Cryptographic Tokens: Three Categories of Personal Property?

Protocol Tokens and Application Tokens

The key innovation of the Ethereum protocol was to facilitate the deployment of complex program code of unlimited variety as part of the network protocol, essentially turning the protocol and network into a public computer that can be used for any programmable purpose. Where the Bitcoin protocol was programmed only to create, record, and send a cryptographic token known as “bitcoin”, Ethereum’s innovation facilitated the deployment of program codes that can function as containers that hold data and methods and execute deterministically as part of the network protocols in accordance with its program design. The term “smart contract”, despite it being an obvious misnomer, is now the prevailing term-of-art to describe program code that is deployed via the network consensus mechanism and that will operate as part of the network protocol.¹

A smart contract can be used to create, record, and send cryptographic tokens. A token smart contract functions as a rights management tool, that is, it assigns permissions to the tokens, and thus to the token holders. The token holder/s is/are the person or persons who, by way of a private/public key pair, control the network address to which the token has been assigned by the token contract. The controller of an address who wishes to acquire or dispose of certain tokens supplied and administered by a smart contract can initiate a transaction, which, if completed without fault, results in the smart contract recording a new balance of the acquired tokens for the recipient address, which is also known as “transaction output”. The network operated state machine will be updated accordingly so that the transaction in question is immutably recorded as part of the blockchain record. Note that the tokens supplied and administered by a smart contract are not transferred to the recipient’s address. Instead, the transaction output is recorded by the smart contract as associated with that address. It authorises the recipient address to call the smart contract and initiate transactions in the tokens up to the balance associated with that address.

Tokens supplied by a smart contract are also referred to as “application tokens”. Application tokens must be distinguished from tokens supplied and administered by the blockchain protocol itself, such as bitcoin or eth. That type of token is typically referred to as a “native token” or “protocol token”. The protocol tokens are a critical component of the incentive scheme of the relevant blockchain protocol and balances are recorded as part of the blockchain address of the recipient of the protocol token. In case a protocol token is sent to a recipient’s blockchain address, the state of that recipient’s address changes as it will update the balance of protocol tokens recorded at that address. Application tokens have moved one layer up in the technology stack. If an application token is sent to a recipient’s address by the token contract, the state of the recipient’s address does not change. Instead, the recipient’s address is added to a map within the token contract and therefore, the transaction only changes the state of the token contract.²

Application tokens were originally created as a class of n identical tokens, meaning that the smart contract is programmed to supply a certain number of identical tokens of a certain type and description. In the case of n supply of application tokens, the tokens may be described as fungible. Further innovation of smart contracts led to the development of a type of application token that is created as an indivisible token that has a unique token ID. To create and deliver a unique and indivisible token, the token contract is programmed to issue a unique token ID that is mapped to the token holder’s blockchain address and permits inspection and confirmation that the balance in the token contract of the linked address is 0, the address does not control the unique indivisible token, or 1, the address controls the unique indivisible token. These types of unique and indivisible tokens are commonly referred to as “non-fungible tokens” or “NFTs”.

In all cases, though, whether it concerns a protocol token or an application token, and whether a fungible application token or an NFT, the reference to “tokens” is a reference to an electronical record of a certain number of units, or fractions of units, that is associated with a certain network address, which electronic record can be manipulated, via the relevant network, only by the person/s who control/s that address through its private key.

Tokens as Personal Property

The question arises how to characterise tokens under property law. Is the electronic record of a certain number of units, or fractions of units, that is associated with a certain network address, which electronic record can be manipulated only by the address controller, capable of being the object of a proprietary interest under common principles of private law?

It is sometimes suggested that the question de jure has limited relevance, as ownership and transfer questions regarding tokens are de facto control questions. Only the person controlling the private key to the relevant address can alter the network-operated state machine in respect of the token. If the network is operational, the holder of the private key can access the address and initiate a token transaction. The blockchain network, protocol and, where applicable, smart contracts will carry the transaction out, without censure or curation beyond validation of the proposed transaction, so that in case of a validated and executed token transfer transaction, the recipient’s address will irrevocably control the token sent by the transferring address. It could be argued that characterisation of tokens under property law principles is of less relevance, at least, in the context of the blockchain network itself.

Notwithstanding, property law matters “off chain” between the sender, the recipient, and potential third parties who may have an adverse claim based on fraud, breach of trust or other fiduciary duty, etc. Also, principles of property law will need to operate on tokens if the controller of the tokens is bankrupted or liquidated, or indeed, deceased. ³ Finally, as tokens, depending on their economic utility, may have tradable value, it would need to be confirmed, for instance, that a token can serve as good consideration for a contractual bargain or as a contribution in specie on equity interests issued by a body corporate or partnership. The traditional restatement of the legal classification of objects as personal property is that of Fry LJ in Colonial Bank v Whinney (1885), where he said:

"All personal things are either in possession or action. The law knows no tertium quid between the two." ⁴

Conceptually, a token cannot be characterised as an intangible right of action as the blockchain network is not a person against whom or which a right can be exercised. An argument could be made that the token is capable of possession via the private key and therefore, should be treated as a chose in possession. It would, indeed, seem unsatisfactory to limit the notion of possession to tangible assets, which is an observation made recently by the Law Commission in relation to electronic trade documents.⁵ Notwithstanding, as the law stands, the dictum of Fry LJ in Colonial Bank presents a doctrinal conundrum in relation to the classification of cryptographic tokens as personal property.

Bryan J faced this conundrum in the context of Bitcoin tokens in AA v Persons Unknown, Re Bitcoin [2019],⁶ but dismissed it, saying that “it is fallacious to proceed on the basis that the English law of property recognises no forms of property other than choses in possession and choses in action”. He cited the observations of the UK Jurisdictional Task Force (UKJT) in a paper published in November 2019, Legal statement on crypto assets and smart contracts, and concluded that “for the reasons identified in [the UKJT] legal statement, I consider that a crypto asset such as Bitcoin are property. They meet the four criteria set out in Lord Wilberforce’s classic definition of property in National Provincial Bank v Ainsworth [1965] 1 AC 1175 as being definable, identifiable by third parties, capable in their nature of assumption by third parties, and having some degree of permanence”.⁷ Accordingly, it was accepted in this case that tokens can be personal property.⁸

A Third Way?

The Law Commission has sought to address the conundrum regarding the property law characterisation of certain electronic records such as tokens in a July 2022 Consultation Paper.⁹ The Consultation Paper reviews the taxonomies of the notions of things in possession and things in action and concludes, provisionally, as certain digital assets do not fall neatly within either category, that “the law of England and Wales should explicitly recognise a third category of personal property to allow for a nuanced and idiosyncratic approach to the legal characterisation of new things”.¹⁰ The Law Commission concludes that the legal concept of property “consists of three principal elements”, which are “(1) the existence of a thing with particular characteristics; (2) a person’s liberty to put the thing to various uses; and (3) the law conferring on that person a legal right to exclude others from the thing”.¹¹ In considering the criteria for a third category of personal property, the Law Commission is principally concerned with the first of these elements:

“It is the fact that a particular thing exhibits certain characteristics that makes it suitable as an object of property rights.”¹²

From there, the Law Commission introduces the term “data object” as an “overarching descriptive term for objects that fall within our proposed third category of personal property”, which a thing does if:

“(1) it is composed of data represented in an electronic medium, including in the form of computer code, electronic, digital or analogue signals; (2) it exists independently of persons and exists independently of the legal system; and (3) it is rivalrous.”¹³

There is a risk that the introduction of a new category of personal property as envisaged by the Law Commission will cause more uncertainty than that it reduces. For instance, the proposed definition of “data object” provides that to be a data object, a thing “must also be distinguishable from things in action” and therefore, it “must exist independently of persons and exist independently of the legal system”.¹⁴ A token exists independently of the legal system but as an electronic thing, cannot exist if the network ceases to exist. The network by its very nature is a network of persons that control the nodes that contain the distributed, and controlled, record that is the token. Should the question whether the token is a data object turn on the legal characterisation of the network? Should that question even need to be asked?

Courts in the common law world globally have already unreservedly recognised that at least certain tokens are capable of being the subject of property rights. Perhaps, the proposed intellectual distinction between a dataobject and things in action or indeed a thing in possession is a red herring, as Justice Gendall observed more generally in Ruscoe v Cryptopia Ltd (In liquidation), a New Zealand case, in relation to the idea that a token must necessarily fall into one of the two categories of personal property to attract property rights.¹⁵ Bryan J, in AA v Persons Unknown, also was not detained for long on the dogmatic distinction between choses in action and choses in possession made in Colonial Bank v Whinney and applied Lord Wilberforce’s classic definition of property effectively and efficiently without much ado. The English and other common law courts have shown time and again that complex property questions can be resolved elegantly and efficiently, applying general principles of law. A most persuasive example of that prowess is the series of decisions of Briggs J, as he then was, in the insolvency of Lehman Brothers International (Europe), where he had to consider the application of principles of trust law to cash and securities commingled in bank and custody accounts.

Statutory intervention can be effective and welcome if done surgically. The Financial Collateral Arrangements (No 2) Regulations 2003 (FCR) have been very effective to remove uncertainty regarding the enforceability of collateral in the form of cash and securities credited to bank and custody accounts. The 2022 Amendment to the Uniform Commercial Code (UCC) proposed by the American Law Institute and the Uniform Law Commission could also present a good example of efficient statutory intervention. It is very specifically focussed on the transfer of property rights in a “controllable electronic record”(CER)such as tokens. Control of a CER is established where persons can demonstrate the power to enjoy “substantially all the benefit” of the CER, exclusively prevent others from enjoying “substantially all the benefit” of the CER, and exclusively transfer control of the CER. Through the definition of a CER, the legislation excludes any digital assets that arenotsubjectto“control”andthosethatare already subject to other commercial laws, including other parts of the UCC. In common with the method applied by the FCR, the UCC steers clear of reforming common principles of property law and confines itself to removing uncertainty around enforceability of transfers, acquisition, protection and collateralisation of a specific asset. The new Art 12 UCC will also include a conflict of laws rule that points at the local law of the law specified in the CER or in the rules governing it. In the absence of a designation, the default law is that of the District of Columbia.

In the Law Commission’s view, a new concept of control, though in many ways equivalent to possession, is the appropriate concept to apply to data objects such as tokens.¹⁶ That approach must be right. The combination of information technology, computer networks, and cryptography has created a form of intangible asset that, if the network persists, exists independently, permanently, and immutably, and is controlled through a private key. It would seem self-explanatory that tokens should therefore be capable in law of some modified form of possession. It is the approach taken in the new Art 12 UCC. The Law Commission puts the concept of control at the heart of the methodology to answer transfer, acquisition, asset protection, and collateralisation questions. Certain questions remain to be answered. The location of the private key is fluid, and also, a private key is copyable. It may be held on a disk or other physically mobile carrier, or it could be stored on servers, or be “sharded” and held on a distributed basis. What is not obvious, however, is why such statutory intervention needs a reconceptualization of the concept of property, possibly opening the law of property up to a range of unforeseen discussions. It would appear less risky simply to define the notion of “dataobject” instructural terms, much in the way that the Art 12 UCC defines“ controlled electronic record”, and provide certainty of transfer etc, in that manner.