Smart Contracts: Key Legal Issues

Last week we started talking about legal issues with smart contracts application. This week, we will take a closer look at their application and the actual identification of smart contracts in different countries.

Smart contract achieves efficiency, timing and performance improvements because of automation of the contract’s terms. This automation is effected through the computer code which governs the automated performance. This raises a critical issue — whether contractual provisions which are expressed in computer code can be valid and effective under law. This is sometimes regarded as a difficult hurdle to clear for the widespread use of smart contracts in complex and regulated areas, such as finance. Often this issue is considered in the context of a contract which is expressed entirely in computer code. In such cases, basic contractual formation issues can cause concerns, such as the identity of parties, the identification of terms, the time of creation and the governing law.

However, before considering these issues, it is important to keep in mind that not all of a smart contract needs to be set out in code. Some terms of contracts which are more complex than the immediate transfer of value and property are likely to not be efficiently encoded. This is because computer code (like mathematics) is well adapted to represent terms which are expressions of logic but not terms which are based in concepts such as reason or conscience. Further, they are not useful to represent terms which are based on the exercise of discretion that is outside of clearly defined frameworks. For example, code could be used to represent the contractual agreement that, if an event happened: “the price is to be adjusted by subtracting the product of x and y.” This provision can be coded easily because it is an expression of logic.

However, code would not be useful to accurately represent that, if an event happened: “the price is to be adjusted by the party in a commercially reasonable manner.” Or: “the price is to be adjusted by negotiation between the parties in good faith.” These two provisions are based in the exercise of reason, conscience and discretion in the future. They cannot be easily coded because their meaning is not able to be comprehensively expressed as a matter of logic. An attempt to do so, would create the risk of divergence expressed in natural language between the meaning of the original contractual provision and its expression in code.

Traditional commercial and financial contracts are a mixture of contractual provisions based in logic, reason, conscience and discretion. Accordingly, there are a mixture of provisions which are able to be efficiently coded and those which are not. It follows from this that if smart contracts are to be used meaningfully in commercial contracts then they will need to be blends of both coded and natural language terms. As the logical provisions are usually applicable during the normal life-cycle of contracts (as opposed to the provisions which apply when unexpected events occur) then this is where the most efficiency should be obtained from using coded terms.

So, how should legislators identify smart contracts? That is one of the main questions regarding legal side of smart contracts application. There are only a few countries that accept smart contracts legally. For example, in Japan there is no governmental definition for the terms ‘blockchain’ and ‘smart contract’. While the Japan Blockchain Alliance provides a working definition in Japanese for ‘blockchain,’ ‘smart contract’ is yet to be defined, and definitions are also absent from the main text and legal summary and analysis of the Virtual Currency Act. This is likely because there is not yet consensus on a common-sense or legal definition for ‘smart contract’ in Japan.

The USA master a nice example of both definition and application, though. Smart contracts are not regulated by any federal law, but there are new laws on the state level. Tennessee was one of the states to adopt the legal concept of smart contracts. State law identifies smart contracts as an event-driven computer program, that executes on an electronic, distributed, decentralized, shared, and replicated ledger that is used to automate transactions, including, but not limited to, transactions that:

(A) Take custody over and instruct transfer of assets on that ledger;

(B) Create and distribute electronic assets;

(C) Synchronize information; or

(D) Manage identity and user access to software applications.

Law also states that smart contracts may exist in commerce. No contract relating to a transaction shall be denied legal effect, validity, or enforceability solely because that contract is executed through a smart contract. Arizona State Law describes smart contract in the same way, except it puts more emphasis on smart contracts usage in commerce: “Smart contracts may exist in commerce. A contract relating to a transaction may not be denied legal effect, validity or enforceability solely because that contract contains a smart contract term”. Florida plans on adopting the same legal concept for smart contract.

More interesting that in some cases you can already use smart contracts in certain spheres, while the concept of smart contracts is still nowhere to be found. The French Civil Code specifically envisages the possibility of entering into a contractual relationship by electronic means. In B2B contexts, there are no limitations on the use of electronic means to enter into a contract. Smart contracts could therefore be formed under French contract law, provided

the essential terms of such contract would be accessible and understandable by each party, and that a technical mechanism would allow each party to express its consent (by the use of cryptographic means, for instance). The French Civil Code specifically provides for the validity of an electronic signature, using asymmetric cryptography, to express a party’s consent to a contract. Distributed ledger technology typically uses asymmetric cryptography, which can also be used in relation to smart contracts too. Where that is the case, the current rules governing electronic signature could apply to smart contracts.

Finally, here’s a checklist of what must be considered by legislators, while talking about smart contracts:

• Legitimacy of multilingual contracts. In one sense, a contract which includes provisions which are expressed in code is similar to a contract which includes provisions which are expressed in different languages. If contracts which are expressed in more than one language are not effective under local laws, then it is likely that contracts expressed partly in code and partly in natural language may not be effective either;
• Smart contract equality to traditional contract. Legislators will have to identify smart contracts as an act equal to a traditional contract or it will be identified as the tool for enforcement of obligations;
• Understanding of coded terms. If a contract is partly expressed in code then the understanding of that code by the parties is relevant. This relevance can be a matter of regulation, such as whether particular parties (such as consumers) can be bound by terms which they do not understand, or it can be a matter of fundamental contract law, such as whether there was sufficient mutual understanding of the terms to form the contract at all;
• Evidence of coded terms. Even though the parties can agree to express specific terms of their relationship in computer code, it is important that that expression is admissible in any judicial and arbitral proceedings which arise out of that relationship. An inability to admit this record of the parties’ agreement would impair its legal effectiveness.

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