As a Kings Counsel, where do I see some of the potential legal challenges of the growing trend of tokenization?
Written by James Ramsden KC, co-founder of Astraea Group
With the current proliferation of tokenization across all business sectors, in the legal sphere we are seeing a variety of issues both in transactional market practice and in terms of disputes before the Courts. Tokenization itself reflects the application of blockchain technology to a vast array of business scenarios (which is expanding as the technology takes hold). Current business use includes: cryptocurrency units; secure messaging payment transactions and the digitisation of assets (i.e. the digital recording of ownership and transfer rights in property, as opposed to paper format).
One of the more recent tokenization trends is in relation to digital assets, as reflected in the Law Commission’s Report of June 2023. So, the first part of this article will focus on some of the legal challenges of digitising assets by reference to a couple of examples. It is worth noting, however, that English property law, which governs ownership and transfer rights in assets, has evolved differently based on the features of the asset itself. So, the rules governing the ownership of real estate are different, for example, from the rules governing shares or the rules governing debt. The legal processes for transferring such assets also differ. Against that backdrop, existing blockchain technology, which seeks to change the basis on which assets may be held and transferred, is not used uniformly across different markets or even within the same market. Added to that, the different technology providers are constantly testing, improving and diversifying their products to meet each market’s needs. The net effect of all this, is that we should expect the legal challenges of tokenization to differ depending on the asset being digitised and for the legal challenges to change over time given the continued advances in technology.
Digitalization of assets
Assets take different forms (ranging from physical assets such as houses, cars and cash to assets which the law describes as “intangible” such as rights to debts, intellectual property and equity). When assessing competing rights to an asset, one of the starting points in English law has been to consider who is in “possession” of the asset. For assets such as land and cars, possession is straightforward. However, for some intangible assets founded on contractual rights, such as the right to repayment of a debt or the right to equity in an English incorporated private company, English law looks instead to physical possession of a paper document which represents the asset. One example of this arises in relation to a shareholding in an English incorporated private limited company where legal title is currently represented by a sole physical share certificate. This differs from uncertificated shares which follow a different process and where settlement is via Certificateless Registry for Electronic Share Transfer (CREST).
Taking shares as an example, as a matter of practice under Companies Act 2006, the corporate is responsible for ensuring only one certificate per shareholding (to mitigate against fraud) and for registering any change in shareholding against production of the original physical share certificate (or against a letter of indemnity if the original share certificate is lost). As it stands the law governing the registration and transfer of shares is based, therefore, on the existence of physical paperwork. As the equity market considers a move to permission based blockchain (controlled by the company) to digitally reflect the ownership and transfer of shares, the market process is changing in a way which isn’t contemplated by the existing legal framework. To the extent that the shares in English incorporated private companies are to be digitalised, therefore, English corporate law really needs to be amended. That in turn requires a legal understanding of how the technology actually works in relation to the digitised asset and an agreed, tested, market process. Another complicating feature of tokenization, at least for the lawyers, is the extensive and bewildering technological vernacular, with a profusion of terms with the same meaning. In order to have some legal clarity, there needs to be agreement on terminology, as recognised in the Law Commission’s report of June 2023.
Another example of intangible assets where ownership and transfer are decided by physical possession of a document, is promissory notes. For these, ownership sits with the person in possession of the paper note and may be transferred by the holder endorsing the note in favour of another. As these documents are widely used in transport, finance, trade and logistics, the government has responded swiftly to calls to amend paper-based legislation so as to allow for electronic promissory notes. The Electronic Trade Documents Act 2023, which came into force on 20 September 2023, confirms that electronic promissory notes will be recognised as equivalent to paper promissory notes, that it is possible for a party to possess an electronic promissory note and it is further possible for paper notes to be transferred to electric notes and vice versa (subject to conditions). The Act also covers other trade documents which have historically been paper based and which are used internationally, for example, bills of exchange, bills of lading, warehouse receipts and marine insurance policies. The ability to convert electronic promissory notes to paper notes is interesting. That is because it reflects the fact that the digitalisation of assets may not work in all circumstances. As international trade documents, it is possible that commercial parties in some jurisdictions may not be able to own or transfer digitised promissory notes practically or as a matter of local law. Whilst English law has moved to implement legislation to allow for maximum flexibility, as an international trade document, other countries would need to recognise the note as a digitalised asset also and we are not there yet. The Bank for International Settlements announced in November 2023 that it is planning a project called Promissa with the Swiss National Bank and the World Bank to tokenize promissory notes with a target deadline of early 2025 for completing the proof of concept.
The speed and ease with which certain asset classes in established markets can be tokenized will, therefore, depend on the ease with which the existing English law regime can be made to work as it stands with a digitalised asset and, if not, how aggressively the market in question pushes for rapid digital change (and changes to legislation). Where the asset involves international counterparties and the foreign law position as to digitisation of assets is unclear, we can expect a delay in widespread use of that digitised asset.
The litigation perspective
It is extremely likely that anyone based in England or conducting a business here which uses tokenization is likely to be doing business with an individual or entity not located in England. This issue brings with it a number of litigation issues as highlighted by the recent cryptocurrency fraud cases brought before the English courts. In the context of cyber currency fraud where the transaction is carried out using a decentralised, anonymous, blockchain, the technology is readily accessible by international victims and fraudsters. In this scenario, English lawyers are no longer just considering how English law will apply to the transaction; they are presented with significant and costly jurisdictional challenges to establish how the fraud has been carried out and how to trace the funds. Whilst the English courts have the power to make information disclosure orders against administrators of the exchange and worldwide freezing injunctions (in a bid to halt the further movement of funds), the real challenge is identifying the anonymous offshore perpetrators of the fraud and what they have done with the money. This requires a level of cooperation from both exchange provider and other jurisdictions which may not be available. Another challenge is that even with an English judgment or arbitration award, there may be recognition and enforcement issues on national public policy grounds where the tokenization is unlawful in the enforcement jurisdiction. For example, whilst China was initially involved in bitcoin trading, it announced in 2021 that all cryptocurrency transactions were illegal, making it highly unlikely that a Chinese court would recognise an English award relating to a cryptocurrency transaction.
Thus, tokenization’s from a legal standpoint prompts questions on reconciling traditional laws with evolving blockchain tech. How can English corporate law adapt to digitalising shares, and what challenges arise in international trade digitisation? The litigation aspect raises concerns about jurisdictional hurdles and enforcing judgments in a decentralised, fraud-prone blockchain environment. The evolving legal-tech dynamic sparks inquiries into the feasibility of global cooperation and recognition. The ongoing dialogue between technology and legal frameworks necessitates continual adaptation amid a changing legal landscape. The good news is this all offers plenty more work for a KC like me……
