01/14/2022 | News release | Distributed by Public on 01/14/2022 03:03
Smart contracts are in their infancy but have already shown signs of revolutionising the way we do business. They are increasingly being considered by contracting parties as a means of automating processes within conventional contracts, not only improving efficiency and transparency, but also minimising costs and the risk of human errors.
In light of the growing use of smart contracts, and the soaring popularity of the crypto markets and blockchain technology generally, the UK Law Commission has published a report1 confirming that English law is able to accommodate smart legal contracts without the need for any statutory law reform. However, new technologies can give rise to novel legal issues and the Law Commission has advised users to cater for such uncertainties through the drafting of natural language in their smart legal contracts or in separate supplemental agreements. We summarise below some of those uncertainties and the options to mitigate the risks arising.
What is a Smart Contract and a Smart Legal Contract?
Smart contracts have been defined as "systems which automatically move digital assets according to arbitrary pre-specified rules".2 Current blockchains such as Ethereum provide for smart contracts to be coded and run on their networks, and are often embedded in larger computer applications or programs. However, it has been noted by some commentators that "smart contracts" are neither "smart" nor "contracts". Smart contracts are essentially lines of code which on their own may not meet the requirements for a binding contract under English law. They are simply attempts to automate transaction terms so that transfers of value can occur in the context of the operation of a wider computer program without human interaction or approval.
For the purposes of its report, the Law Commission therefore distinguished a smart contract from a smart legal contract, defining the latter as a "legally binding contract in which some or all of the contractual obligations are defined in and/or performed automatically by a computer program".3 As part of this definition, the Law Commission recognised that many commercial circumstances will entail a combination of a legally binding contract and smart contract code elements running in parallel.
Smart contracts can be used for a variety of purposes including facilitating cross-border financial activity, supply chain management and peer-to-peer transacting, as well as being more commonly deployed on the blockchain or other distributed ledger technology in a wide variety of cases. For example, there may be smart contract functionality built into non-fungible tokens ("NFTs") to create an automated ongoing payment of royalties or commission to the owner of the underlying digital asset to which the NFT relates on any resale of the tokens.
Smart legal contracts can take different forms with varying degrees of automation and proximity to traditional contractual terms, including: (i) a natural language agreement with performance to be automated by code; (ii) an agreement written solely in (and to be performed by) code; or (iii) a hybrid consisting of both natural language and coded terms. Smart legal contracts drafted primarily or solely in code and recorded on a distributed ledger (such as blockchain) are those most likely to give rise to novel legal questions.
Potential risks and how to mitigate them
Formation of smart legal contracts
The Law Commission concluded that in most cases, whether a particular smart contract constitutes a legally binding contract will be determined by the same formality requirements as apply to a traditional contract. It noted that an offer can be made by a computer program (containing the code underlying the smart legal contract) and a computer program can also accept an offer, meaning that in principle an agreement can be reached by the autonomous interaction of computer programs deployed by parties. However, it is not always clear whether the deployment of the computer program, without engaging in natural language negotiations or communications, represents a formal offer (capable of acceptance) or merely an invitation to treat (i.e. to enter into negotiations). The answer will typically depend on what the parties objectively intended by the deployment of and interaction with the code. In order to deal with that uncertainty, it would be prudent for market users to make clear in natural language, either in a separate agreement or by way of comments in the code, if the parties intend their automated transactions involving smart contracts to create legal relations.
English contract law requires the terms of an agreement to be sufficiently certain for it to be enforced as a binding contract. Where natural language is used, the parties should consider the relationship between any natural language and coded terms. Where the same term is expressed in both natural language and computer code, it would be prudent to make clear which term takes precedence in the event of a conflict in order to avoid any argument that the contract is lacking certainty.
In the case of deeds, the Law Commission noted that although smart contract technology could potentially be used to create deeds, parties cannot be confident that the current law supports the creation of deeds which are wholly or partly defined by code. For example, under English law deeds need to be witnessed when being executed by an individual and it is not clear how this could be done when dealing with an automated smart contract based on computer code. The Law Commission intends to consider these challenges in a broader project on the law of deeds, when it will assess the current requirements for the execution of deeds and make recommendations for reform. In the meantime, it would be prudent for parties not to attempt to execute smart legal contracts as deeds and to ensure their smart legal contracts are clearly supported by consideration (expressed in code, natural language or both).
Transacting parties of digital assets on public, permissionless platforms can operate under pseudonyms. Whilst this does not prevent a smart legal contract from being formed, it may make the enforcement of such a contract challenging. Parties should therefore consider using smart legal contract platforms with sophisticated permissioning, identification and authorisation to mitigate this risk.
Interpretation of smart contracts
Where the parties have not dealt with a particular matter in natural language, if a dispute arises difficulties may arise in a court's interpretation of the role of the underlying computer code. Market users would be well advised to:
The Law Commission concluded that the most appropriate test for interpreting coded terms in a smart legal contract would be to consider how it would be interpreted by a person with knowledge and understanding of code - known as a "reasonable coder".4
In the case of implied terms, the parties would have to overcome a high threshold in order to persuade the court to imply a term into a smart legal contract (particularly where coded terms are present); as in the case of traditional contracts, they would have to establish that the term they wish to see implied would be necessary in order to give business efficacy to the contract. The Law Commission did not consider that evidence of the parties' pre-contractual negotiations (to the extent that any exist in respect of automated contracts) should be admissible to assist in the court's interpretation of the coded terms.
Jurisdiction and applicable law
Given that smart legal contracts are currently being built using decentralised ledger technology, they are likely to give rise to a variety of jurisdictional connections to different legal systems, making it more difficult to determine (i) the appropriate court to adjudicate any dispute arising from the smart legal contract and (ii) the applicable law to govern the dispute. It also gives rise to difficulties in establishing the identity and location of parties, causing uncertainty around conflict of laws. The Law Commission therefore recommended that parties include jurisdiction and choice of law clauses in any smart legal contract, either in a separate natural language agreement, or by way of comments in the code. That recommendation is to be applauded but if the parties fail to do so, the English court has given a preliminary indication that the location of a cryptoasset (which is a factor in determining the applicable law of a dispute related to that cryptoasset) can be determined by the place where the owner of the cryptoasset is domiciled, as reported on in an earlier OnPoint.5
Confirmation from the Law Commission that smart legal contracts can be accommodated under English law without the need for legislation or other legal reform will bring welcome comfort to the millions of market users who already employ smart contracts in their transactions. The Law Commission commented that the flexibility of the English common law is such that the jurisdiction of England and Wales provides an ideal platform for business and innovation. This is mirrored by the approach of the English court which has already handed down a number of interim decisions concerning cryptocurrencies, showing a willingness to grapple with new and popular commercial trends in order to provide much needed legal guidance on the issues that can arise.6
Nevertheless, coding smart contracts and entering into smart legal contracts is not without its legal uncertainties and issues of the sort reported on above should be carefully considered, and ideally it is suggested addressed expressly, in the way that we have described. The Financial Services and Litigation teams at Dechert are very experienced in dealing with the types of issues that arise in connection with building and deploying smart contracts in distributed computer applications and programs, and are able to advise on the steps that market users should consider taking to mitigate future risks.
The authors would like to thank Sahil Kirpalani for his contributions to this article.
1Smart legal contracts Advice to Government, The Law Commission, CP 563, Law Com No 401, November 2021.
2 Ethereum White Paper, A Next Generation Smart Contract & Decentralized Application Platform, Vitalik Buterin, 2013.
3 Page vii, Smart legal contracts Advice to Government.
4 Para 4.32, Smart legal contracts Advice to Government
5Dechert OnPoint; Ion Science Limited and Duncan Johns v Persons Unknown, Binance Holdings Limited and Payment Ventures Inc. (unreported, 21 December 2020), confirmed in the more recent case of Fetch.ai Ltd and another v Persons Unknown and others  EWHC 2254 (Comm).
6 For more information on recent decisions from the English courts on cryptocurrency related issues, please see our recent webinars available at Crypto is Here to Stay- June 2021 and Crypto is Here to Stay- December 2021 Update