November 20, 2019

The UK provides legal certainty for smart contracts and cryptoassets in its landmark legal statement

Earlier this week the UK Jurisdiction Taskforce (UKJT), part of the LawTech Delivery Panel of senior solicitors and barristers headed by Chancellor of the High Court, Sir Geoffrey Vos, published a landmark “Legal Statement” providing long awaited clarity as to how cryptocurrencies, distributed ledger technology (DLT) and smart contracts might be treated under English law.

The statement follows several rounds of public and private consultation, conducted to address the perceived legal uncertainties of these innovative technologies.

For the first time, the Panel has recognised that cryptoassets, including but not limited to, digital currencies, can be treated as property in principle, and that smart contracts are capable of satisfying the requirements of contracts in English law, making them enforceable by the Courts.

Cryptoassets

  • What is a cryptoasset?

    The Legal Statement does not seek to define the term "cryptoasset", the Panel having recognised the wide variety of systems in use, and the kinds of assets represented.  These range from purely notional payment tokens, such a Bitcoin, to tangible objects which are external to the system, such as a share or unit in a company or fund.   Rather the Panel has sought to identify and describe, in broad terms, the features of cryptoassets which make them novel and distinctive from more conventional assets, to allow for a detailed consideration of their legal and proprietary status.

    In summary, the Panel explains that a cryptoasset is defined by reference to the rules of the system within which it exists.  It is typically represented by a pair of data parameters: one public (disclosed to all participants in the system) and one private. The public parameter contains encoded information about the asset, such as its ownership, value and transaction history.  The private parameter (the private key) permits transfers or other dealings in the cryptoasset to be cryptographically authenticated by a digital signature.  The private key should be kept secret to the holder.

    Dealings in cryptoassets are broadcast to the entire network and, once they are validated, they  are added to the digital ledger.  Most commonly the ledger is decentralised meaning no one person or entity has control over it.  It is also immutable and cannot be changed.  The most common type of ledger being used today is blockchain, although other models do exist. The rules governing the system are established by the informal consensus of the participants.

The novel features of cryptoassets are therefore broadly summarised as follows:

  • intangibility;
  • cryptographic authentication;
  • use of a distributed transaction ledger;
  • decentralisation; and
  • rule by consensus.
  • Can cryptoassets be characterised as property?

    The Legal Statement focuses on the status of the cryptoasset itself (referred to as the “on-chain” asset), not any other asset it may represent (such as conventional assets linked to the system, which will already be classed as property).   

    The Panel has considered what property is, as a matter of English law. As no general or comprehensive definition of property exists in statute or case law, the Legal Statement focusses upon the necessary characteristics of property as identified in a number of authorities. The Legal Statement provides that before a right or interest can be admitted into the category of property: "it must be definable, identifiable by third parties, capable in its nature of assumption by third parties, and have some degree of permanence or stability. Certainty, exclusivity, control and assignability have also been identified in case law as characteristic of property rights."

    The Panel then considered firstly whether cryptoassets possess those important characteristics and secondly if so, whether there is some special legal reason to disqualify them from being considered to be property.

    Although whether English law would treat a particular cryptoasset as property will be fact sensitive and require a consideration of the nature of the asset concerned, and the rules of the system in which it exists, in general, the Panel concluded that “cryptoassets have all of the indicia of property.”

    The Panel also concluded that the “novel or distinctive features possessed by some crypto-assets" set out above, did not "disqualify them from being property…..nor are cryptoassets disqualified from being property as pure information, or because they might not be classifiable either as things in possession or as things in action.” 

  • Why does it really matter if a cryptoasset is property?

    It is important to determine whether a cryptoasset is capable of being property because it means that it can be owned, which gives rise to important proprietary rights that can be recognised against the whole world. The owner of a thing is entitled to control and enjoy it to the exclusion of anyone else.

    Proprietary rights are of particular importance when it comes to issues relating to succession on death, the vesting of property in personal bankruptcy, and the rights of liquidators in corporate insolvency, as well as in cases of fraud, theft or breach of trust.

  • So, what is the asset and who owns it and how is it transferred?

    The Panel explains that the asset does not consist of the public or private keys, or the distributed ledger itself; these are all deemed to be items of pure information.  The asset is something that arises from their combination with the rules of the relevant system, which provide the owner with the exclusive ability to effect or authenticate dealing with the cryptoasset.

    In the Panel's view, the owner of a cryptoasset is described as typically being the person who has acquired control of a private key by some lawful means, in much the same way that a person lawfully in possession of a tangible asset is presumed to be the owner. However, the Panel also notes that ownership may be dependent on the circumstances and the rules of the relevant system. 

    The Legal Statement confirms that whilst cryptoassets can be transferred either via an “on chain” transfer (with the ledger being updated in the usual way) or by way of an “off chain transfer” (another type of transfer outside the ledger which is vulnerable to a superseding on-chain transfer i.e. double spending by the transferee)) these will not constitute transfers in the legal sense.  This is because of the way the distributed ledger technology operates: unlike a tangible asset, the same cryptoasset does not pass, unchanged, from one person to another. Instead, the transferor typically creates a new cryptoasset, with a new pair of data parameters: a new or modified public parameter and a new private key. The data representing the “old” cryptoasset persists in the network, but it ceases to have any value or function because the cryptoasset is treated by the consensus as spent or cancelled so that any further dealings in it would be rejected.

  • What type of property is a cryptoasset?

    The law has traditionally recognised two distinct types of personal property: things in possession and things in action. The Legal Statement confirms that a cryptoasset is not a thing in possession; cryptoassets cannot be physically possessed, being purely “virtual”.

    The issue of whether a cryptoasset is a thing in action gave the Panel more pause for thought, though it ultimately concluded that they will fall within this category of property. In doing so, the Panel drew upon the fact that the term thing in action has historically been used more broadly as a kind of “catch all” to refer to any property that is not a thing in possession.

    This categorisation is potentially important because it has been said that the law recognises as property only things in action and things in possession but not anything else.  The Panel took the view that despite these statements, it considered that the common law is and should be flexible and the Courts should interpret traditional definitions and concepts widely to adapt to new business practices (as we have seen in the past in respect of the development of shares in a company).

    Furthermore, even if cryptoassets cannot be defined as a thing in action, the Panel found precedent for the treatment by the Courts of novel types of intangible risks as property, EU carbon emissions allowances being one example. This, said the Panel, recognised that personal property can include things other than things in action or things in possession.

  • What consequences does this classification have?

    The Legal Statement concludes that it is possible to declare a trust over an ownership interest in a cryptoasset.

    However, as the Panel found that a cryptoasset is not a physical thing, it cannot be subject to a possessory relationship, such as a bailment, a lien or a pledge. That said, the Panel expressly states that it could see no obstacle to the granting of other types of security such as charge or mortgage.

    It is also clear that cryptoassets are not documents of title, documentary intangibles or negotiable instruments (though some form of negotiability may arise in future as a result of market custom), nor are they instruments under the Bills of Exchange Act.

    Nevertheless, as the Panel was of the view that cryptoassets can be property at common law they were in no doubt that they may therefore also be property for the purposes of the Insolvency Act 1986 (IA 1986) which contains a very wide definition of property. Indeed, even if a cryptoasset was  deemed not to be property at common law, it might still be deemed to be property under the IA 1986.

Smart contracts

The Legal Statement also discusses smart contracts starting from the position of identifying the legally novel or distinctive features of these contracts.

In the Panel's view the characteristic feature of a smart contract is automaticity.  A smart contract is performed automatically and without the need for human intervention.  That requires the terms of the contract to be recorded in code. Many smart contracts are embedded in a networked system that uses the same techniques as cryptoassets (i.e. cryptographic authentication, distributed ledgers, decentralisation, consensus), as discussed above.

The Panel went on to consider whether this automaticity amounted to a good reason for treating smart contracts as different in principle from conventional contracts and considered that it did not. In doing so, the panel acknowledged that the scope for legal intervention in smart contracts may be reduced, as the automaticity of smart contracts, and the manner in which computer code operates, should mean that there is strictly no need for a party either to promise performance or to resort to the law to enforce a promise by their counterparty: the code will simply do what it has been programmed to do.  

However, the Panel was of the view that the risk that performance of the contract is affected by an event external to the code, such as a system failure, or that the code may behave in an unexpected way still remained, and it was important that any disputes that arise should be capable of adjudication. 

The Legal Statement also discusses the requirements for the formation of a contract, namely that two or more parties have reached an agreement, with the intention to create a legal relationship and consideration has passed. The Panel concluded that a smart contract is capable of satisfying these requirements just as well as a more traditional or natural language contract, and a smart contract is therefore capable of having contractual force.

Although the parties’ contractual obligations in a smart contract may be defined by computer code (in which case the code may not be susceptible to the exercise of contractual interpretation at all), a smart contract can be identified, interpreted and enforced using ordinary and well-established legal principles.  For example, just as with any other contract, a Court will intervene in cases of duress, fraud, misrepresentation and so on.

The Legal Statement also highlights that English law provides a suitable framework for dealing with a number of issues that arise in relation to smart contracts. For example, English law does not struggle with the concept of anonymous or pseudonymous parties contracting.  There is no requirement under English law for parties to a contract to know each other's real identity.  English law also does not struggle with the notion that a contract can be formed between individuals by virtue of them each having agreed to subscribe to a set of rules (as happens, for example, in a club). English law is fully equipped to deal not only with bilateral smart contracts but also those structured around Decentralised Autonomous Organisations (DAOs).

One of the most welcome parts of the Legal Statement, when it comes to smart contracts, is the analysis around whether a statutory signature requirement can be met by using a private key:The Legal Statement discusses the legal rules which require certain documents to be “signed” or “in writing”. The Panel concludes that, in their view, a statutory “signature” requirement could be met by using a private key which is intended to authenticate a document, and a statutory “in writing” requirement can be met, in principle, in the case of a smart contract whose code element is recorded in source code.  This is encouraging and reflects the reality of modern day commerce.

Comment

Many commentators believe the legal uncertainties surrounding cryptoassets and smart contracts (and the technologies which underpin them) have been the most significant barrier to their mainstream adoption. It is hoped that the Legal Statement demonstrates the ability of English law to respond consistently and flexibly to new commercial mechanisms, proving a foundation for the responsible future utilisation of cryptoassets and smart contracts.

Indeed, Sir Geoffrey Vos recognised the potential of cryptoassets and smart contracts, and the potentially huge benefits to society that they can deliver, saying:

"In legal terms, cryptoassets and smart contracts undoubtedly represent the future.  I hope that the Legal Statement will go a long way towards providing much needed market confidence, legal certainty and predictability in areas that are of great importance to the technological and legal communities and to the global financial services industry."

The thorny issue of how dealings in cryptoassets should be regulated will need to be tackled next,  the Panel having concluded that it was "more appropriate for regulation to follow the logically prior issues of common law characterisation".

In the meantime, for insurers writing crypto-related risks, the Legal Statement confirms that cryptoassets are "property", which is likely to be welcome clarification and allows for further consideration as to how they are treated under insurance policies to be undertaken. 

It also important for insurers who may be providing crime cover to crypto-related businesses for for hacking incidents. Although the Legal Statement does not address the issue directly, the classification means that important proprietary rights and remedies may exist for victims.  For example, if a hacker causes a cryptoasset to be spent or cancelled in someone's favour, and a new cryptoasset is thus created, whilst it may be possible for the victim to argue for the original cryptoasset to be returned to him/her, the ownership of the newly created cryptoasset may remain subject to other proprietary remedies which are available as a result of the hacker's misconduct (such as unlawful spending).

The clarification provided in the Legal Statement as to the legal status of cryptoassets may therefore increase the prospects of recovering losses, which may, in turn, reduce the losses being claimed from insurers in the first instance and/or pave the way for subrogated recoveries to be made in future. 

Cryptocurrencies and blockchain undoubtedly represent potential areas of growth for the insurance industry.  As we enter a new decade, we can expect to see insurance demands increase especially if the Legal Statement has the desired effect of promoting further utilisation of these technologies going forward.  With this industry starting to show signs of stability it will be interesting to see if insurers' appetites to write such risks also expand.