On-Chain Asset Partitioning and the Future of Property without (Organizational) Law

While their contours vary by jurisdiction, there is a fundamental divide between property and contracts that is common to all Western legal systems.

Contracts have in personam effects, that is, they bind only contractual parties and in the standard case have no effects on third parties. This implies that contractual rights do not ‘run’ with the asset, but take effect only within the specific relationship from which they originate. It also implies that contractual obligations do not (generally) need to be disclosed to the wider public. Moreover, parties enjoy wide freedom in designing contractual obligations.

In contrast, property rights have in rem effects, that is, they bind contractual as well as third parties who come in contact with the asset at any point in the future. They ‘run with the asset’, meaning that their legal effects extend beyond the original relationship, through subsequent transfers. In turn, this creates the need to provide notice of the creation of a property right to third parties.  As a counterbalance, parties have limited freedom in designing property rights, as they are bound by the numerus clausus principle according to which only rights so recognized by law have in rem status.

This classical framework, however, is being unsettled by new technologies that blur the line between contract and property. In a recent paper (forthcoming in the Yale Journal on Regulation), we show that parties can now use smart contract to create de facto property rights without the need for state recognition through technology-enabled applications — a phenomenon we call ‘property without law’. 

‘Property without law’ rests on three building blocks: (1) a distributed ledger with a consensus protocol, (2) smart contracts to encode promises, and (3) digital or tokenized assets. The ledger records all transactions and allows participants to validate them without a central validator, mimicking the role of property and business registries. Smart contracts encode contingent promises in machine-readable form and automatically enforce them when conditions are met. Automatic enforcement mimics the in rem feature of property rights, as the encoded contractual clauses remain stored on the ledger and also bind subsequent transferees. Finally, the assets must exist in digital form and be transacted on-chain — a condition met either by native digital assets or by tokenized real-world assets (RWA).

To grasp the mechanism through which automatically enforced digital contracts can be made to mimic property rights, the transferor needs to encode two types of clauses in the contract with the first transferee: (1) a substantive clause detailing the contours of the right in question, and (2) a covenant to bind subsequent transferees, which should ensure that the substantive clause is passed on to subsequent transferees. The problem with this chain-structure is that if transferee 1 fails to pass on the clause to transferee 2, the right evaporates, and the transferor (i.e., the original owner) will typically only have a damage claim against transferee 1.

This result changes when a smart contract that is automatically enforced is used. The substantive clause is automatically enclosed in any subsequent transfer and impossible ¾ by fiat of technology ¾ to delete. So, transferee 2 receives the transferor’s substantive clause for sure, making the mimicking watertight.

Given the flexibility of this system and the wide range of potential substantive clauses that can be encoded and passed on to subsequent transferees, ‘property without law’ holds the potential to disrupt the economic reality we are currently experiencing in several fields. Among these, organizations and the role of organizational law in partitioning assets offer two prominent applications of these ideas.

Tokenizing Real Estate: Liquidity, Transferability, and Capital Lock-in

The first application combines asset partitioning with tokenization to enhance the liquidity of real-estate investments, while circumventing many of the legal hurdles that currently limit them. A real estate asset is owned by a legal vehicle ¾ such as a fund or a limited liability company ¾ in compliance with the formalities required by property law. The ownership interest in the vehicle is then tokenized, and the tokens are offered to investors. Circulating a token functionally transfers control and economic rights in the property.

This design achieves results that off-chain contracting cannot. Suppose ownership of a real-estate asset is equally split into two tokens held by A and B. A can transfer one token to C quickly and informally, effectively transferring 50% of the asset. Off-chain, the same transaction would require costly formalities, and co-ownership would allow any party to seek partition, making the investment unstable. Tokenization avoids this by holding the undivided legal title in a single vehicle while making it circulate fractionally through tokens.

Therefore, tokenization adds a measure of capital lock-in to the investment. To connect back to the general mechanism presented above, tokenization effectively embodies a de facto promise not to withdraw unilaterally from the investment and push for the liquidation of the asset, which would not be easily enforceable under traditional property regimes, while it becomes a simple feature of the underlying smart contract and one that can be easily passed on to future transferees of the tokens. While some of these benefits may be achieved by share ownership in lieu of token ownership, tokenization is much more flexible and allows parties to add a possibly unbounded number of tailor-made and automatically enforceable covenants to the token, such as on use rights or profit distributions. Token ownership also guerantees a level of liquidity that is not achievable with share ownership in non-listed corporation.

DAOs: Mimicking Organizational Law On-Chain

The second application is even more disruptive and aims at creating an alternative way to partition assets outside of organizational law. The key features of organizational law – agency, limited liability, entity shielding, capital lock-in, and transferability of ownership instruments – are proprietary in nature and cannot be replicated by (traditional) contracts alone. However, smart contracts can be used to mimic some or all of these features through Decentralized Autonomous Organizations (DAOs), which are partnerships encoded in a smart contract whose economic and voting rights are tokenized. Tokens can then be freely transferred but token ownership does not confer a liquidation right the way in which a traditional partnership would. As a result, token holders and their creditors can only pledge or seize the token, while the initial investment remains in the partnership. These features realize de facto capital lock-in and entity shielding without the partnership ever being recognized as a legal entity under the law.

Interestingly, since there is in fact no legal entity, token holders remain unlimitedly liable for company debts, reversing a commonly understood patter in history and theory. Traditional partnerships have commonly been thought to be able to mimic limited liability more easily than entity shielding and capital lock-in, whereas DAOs do exactly the opposite. Smart contracts deploying DAOs create an asymmetric pattern of creditor rights: personal creditors cannot seize on-chain DAO assets, but DAO creditors can pursue token holders’ off-chain assets.

These developments show that the boundaries of property and organizational law are increasingly blurred. As tokenization and smart contracts enable the creation of ‘property without law’, policymakers and scholars will need to rethink the legal architecture that underpins asset ownership and circulation.

The authors’ full paper can be found here.

Stefan Bechtold is a Full Professor of Intellectual Property at ETH Zurich. 

Giuseppe Dari-Mattiacci is a Professor of Law and Economics at the University of Amsterdam. 

Edoardo D. Martino is an Associate Professor of Law and Finance at the University of Amsterdam.

Gideon Parchomovsky is a Professor of Law at the University fo Pennsylvania.