The Legalities of Smart Contracts

The American scientist Roy Amara stated the following: “We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run. The smart contracts may consist a perfect illustration of this adage.”

Introduction

Blockchain technology is frequently presented as the new Eldorado for transactions and the organization of human relations. A decentralized database is based on the principle that several actors in the network, called nodes, compile and record all the operations performed by users on the network since its conception. Each group of operations, each block, is then added to the previous ones in a large register, just like adding a link to a chain, hence the name blockchain. Among the many uses of blockchain is the smart contract. This concept is based on the use of the blockchain, which allows parties to a contract to record their contractual obligations with a degree of certainty and also to automate their execution. For example, in a lottery contract, each of the participants agrees to bet 5 and that this amount will be unavailable until the prize is distributed. They also agree on the random event that will allocate to the winner the stake that each of them will have placed once the said event has taken place. The advantage of using the blockchain is that all the network nodes and users will know the terms of the contract that binds the participants, including non-participants. In theory, it might prevent fraud from happening. Once the contract is agreed, it will execute itself like a line of computer code, without the participants being able to intervene. No bad player will be able to retain the stake they placed if they lose, as the amount of the stake will be directly transferred to the winner.

 

Elements of validity for a traditional contract

Although the conditions of validity of a contract are not the same in each jurisdiction, certain elements are common to most of them. In general, a contract in a western jurisdiction must meet the following requirements: offer and acceptance must be characterized, consideration, the intention to create a legal relationship, and certainty. It seems relevant to be precise that certainty does not need to be absolute, parties simply have to not draft the contract in a too imprecise manner. Whereas for instance in Sharia Law it appears that certainty has to be absolute, if there is a lesser degree of uncertainty then Sharia judges should consider the contract as invalid.

 

Differences between Traditional Contracts and Smart Contracts

There is one main similarity between both types of contracts is that they are the encounter of two wills, and aim at creating legal facts and acts out of these wills. However, from a formal standpoint, smart contracts and traditional contracts are very different. A traditional contract is drafted in specific legal wordings, in a natural language, English or Arabic for instance, the execution of the contract depends on the concrete actions of human beings, and finally, it is in a certain way easy to amend in the situation where provisions are unclear. On the other hand, a smart contract is coded through software, executed, and performed by a machine following this software, it is complicated to amend the contract as the machine will execute it literally, and as a consequence of that the contract may not be carried out the right way, it may even not be executed at all.

 

The Validity of Smart Contracts

Much of the standards developed for blockchain come from the United States. We can mention examples of hard law specifically concerning the U.S. state of Arizona’s HB 2417, Tennessee’s HB 1507, and Ohio’s SB 300. The first law cited, that of Arizona provides that smart contracts on the blockchain cannot have their legal status, validity or enforceability denied simply because of their form, following the principle of non-discrimination. The other important aspect of this law is the definition of a smart contract as follows: “an event-driven program, with state, that runs on a distributed, decentralized, shared and replicated ledger that can take custody over and instruct transfer of assets on that ledger”. The second law mentioned, that of Tennessee, ensures the legal possibility to use smart contracts in order to conduct electronic operations. Similarly, Ohio’s SB 300 states that “records and contracts secured by blockchain technology are electronic records” by authorizing the use of terms of smart contracts. In Ohio, smart contracts are recognized as legally binding contracts as are traditional contracts, and hence can be used as evidence in litigation proceedings.

This example of the United States, although it is not the only country considering this question, shows that governments around the world are addressing issues related to blockchain and its applications. Each state is doing so in its own procedure, preserving its particularities as the subjects of the regulation. Thus, we note that smart contracts and blockchain, in general, are already submitted to regulation by hard law. If we take the example of Italy, it has recognized the legal nature of blockchain and smart contracts through Law Number 12 of February 11, 2019, which converted Decree Law Number 135 of December 14, 2018, into law. Along with the definition of these two technologies, the new regulation provides that the registers in a blockchain holding a mechanism for validating the time will be valid. As far as smart contracts are concerned, Italian law recognizes their legal validity binding nature. In summary, smart contracts are equivalent to traditional contracts with respect to the concepts of consent and probative value, as long as the authentication of the parties respects the standards established by the “Agency for Digital Italy”. Recently in Germany, smart contracts have been adopted in the frame of industry 4.0 (industry 4.0 being a new way of organizing the means of production. This new industry asserts itself as the convergence of the virtual world, digital design, and management with the products and objects of the real world).

 

The Limits of the Enforceability of Smart Contracts

It should be remembered that the term “smart contract” can lead to confusion. Indeed, the contractual relationship between two parties to a contract is not reduced to this. It is only the automation of the execution of the obligations of each of them. As with any traditional contract, it is always possible to challenge the validity of the contractual relationship before a court, for example, to have it annulled on the basis of a defect in consent such as duress. However, the consequence of the nullity of a contract is the restoration of the situation in which the parties were before they contracted. It will therefore be necessary for the smart contract’s code to provide for such an eventuality. This example of the nullity of a contract is only the first limit we could think of. Let’s take the example of France. The laws of contract and civil procedure in France, are very strict and precise, and such law is very difficult to take into account in smart contract. For instance, French contract law allows a party to obtain the unwritten reputation of a clause causing a significant imbalance between the rights and obligations of the parties in the case of a non-negotiated contract, or to obtain the re-evaluation of obligations in the event of a change in unforeseeable circumstances that makes their performance too onerous for one of the parties, with judicial review in the event of failure to reach an agreement. All these cases must therefore be anticipated and taken into account in advance in the code of the intelligent contract in order to be able to be executed correctly. Taking this reasoning further, smart contract will have to contain almost all of the contract law and civil procedure of the country in its code if the parties do not want to lose the benefit of the numerous legal and judicial tools at their disposal. This is not impossible in theory, but it appears that no actor globally or on a European level has yet undertaken the difficult and costly task of converting legislation into computer code.

Smart contracts also have limits regarding the exercise of legal action and the execution of court rulings. The smart contract system in a confidential blockchain network makes it possible, through the automation of the execution of obligations on the part of the parties, not to need to know one’s co-contractor if the terms of the contract to which one is considering agreeing are satisfactory. In the previously imagined lottery contract, none of the participants need to know who has participated in the lottery and who is the winner. It is enough that they know the terms of the contract, that they accept it and they are sure that it will be executed as planned. However, this anonymity makes it impossible for each of the parties to the contract to challenge the contract they have concluded in court. Indeed, in order to be able to sue, it is necessary to know the persons with whom one has contracted. We are therefore faced with a situation where, having entered into a contract and subjected the performance of obligations to a smart contract, all the contracting parties are deprived of the possibility of taking legal action.

 

Conclusion: The Future of Smart Contracts

On a certain level, the smart contract tool is still in its infancy. However, some sectors, such as finance, are beginning to look at how companies could potentially implement it in their business in order to reduce the costs of managing traditional contracts, the associated risks of fraud, and optimize transactional processes. On this point, some experts in the field consider that the smart contract market will burst within the next decade. Until then, blockchain actors will necessarily have to meet many challenges, including those outlined above, both on their own, but also in dialogue with public authorities in order to be able to integrate smart contracts more easily into the legal and judicial order: perhaps we will see administrations on a global scale publish new laws both in natural language and in code. However, we should not underestimate nor overestimate the potential of smart contracts as they represent a possible “Amara’s Law” case, a concept named after the American scientist Roy Amara who stated the following: “We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run”. To know more about the legalities behind smart contracts reach out to TMT legal experts at Fotislaw.