Controllable Digital Assets and YOU!

Around these parts (the blockchain parts), I see people asking (and answering) a lot of curious and futuristic social questions, like “Could AI-driven smart contracts fully manage central bank monetary policy?“ and “I just turned my cat into an NFT?”

But, as a small-town-pizza-lawyer-turned-legal-thought-leader, I don’t see people asking enough tedious and esoteric legal questions, like “Is a smart contract bankruptcy remote?” and “Is your NFT cat eligible for a driver’s license under Wyoming motor vehicle law?”

And I think this is probably because, to get to that apex-level legal tedium and esoterica, you have to first hike through miles of fundamental commercial-code drudgery and frustrating “Honestly, it’s a bit of a gray area, Dan”-type complexity.

Now, we can’t summit that whole jurisprudential metaverse mountain in under 3,000 words, but we can reach a respectably elevated Wendy’s-sponsored digital basecamp — i.e., let’s talk about digitally-native assets and protecting your rights therein. Here we go.

What is “Control” of a Digital Asset?

One of blockchain’s great transformative promises is facilitating disintermediated creation and exchange of digitally-native assets. Anybody can create an asset on a blockchain, and anybody else can trade for that asset in a truly bilateral transaction.

However, in the absence of intermediaries, parties are left to themselves to sort out their respective asset rights, and so it’s critical for them to understand the commercial law underpinning those rights. These laws governing how (and whether) you own an asset are, of course, convoluted and full of terms of art and self-referentiality. But they do abide by some basic, common-sense principles.

Generally speaking, for different types of assets, there are different methods to establish ownership, as well as a hierarchy of the strength of those ownership methods. So when taking an ownership interest in an asset, a person needs to appropriately identify the asset and understand where their claim fits into the hierarchy.

For most types of tangible assets — say, physical goods like a statue or a paper promissory note — establishing ownership through possession creates the strongest claim to ownership.

Digital assets, on the other hand, can’t really be “possessed,” at least not in the legal sense. The old story goes that digital assets — a digital picture stored on a phone, an electronic contract stored on a computer, or really any thing of value represented by a discrete, identifiable set of electronic data — are just electronic files that can be endlessly and perfectly copied, so, if multiple people can each possess identical copies of the same file, trying to establish which of those copies is the primary copy, and, really, which person has possession of that primary copy, would be futile and chaotic.

So some fine lawyers created the possession-parallel concept of “control.”

“Control” varies across digital asset classes, but generally requires the digital asset to be maintained in a system that identifies one person as having control (the “controller”) and allows only that person to exercise possession-like power over the asset, such as by being able to alter the asset or transfer control of the asset to another person. Now, if someone takes “control” of a digital asset — that is, they are identified as the controller in a satisfactory control system — they have the strongest claim to ownership of that asset, in the same way that someone with possession of a tangible asset can have the strongest claim to ownership of that tangible asset.

In a simple example, Alvin first sells an asset to Simon and then later to Theodore, but possession/control is transferred only to Theodore. Because Theodore has possession/control, Simon has no claim against Theodore for the asset — the transfer of control/possession to Theodore essentially wiped out Simon’s competing claim. Simon could still sue Alvin, but Simon can’t take the asset from Theodore or from anyone to whom Theodore transfers the asset (maybe one of the Chipettes). Stated simply, Simon’s claim sticks only to Alvin, not the asset.

There are a number of reasons for putting possession and control at the top of the hierarchy, and the primary driver is that the resulting free transferability generally facilitates commerce. We want assets to move easily, without every buyer having to undertake a slow and cumbersome review of the provenance of the asset (think buying real estate). Also, it makes sense that the person buying an asset should be able to presume the ability of a seller with possession/control to deliver good title (compare with buying a bike from someone who can’t actually show you the bike). And these reasons hold so long as the buyer doesn’t actually know that the seller already transferred some interest in the asset to another person.

So, if an innocent buyer comes into possession or control of an asset, they will be at the top of the ownership hierarchy — and, most importantly, that innocent buyer can freely transfer the asset to another buyer, who will then have top priority and take the asset free of any prior claims.

Limits on Controllable Digital Assets

Naturally, then, when dealing with digital assets transfers, a buyer should always want to take control of the asset. The problem, however, is that not all digital assets can be “controlled” in the legal sense.

In US commercial law, the concept of control applies only to a subset of digital assets, generally traditional asset types in financial industries that have evolved from paper to electronic transactions — commonly bank accounts, stocks, and loans. This subset of digital assets can be subject to “control,” with all those protections afforded to a “controller,” namely taking free of competing claims, which don’t stick to the controllable digital asset.

However, the proliferation of blockchain technology has created several new digital asset classes — cryptocurrencies, stablecoins, NFTs — that are not specifically contemplated by our commercial law. And, unless these asset types can be squeezed into an existing, defined digital asset type that allows for control, they’re stuck in a catch-all asset class (thoughtfully-named “general intangible” assets) that doesn’t allow for control (or possession). These digital assets would not be “controllable digital assets,” and, thus, they lose the resulting benefit of free-transferability.

Where the assets don’t fit cleanly into existing commercial law classifications and lack control-ability, the ownership of these new blockchain-native digital assets remains murky. 1

NFTs in particular can be problematic as there are asset classification challenges with both the NFT itself and its tethered reference asset. 2

Ultimately, an NFT tethered to a possess-able or controllable asset grants questionable rights to the NFT owner. And cryptocurrency and stablecoins that are purchased may come with some competing (and stronger) claims stuck to them. The upshot is that, if you don’t or can’t take control of an asset, you need to seriously question and investigate your ownership rights.

Present and Future for Controllable Digital Assets

A blockchain can constitute a legally-compliant control system (see provenance.io), but, for that control system to work, the assets on the blockchain need to be capable of legal control. Under current law, the most common blockchain-native assets do not, in most cases, constitute controllable digital assets. And, if you don’t have that control over your blockchain assets, your blockchain’s transactional benefits get diminished by your blockchain assets’ limitations.

Of course, the law will eventually catch up. The groups responsible for updating the uniform commercial laws are cooking up legal reform that should extend the concept of control to almost all digital assets, and those laws could be on the menu in most states in a few years.

In the meantime, there’s already an existing universe of controllable digital assets — electronic mortgage, automobile, and personal loans; solar and other equipment financing; monetary accounts; most types of securities — that can (and should) be moved into the blockchain universe, where they can offer all the security and free-transferability that come with “control,” while also unleashing all of a blockchain’s digital-asset potential, including full disintermediation, real-time bilateral settlement, and immutable asset and transaction histories.

So when people ask insightful questions like “What types of assets make the most sense to create and exchange on a blockchain?” the answer should be “controllable digital assets.”

[1] Take stablecoins as an example. Assume A has $40k worth of stablecoins in their digital wallet and executes a loan agreement with B, whereby A pledges the stablecoins as collateral to B in exchange for a $30k cash loan. A then turns around and sells those same stablecoins to C. Because the stablecoins can’t be legally possessed or controlled — so regardless of whether A kept the stablecoins in its wallet, transferred the stablecoins to B’s wallet (or an escrow wallet) in connection with the loan, or transferred them to C’s wallet in connection with the sale — B’s claim to the stablecoins sticks with the asset. And, if D tried to buy the stablecoins from C, D would need to investigate A’s, B’s, and C’s ownership of the asset in making its purchase decision.

[2] Assume A owns a tangible, possess-able asset (like a statue or a paper loan agreement), and A mints an NFT that is “tethered” to that asset — so the NFT is meant to represent the ownership of the tangible reference asset. Then A sells the tangible asset to B by transferring ownership of the NFT to B. And then A sells the tangible asset to C by delivering possession of the asset to C. C can take ownership of the asset free of B’s claims.

CHRIS KARLSSON

Attorney with Figure Technologies focused on digital lending strategy and the development of new blockchain-based assets and marketplaces. Former litigator and “cool” compliance guy. Not a right-clicker — don’t play.