Smart contracts: are they as smart as they sound?


Author: Katherine Foweather, Charles Proctor


Charles Proctor, Partner, Fladgate LLP (cproctor@fladgate.com)

Katherine Foweather, Senior Associate, Fladgate LLP (kfoweather@fladgate.com)


 

Smart contracts are one of the major developments arising out of the distributed ledger and are intended to simplify how contracts are made and executed.   This briefing considers what they are and how they fit into the law of contract.

What are smart contracts?

There is no standard, generally accepted definition of smart contracts but broadly they can be seen as contracts which self-execute once certain conditions are met, without the need for further action by the parties.

Classic examples include vending machines which dispense an item of confectionery once the correct payment has been inserted or an insurance contract under which a payment is automatically made once a specified event does or does not take place.

Smart contracts generally consist of pre-agreed terms which are written in computer code and which are recorded in a distributed ledger.   Once a particular event takes place, the contract self-executes and, where relevant, assets or payments can be transferred automatically.

A large number of benefits have been identified in respect of smart contracts, including increased certainty and accuracy, as the obligations and rights are enforced automatically and therefore there should be no scope for human error. Other benefits include reduced cost, as there is no need for intermediaries, and increased speed, as execution is immediate and simultaneous. Finally, as the terms are recorded on the distributed ledger, there is transparency, the parties can easily ascertain their positions and tampering should also not be possible.

However, the status of smart contracts is something that has been exercising lawyers and academics for quite some time. Issues which are being considered include whether smart contracts are contracts in the first place, whether they are they valid and enforceable and whether they provide appropriate contractual protection for the parties.

Application of the law of contract

A valid contract generally requires: offer and acceptance, intention to create legal relations, certainty as to the subject matter and consideration. In theory, a smart contract could meet these requirements but it is not necessarily the case for all contractual arrangements.

One of the main issues that smart contracts face is that not all contractual provisions are easily translatable into code or can be self-executed. For example, operational clauses which provide that if one party does X then Y happens are relatively easy to translate into code due to their binary nature. On the other hand, it is less clear how provisions which rely on some form of human intervention, such as a value judgement or discretion, can be incorporated into smart contracts. Further, parties may deliberately introduce uncertainty into their contracts such as where future decisions are to be made on the basis of reasonableness to accommodate future events. Again, this is difficult to represent in a smart contract.

While the automatic nature of smart contracts has many advantages, it also means that execution cannot be prevented even where this would be desirable. For example, where there are errors in coding the parties would not be able to prevent execution from taking place and assets being transferred or payments being made. This could have even more serious consequences if a party is unable to prevent actions which would involve it breaching the law such as transferring property where to do so would involve a breach of money laundering rules.

There are also potential issues around the extent to which current contractual and regulatory safeguards can be incorporated into smart contracts. Certain basic rights, such as the right to rescind in the event of misrepresentation, do not appear compatible with a smart contract. Similarly, there are an increasing number of legal and regulatory requirements to provide information, to document terms in clear language and to make disclosures, particularly when dealing with consumers, which are not consistent with a contract documented in computer code.

Finally, there are certain contracts which are only valid if specific formalities are complied with which could be difficult to translate into smart contracts. For example, a transfer of land under English law requires a signed contract in writing which incorporates all agreed terms. This may not be possible with a smart contract.

Conclusion

While we think that smart contracts have the potential to replace traditional contracts in many cases, we also think that there are a lot of questions about how they fit into the current contractual framework and how they ensure protection of the parties, particularly where one of the parties is a consumer.

It is possible that smart contracts will only be used for a small subset of arrangements between professional counterparties where the subject matter of the contract is such that it is suitable for self-execution. For example, in the financial services world, smart contracts could be used as part of trading settlement processes.

However, given their obvious benefits, there is considerable appetite to use smart contracts more widely. This is likely to require changes to the law and we note that the English Law Commission is planning to review the current English legal and regulatory framework to ensure that it facilitates the use of smart contracts.

Therefore, we think that the use of smart contracts is only going to increase and we will be watching this developing area closely.


Fladgate has already been advising on a wide variety of fintech matters including ICOs and cryptocurrency related issues such as cryptocurrency exchanges and the regulation of crypto-assets. Fladgate’s regulatory team, therefore, has specific regulatory expertise in and market insight into this fast-moving area.

 

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