and Sam Goodman.
²[2019] EWHC 3556 (Comm) [57] & [59].
³[2020] NZHC 728 (New Zealand).
⁴[2020] SGCA (I) 02 (CA) (Singapore Court of Appeal).