Smart legal contracts – how smart are they?

In a paper published on 25 November 2021, the UK's Law Commission has confirmed that there is no need for new legislation on smart contracts because the existing laws of England and Wales can accommodate them. The Commission said that current principles of contractual interpretation could apply to smart contracts, with only a minor modification of common law necessary in some situations.
 

These findings build on the conclusions reached by the UK Jurisdiction Taskforce’s legal statement on smart contracts in November 2019. The legal statement established that the current legal framework is sufficiently robust and adaptable so as to facilitate and support the use of smart legal contracts; a view affirmed by the Law Commission’s advice.

What is a smart contract?

A smart contract is effectively a self-executing contract, where the terms of the agreement are written as lines of computer code that can automatically monitor, execute and enforce performance of the agreed terms. The code and the agreements contained within it exist across a distributed, decentralized blockchain network. The code controls the execution, and transactions are trackable and irreversible.

A smart contract can be carried out between two anonymous or pseudo-anonymous parties, unlike the traditional contract which would require physical signatures. A smart contract is performed automatically, without the need for human intervention once the code has been mapped.

Examples of smart contracts include automatic financial trading, automatic monitoring of service level agreements, automatic document creation and filing for real estate transactions, and insurance paying automatically when an event occurs.

What form can a smart contract take?

The Law Commission has identified three main types of legal smart contract.

Form 1 – natural language contract with automatic performance by code

This is a natural language contract in which some or all of the contractual obligations are performed automatically by the code of a computer programme. This appears to be the most commonly used form of smart contract at present.

Form 2 – hybrid contract

This is a contract in which some contractual obligations are defined in natural language and others are defined in the code of a computer programme. Some or all of the contractual obligations are performed automatically by the code.

Form 3 – contract recorded solely in code

This is a contract in which all the contractual terms are defined in, and performed automatically by, the code of a computer programme. No natural language version of the agreement exists. This type of smart contract is likely to be rare in practice, as commercial contracts are typically too nuanced to be reduced solely to code. This type of contract also presents the most challenges from a contract law perspective.

The current position is that most smart contracts are form 1, but in light of the Law Commission analysis, we may be seeing a move towards more hybrid contracts in the future. 

Why is the Law Commission's paper so significant?

The recent growth in the use of smart contracts has so far been achieved within a legal vacuum. There is virtually no case law, legislation or regulation which addresses or even considers the legal implications of this rapidly developing technology, which has led to a lack of certainty as to the legal status of smart contracts.

The Commission's paper effectively gives smart contracts the green light to be used with confidence, and allows lawyers to draw these contracts up for their clients without concerns that they are in a legal grey area. This is an extremely significant development, both in terms of providing certainty and also because it may mark the beginning of a new era for the adoption of smart contracts and the scope of legal principles in contract under English law. However, as the technology underpinning smart contracts develops, so do the potential risks.

What legal issues could arise?

The terms of a smart contract (using natural language or computer code) can only be automatically performed where such terms are unambiguous and there exists a logic path which can be used to trigger the automatic performance. However, this may overlook the reality of the commercial arrangements and the disputes that are likely to arise from them. For example, clauses involving terms like 'bona fide', 'using best efforts' or 'to the extent possible' cannot be implemented as code and therefore cannot form part of a smart contract. Lawyers will have to think of creative and innovative ways of getting around this issue, such as supplementing the code with natural language to explain the parties' intentions.

• ​A smart contract is performed automatically without the need for any human intervention once the code has been mapped. This means that once the automated transaction has occurred, it is unlikely that the smart contract can be reversed or modified, and there is no central body that oversees or governs the transaction. Practically speaking, this may make it more difficult to take action in response to non-performance.

• In addition, as an executed smart contract cannot be legally reversed, dealing with void contracts could pose a challenge. The parties could agree on further transactions reversing the result of the void transactions but the void transaction would be kept on the smart contract's blockchain.

• As stated above, a smart contract can be carried out between two anonymous or pseudo-anonymous parties. There are, potential practical difficulties, however, for example in identifying who can be sued if the contract is breached and in what jurisdiction.

• There is a question of where the risk lies if external events beyond the parties' control affect the contract's performance, for example if there are errors in the code or if data inputs go wrong. Interestingly, in the recent Singapore International Commercial Court case of B2C2 Ltd v Quoine Pte Ltd, the Court looked to the contract's programmer when deciding what was intended in a smart contract using a deterministic algorithm. 

Conclusion

The Law Commission paper is a strong statement of confidence in the English legal system's willingness to support developing technologies and its ability to handle disputes arising out of them. The Law Commission stated as part of its conclusion that more study was required in the area of conflict resolution arising from smart contracts (and emerging technology in general). The Commission made the point that some types of smart contracts will come with their own unique legal issues.

As smart contracts continue to develop and become more widespread, it will require case law to develop for parties and developers to see how smart contract risks play out in Court. What this report recommends, in effect, is that no new legislation is required to address legal issues arising out of smart contracts specifically. However, new regulation or legislation may be required in the future as the technologies underpinning smart contracts develop and novel issues arise.

Helpfully, an appendix to the report identifies issues that parties may want to address to promote certainty and party autonomy, which is a useful starting point when thinking about the types of disputes that may arise and the risks that may need addressing.
 
James Lewis is a Partner and Bhavul Haria is an Associate in the dispute resolution team at Fieldfisher. For more information on our litigation expertise, please visit the dispute resolution pages of the Fieldfisher website.