Cryptoassets and smart contracts | What is their legal status under English law?
Published on 13th Dec 2019
Innovators and investors in blockchain-based business models can take comfort from a recent analysis that cryptoassets can be a form of legal property under English law and smart contracts are capable of forming enforceable contracts.
Are cryptoassets assets? Are smart contracts contracts?
Blockchain has long been used to develop new "cryptoasset" products, instruments and applications, and new forms of self-executing arrangements. Guidance and/or legislation to clarify how these new products fit with existing law and regulatory regimes has been developed in a number of fields including financial services and prudential regulation, money laundering, taxation, and the GDPR.
However, fundamental questions mostly remained unanswered about how these new constructs should be classified for the purposes of the laws of property and of contract. Are cryptoassets pure information, not capable of being "owned"? Is a private key analogous to a bearer share? Is a "smart contract" neither smart nor a contract? These are not merely questions of academic interest, given the commercial imperative that the investment of significant effort and money into these structures should be backed up by legal recognition of what has been created, enforceability of agreements and availability of effective legal remedies.
The UK Jurisdiction Taskforce (UKJT) has published its analysis (Legal Statement) of the status of cryptoassets and smart contracts under the law of England and Wales. In short, its Legal Statement concludes that cryptoassets are capable of being a form of property in law, and smart contracts can (depending on the facts) meet the requirements for valid formation of a binding and enforceable contract between the parties. Our review of the more detailed findings of the Legal Statement is set out below.
Have these questions now been definitively answered?
The UKJT commissioned four barristers to write the Legal Statement. A public consultation on the questions to be considered closed in June 2019, and the Legal Statement itself was published in November 2019 (following private, but no public, consultation on its answers).
The four authors are experts in their field, but this Legal Statement is not legal advice. Nor is it law: it is not a considered ruling from judges by way of case law, nor is it a legislative change. The conclusions in the Legal Statement are therefore not definitive and may yet be challenged.
Nevertheless, the Legal Statement provides a line in the sand which many (for whom it suits) will rely upon. For example, it is undoubtedly valuable for those who have already invested in these technologies, for blockchain-based businesses seeking funding, and for consultancies building blockchain applications. The analysis provides a framework against which to understand the application of existing law and regulation, and also offers clarity in relation to the availability of legal remedies where disputes arise around assets or contracts built on this technology.
The Legal Statement emphasises the ability of the English common law to adapt to new technologies, and to rise to the challenge of applying existing law to new and unexpected situations. The impression, at times, is that the Legal Statement also serves as a promotion piece for our highly experienced and able judiciary as a choice of forum for resolving technology disputes, and for English law more broadly as a choice of governing law.
What happens next?
For the UKJT, the Legal Statement is an end in itself. However, work by the Law Commission on whether English law facilitated the use of smart contracts was paused to allow the UKJT's work to take the lead. The Law Commission will now review the Legal Statement to identify any areas where it would recommend new law.
For example, there has been much discussion of putting Land Registry or other records of legal title onto a blockchain structure: the Legal Statement notes that legislation would be needed before a blockchain-based ledger could constitute a definitive record of legal rights. The Legal Statement also refers to the challenge, in a fully decentralised blockchain system, of identifying the "location" of a cryptoasset within that system, which might also be an issue requiring clarification through legislation.
As well as its direct relevance to England and Wales, the Legal Statement may also be valuable guidance in many common law jurisdictions around the world.
However, the Legal Statement does not address the issue of governing law and jurisdiction. For both cryptoassets and smart contracts, determining the applicable law and jurisdiction is often a particular area of uncertainty. While the Legal Statement is helpful to the extent the laws of England and Wales are applicable, it will still be necessary to find that that is the case for any particular construct.
Findings of the Legal Statement: cryptoassets
What are cryptoassets?
The Legal Statement analyses a cryptoasset as being, broadly, an asset which is represented digitally, typically by a pair of data parameters (or "keys") within a blockchain system built on cryptographic proof, and which exists in accordance with the rules of that system. One of the pair of data parameters or keys is "public", disclosed to all participants in the system and containing or referencing encoded information about the cryptoasset such as its owner, its value or its transaction history. The other is "private" and is known only to its holder.
Are cryptoassets property?
The key question addressed by the authors is whether the law treats cryptoassets as property. Why does it matter whether cryptoassets are capable of being property? Because, as we have reported, the UKJT identified that "mainstream investors still need to be convinced that their legal rights can be protected when they trade in cryptoassets".
If a cryptoasset is capable of being property, then its holder may have priority over claims made by creditors in the event of an insolvency, it may be possible to hold a cryptoasset on trust for another individual, and it may be that there is a security interest in the cryptoasset. It may also mean that the rules that relate to succession on death, tracing, and the vesting of property in personal bankruptcy apply.
One can see that investors would prefer for these well-established rules to apply to cryptoassets, rather than have their asset class fall in an unsatisfactory way outside of these rules and be something akin to property, but not property.
The Legal Statement concludes that, in general terms, cryptoassets have all the legal indications of property and should, as a matter of English legal principle, be treated as property.
What about the novel features of cryptoassets?
The Legal Statement focuses its analysis on the novel features of cryptoassets, as it is those distinguishing features that have caused many to question the legal and proprietary status of cryptoassets. These are: a cryptoasset's usual intangibility, the cryptographic authentication process, the use of a distributed transaction ledger, the decentralisation of many systems on which cryptoassets are represented, and the consensus mechanisms of such systems.
None of these novel features is found to disqualify cryptoassets from being property.
Who then owns a cryptoasset?
The Legal Statement considers how some of the key concepts relating to property might apply to cryptoassets. The owner of a cryptoasset will, in most cases, be the person who has control of the relevant private key by lawful means. Of course there will be exceptions to this, as there are in relation to tangible property, given that one person may hold a private key on behalf of another person who is in fact the owner, or a person may obtain a private key through unlawful means such as hacking (in such case they would not be regarded as the lawful owner), or a cryptoasset may have multiple owners in systems where cryptoassets have multiple keys.
And how can ownership be transferred?
The Legal Statement explains that in order to make a transfer within the cryptoasset system, the party transferring ownership creates a record of the transfer and the details of the new owner, and authenticates that record of transfer by digitally signing it with the transferor's private key. The cryptoasset becomes linked to the private key of the new owner at that point. The transfer takes effect when consensus is formed on the network that the data parameters (i.e. private and public keys) representing the old cryptoasset should be treated as cancelled or spent, thereby preventing double-spending of the same cryptoassets. At that point, the transfer is confirmed, recorded and complete.
This is arguably more like a novation of a contract, rather than an assignment or transfer. On the above analysis, the same cryptoasset does not typically pass from the original owner to the new owner – instead the original owner effectively brings a new cryptoasset into existence, with a new pair of data parameters, being a new public key and a new associated private key.
The Legal Statement comments, moreover, that this analysis means that the usual rule that title to stolen property cannot be validly transferred to a third party may not apply to cryptoassets if the "thief" has generated a new private key for the asset – the stolen key belonging to the true owner will be treated as cancelled/spent by the system.
Isn’t a cryptoasset just data?
A private key will be pure information, and therefore is not to be treated as property. But the authors of the Legal Statement conclude that a cryptoasset should not be seen as being constituted solely of the public key and the private key. Instead, it should be considered as the combined effect of the public and the private key authenticating dealings in the relevant cryptoassets, in accordance with the rules of the system in which it exists, which create and ultimately define the cryptoasset.
Can security be granted over a cryptoasset?
Cryptoassets are intangible and cannot be possessed. This means that no lien can be created over a cryptoasset and a cryptoasset cannot be the object of a pledge. Cryptoassets cannot be the subject of bailment because bailment involves the transfer of possession.
But if a particular cryptoasset is property, then a mortgage or equitable charge can in theory be created over it in the same way as such security could be created over any other intangible property. The Legal Statement explains that there are many ways in which a creditor could be given rights over a cryptoasset belonging to the debtor until the debtor pays its debt (in other words, there are many ways in which security may be granted over a cryptoasset), but opines that this type of security would be "simulated" or "quasi" and that the holder may not have the same legal rights as the holder of "true" security. The issue to be worked through is the extent to which the debtor is able to grant some sort of proprietary interest in the cryptoasset to the potential creditor.
Findings of the Legal Statement: smart contracts
What is a smart contract?
A smart contract is essentially a set of functions or operations that are performed automatically (at least in part) and without the need for human intervention. The terms of a smart contract are recorded, at least in part, in computer code. The element which is legally novel or which distinguishes a smart contract from a conventional contract is this automaticity, as the Legal Statement describes it. This unusual feature of automatic performance has led to some legal uncertainty around the status of smart contracts. Are smart contracts capable of satisfying the basic requirements of an English law contract? Can smart contracts give rise to legally binding enforceable obligations?
What does the Legal Statement say about smart contracts?
The Legal Statement concludes that a smart contract is capable of satisfying the requirements of a legal contract under English law. It says that smart contracts are not different, in principle, from more traditional contracts.
The Legal Statement reminds us that there are three key requirements for a contract to be formed – and states that there is no reason why our normal common law rules should not also apply to smart contracts. It explains that whether a smart contract is capable of giving rise to binding legal obligations will depend on whether the parties to the smart contract were capable of:
- reaching objective agreement as to its terms;
- intending to create a legally binding relationship and;
- providing something of benefit – consideration.
It opines that all three requirements can be met in relation to smart contracts.
As the Legal Statement suggests, due to the automaticity of smart contracts, and the fact that the relevant code will perform the steps it has been programmed to perform, there may be no need for a party to resort to the law to enforce the promise that their counterparty has made. But there may still be instances where one party wants to enforce the terms of the smart contract on its counterparty (for example, if the code operates in an unintended or unlawful way). This Legal Statement should be helpful to such a party, as it advocates that a smart contract can be interpreted and enforced using well-established contract law principles and analysing the intention of the parties.
What about contracts which must be "in writing" and "signed"?
The Legal Statement goes further and says that a statutory requirement for a signature is highly likely to be capable of being met by means of a private key. One of the key issues in relation to electronic signatures is whether or not the "signature" in dispute was applied with an intention to authenticate the arrangement. The authors of the Legal Statement state that an electronic signature produced using public key cryptography is just a particular type of electronic signature, and can evidence that crucial intention to authenticate.
And what of the requirement that some contracts must be in writing? Can such a requirement be met by a smart contract? The Legal Statement explains that agreements that are in electronic form can meet a statutory requirement of being in writing. For example, case law has confirmed that a guarantee (which statute requires be in writing and signed) can be formed through a string of emails, with the parties typing their names into the relevant emails with the intention of authenticating the agreement. The only real question, then, is whether computer code as opposed to the English language can also be "in writing".
The opinion of the authors of the Legal Statement is that computer code is likely to fulfil this statutory requirement to the extent that:
- the code can be said to be representing or reproducing words (leaning on the definition of "writing" from the Interpretation Act 1978); and
- the code can be made visible on a screen or a printout.
They therefore state that the requirements will be met in the case of source code (which is specifically designed to be read by humans), but only by object code to the extent that it is in a readable format – which it may well not be, since it is binary code designed to be understood by a computer processor.
This therefore means that where there is a legal requirement that the contract be in writing, this is unlikely to be satisfied by any smart contract which is not in a form which can be read by a human. However, the requirement that a contract be in writing is fairly limited in scope, so may well not be relevant, depending on the context.
As explained above, we welcome this Legal Statement for the detailed analysis which it contains and the degree of comfort which it offers to investors and innovators developing this technology – although it does not have authoritative legal status and may be challenged in the future. The Law Commission is now considering whether new legislation would be sensible in any of the areas considered. If you would like to discuss the Legal Statement or related issues further, please contact your usual Osborne Clarke contact or one of the authors.