In Blockchain We Trust: The Legal Paradigm of Smart Contracts Across Borders
The Formation of Traditional Contracts
Before examining smart contracts, one should primarily lay out the fundamentals of traditional contracts. According to Article 1 of the Law of Obligations №6098 of Türkiye, a contract is formed when parties declare their wills mutually and in accordance with each other. For this, there must be a declaration of intent, which can be made explicitly or implicitly. An offer is a declaration of will that is directed to the offeree by the offeror for the purpose of forming a contract. However, for a statement of will to be considered an offer, the offeror must declare that he/she wishes to conclude the contract upon accepting the offer.
On the other hand, acceptance is a declaration of will directed to the offeror by the offeree in response to the offer made. A response in accordance with the offer will constitute an acceptance and establish the contract, but if the offeree’s response is not in accordance with the offer, this response will not constitute an acceptance. In terms of the conditions for the formation of the contract, it is necessary for the will and intent of the parties to be mutual.
Further conditions for the validity of a contract include the competence of the parties, i.e., their legal capacity to act, the subject matter of the contract must not be contrary to mandatory rules of law, public order, moral standards of society, and personal rights. Further, the subject matter of the contract must not be of an impossible nature, and the declaration of will of the parties must be healthy, devoid of deception and intimidation.
As a rule, unless otherwise explicitly stated in relevant legislation, there is no requirement as to form regarding contracts. Contracts may be formed in various ways, for example, written or orally. However, for some matters lawmakers tend to determine a specific form for contracts. In such cases, if the parties do not comply with the required form, these contracts may be considered void and null.
Legal Definitions and Smart Contracts in General
Smart contract, as a term, was first used by Nick Szabo in 1994, being defined as a computer processing protocol that enforces contract terms. Ultimately, a short definition of smart contracts can be stated as a self-executing legal agreement generated on digital platforms in which the contract terms are embedded in the code.
Various scholars and legislations have their unique definitions of smart contracts. For example, in 2019, Italy defined smart contracts by law as a computer program that operates on technologies based on distributed ledgers and whose execution automatically binds two or more parties based on predefined effects.
On the other hand, in Arizona, United States of America, smart contracts are defined as an event-driven program, with state, that runs on a distributed, decentralized, shared, and replicated ledger and that can take custody over and instruct transfer of assets on that ledger. On the other hand, in Illinois, smart contracts are defined in a far simpler way, as contracts stored as an electronic record which is verified by the use of a blockchain.
In the perspective of Türkiye, as of September 2023, there is no legal definition of smart contracts or any expected definition from lawmakers. In conclusion, smart contracts may simply be defined as self-executing digital contracts of which the terms and conditions of the agreement between the parties are predetermined.
Characteristics of Smart Contracts
Smart contracts are administered by computer programs on a blockchain infrastructure. The technical process involves creating smart contracts as code and storing them on e.g. the Cardano blockchain, allowing for features like immutability, decentralization, lack of intermediaries, peer-to-peer interactions, adherence to specific digital logic, and transparent anonymity.
Due to their nature of being written in code, smart contracts pose a security when it comes to the execution of transactions. Furthermore, once a smart contract is formed, the contract cannot be modified and is implemented automatically.
All actions taken within the contract are easily visible, giving smart contracts a quality that ensures transparency in transactions. This transparency also contributes to reducing both transaction and court costs, streamlining processes and reducing expenses. Since smart contracts function independently, they operate without the need for parties to have any prior knowledge of each other or an established trusting relationship. This also eliminates the need for any third party or intermediary that must oversee the execution of elements of the contract which enhances efficiency.
Smart contracts enable parties of an agreement to not concern whether the other party will satisfy their end of responsibilities. The obligations and responsibilities of each party will be automatically executed.
Smart Contracts vs. Traditional Contracts
The structure of smart contracts presents a challenge in comparison to traditional contracts. Certain provisions that are typically included in traditional contracts may not written in the code of a smart contract**. As a result, creating complex contracts using smart contract code can be difficult.** However, this issue can potentially be resolved by using mixed contracts, where only certain provisions are written in computer code.
Smart contracts require the use of electronic digital signatures, but according to Turkish Law, contracts that are not within the scope of electronic signatures cannot be executed with them. This means that certain smart contracts will not be valid under Turkish Law or in jurisdictions with similar restrictions. The Electronic Signature Law №5070 needs to be amended to meet the requirement of electronic signatures for these contracts. Currently, in Türkiye, blockchain-based digital signatures are not considered electronic signatures as of September 2023.
At first, it may seem like smart contracts only apply to blockchain-based assets. However, it is far from true. Smart contracts are based on IFs and SOs simply meaning that if condition X occurs, do Y. But how does a smart contract know if such X condition is satisfied? There are some external information providers called Oracles. Oracles are third-party services that provide smart contracts with external information. With the help of Oracles, even assets that are not on blockchain may be subject to smart contracts, provided that these smart contracts follow relevant applicable law.
Legal Nature of Smart Contracts
The term smart contract generally refers to processes that envisage the transfer into computer code not only the rules that govern the contractual relationship between the parties, but also the conditions under which a contract will be automatically performed. On the other hand, some smart contracts only realize the execution of a pre-existing contract; that is, the obligatory acts are fulfilled with the help of code.
Smart contracts are well-suited for the automatic execution of certain types of transactions already found in many contracts. Nowadays, the practice of using smart contracts is mainly focused on partial automation of certain parts of contracts (e.g., the transfer of digital assets).
One approach to smart contracts suggests that it is the execution phase of a traditional contract established between parties. In line with this approach, a contract is established between the parties in the traditional sense, and it is accepted that all or part of the provisions of this contract are decided to be automatically executed in the form of a smart contract. In practice, it is seen that many smart contracts are designed in this way and made for this purpose.
Indeed, considering that the computer programmers who write the smart contract cannot decide on the commercial and legal aspects of the contract, there may need to be a document explaining the essence of the agreement between the parties. It can be argued that such a perspective would be compatible with the traditional contract law structure. In this case, a basic contract in accordance with the existing legal order is concluded between the parties, and the parties can agree that the performance of the debts arising from this contract will be carried out through the code to be run on the blockchain. Thus, legal problems that may arise regarding smart contracts will be easier to solve, as they will concern the execution of the contract, not the contract itself.
However, this approach is not applicable to all smart contract structures. Because there is no legal or practical obstacle for people to establish smart contracts in the form of “direct coding” without any prior written or verbal agreement between them.
TL;DR:
Some scholars argue that smart contracts are not a contract but a means of performance of a contract. Even though this approach may be acceptable for some cases, we strongly believe that as long as follows the applicable law, smart contracts may in fact be actual contracts in legal sense.
Legal Developments in Smart Contracts in General
As in Turkish law, there is no legal regulation addressing smart contracts and blockchain technology in all aspects in other countries’ legal systems. The reason for this may be the complexity of these technologies and the inability of modern states to keep up with the pace of technology in the process of making legal regulations. However, especially in Europe and the United States of America (“the U.S.”), important studies are being carried out in this field, and some of them are becoming legal regulations.
Developments in Europe
Belarus was the first country in the world to legislate on smart contracts. According to a 2017 presidential decree, a smart contract is defined as a program code intended to function in a distributed ledger for the purpose of performing various transactions, automated execution or other legal actions.
Studies are being conducted in the EU to determine the legal framework for smart contracts and blockchain technology. A report from the Legal Affairs Committee of the European Parliament highlights the increasing use of smart contracts but raises concerns about their legal validity and enforceability. The committee calls on the European Commission to establish a legal framework to provide certainty for businesses and consumers, particularly regarding the legality of smart contracts, their use in cross-border transactions, and meeting formal requirements. The committee also recommends implementing mechanisms in smart contracts to halt their execution in certain situations, such as protecting the weaker party or creditor rights. However, there is currently no legal regulation on smart contracts within EU legislation.
In recent years, Russia has made notable progress in the field of blockchain. A significant development was the amendments made to the civil code in 2019, which acknowledged the possibility of self-executing contracts through electronic means. This has opened opportunities for smart contracts without the need for manual intervention from the involved parties.
Developments in the United States
The U.S. does not have a consistent national regulation on blockchain or smart contracts. However, federal agencies like the Commodity Futures Trading Commission (“CFTC”) and the U.S. Securities and Exchange Commission (“SEC”) have released reports stating that they do not believe special regulations are needed and are instead applying existing laws to smart contracts.
Arizona has become the first state in the U.S. to acknowledge the legal validity of blockchain technology and smart contracts. The 2017 legislation states that smart contracts executed on a blockchain are legally binding, even if they do not follow the traditional format of a contract written in human language. This recognition is a significant step forward and sets a precedent for other states to follow.
The state of Tennessee passed a law in 2018 called Senate Bill 1662 that defines blockchain technology and smart contracts. This law, like the one in Arizona, states that smart contracts are legally valid and enforceable.
In 2019, Arkansas and North Dakota implemented regulations like Arizona’s, legally recognizing blockchain technology and smart contracts. This makes it safer for parties to choose Arizona or similar states that acknowledge smart contracts as legally valid and binding when entering a smart contract relationship.
The state of Illinois has taken a significant step by passing the Illinois Blockchain Technology Act, which allows the use of smart contracts. This law defines smart contracts as contracts that are verified using blockchain technology and stored electronically. This is important because it legally recognizes smart contracts as valid contracts.
Wyoming has a comprehensive set of laws and regulations, including the definition of smart contracts as automated transactions that fulfill contract terms. This definition aligns with the belief that smart contracts are a means of enforcing legally binding contracts.
Developments in the United Kingdom
In November 2021, the United Kingdom Law Commission issued its report on smart contracts. In this report, the Law Commission defined smart contracts as legally binding contracts in which some or all of the contractual obligations are defined in and/or performed automatically by a computer program. The Law Commission strongly emphasized the increasing usage of smart contracts in areas such as DeFi, real estate transactions, managing supply chains, etc.
In their report, the Law Commission stated five main criteria shall be met to consider smart contracts legal and valid under England and Wales laws. These criteria are agreement, consideration, certainty, completeness, intention to create legal relations, and compliance with formalities.
Agreement Requirement for Smart Contracts
Agreement between the parties of a contract generally consists of offer and acceptance, quite like Turkish law. An offer may be defined as a clear statement of the terms on which one person is willing to be bound. It is a declaration of intent to enter a contract on the stated terms, made with the understanding that it will become enforceable as soon as the recipient accepts it. Contrarily, acceptance is a complete and unequivocal acceptance of an offeror’s terms. If there is contemplation, a purpose to establish a legal relationship, and other necessary elements, this results in the creation of the agreement.
Consideration Requirement for Smart Contracts
Contractual promises generally cannot be given “gratuitously” — that is, for nothing in exchange — according to English and Walsh law. In our opinion, smart contracts won’t pose any special difficulties in determining the pertinent consideration. In most circumstances, the wording of any natural language agreement or the way the code itself operates could be used to determine the consideration (such as payment in money or tokens).
Certainty and Completeness Requirements for Smart Contracts
Certainty generally relates to the sufficiency of the terms of a contract. The terms of a contract shall be clear and precise so that each party to a contract shall be aware of its responsibilities and obligations. It is important to keep in mind that ambiguous terms may render a contract unenforceable or even invalid.
Completeness, on the other hand, is quite like certainty. A contract must be complete to be legally enforceable. This means that all pertinent conditions must be agreed upon by the parties. There might not be a legally enforceable contract if parties agree on some conditions but leave other crucial aspects up in the air.
In terms of smart contracts, these requirements may be met depending on the complexity of the subject matter of the agreement. If parties can state and agree upon the fundamental terms of an agreement via a smart contract, the smart contract shall be deemed to meet these criteria.
Intention to Create Legal Relations Requirement for Smart Contracts
This condition is intended to distinguish between contracts with the intent to be legally enforceable and those that are just social or domestic in character and are not intended to be subject to legal examination.
The Law Commission emphasized in the case of an agreement being reached on a DLT system or other smart contract platforms, it may be difficult to determine if parties meant to enter into a contract with legal force**. It would be wise for parties who do intend for these transactions to establish legal connections to make this explicit in plain language.**
Formality Requirement for Smart Contracts
Like Turkish law, the fundamental rule is that contracts need not be made in a specific form unless a particular form requirement is foreseen by the law. For matters that do not necessitate a specific form requirement for contracts, smart contracts constitute no challenges. However, for matters that require form requirements such as in writing, shall be examined in terms of smart contracts.
The Interpretation Act 1978 defines writing as including all modes of “representing and reproducing words in a visible form” and writing is drawn up in an inclusive way meaning that if words of a contract can be represented and reproduced.
A smart legal contract would meet the “in writing” criteria if its provisions were laid down in a document written in natural language. Which contractual words defined in code could meet this need is the trickier question. This relies on whether the code is presented in a way that a person can read. On this matter the Law Commission believes that source code qualifies as “writing” under the Interpretation Act of 1978. It will be more challenging to claim that a smart legal contract is “in writing” if the terms are said to be stored in machine code or a lower level of code than source code.
Validity of Smart Contracts and Valid Use Cases
The validity of smart contracts mainly depends on their sufficiency to satisfy the requirements of traditional contracts. The main challenges in the validity of smart contracts converge upon form requirements.
Regardless of whether smart contracts are considered as a means of performance of an agreement or an agreement itself, for matters that do not require a particular form for contracts, it is safe to say that smart contracts are as valid as traditional contracts.
However, there are some cases where lawmakers require strict form requirements to be met. For example, according to Article 706 of Turkish Civil Law, the validity of contracts aiming at the transfer of real estate ownership depends on whether these contracts are officially constructed and accepted by the parties. The term “officially constructed” basically means that a contract shall be in written form and signed in the presence of relevant public officials, namely notary public. In conclusion, specific contracts that require a particular format shall not be constructed as smart contracts to avoid any legal risks.
In cases where no written or even stricter form requirement is not sought, smart contracts may be deemed valid and enforceable. For instance, transfer of a certain digital asset such as Bitcoin or some type of crypto asset constitutes an agreement between the parties of such a transaction. This agreement is made and executed simultaneously via smart contracts which are in fact legally valid, binding, and enforceable.
Specific matters that require contracts to be written are another story. In Turkish law and many other jurisdictions, written format rule comes with a need for the signature of the parties. Upon the signature of the parties of a contract, the contract becomes valid and enforceable. However, the need for signatures in smart contracts is tricky. For example, in Turkish law, not all but some electronic signatures are considered equal to traditional signatures.
According to the Electronic Signature Law of Türkiye, a secure electronic signature is an electronic signature that is exclusively linked to the signatory, generated with the secure electronic signature creation device only under the control of the signatory, based on a qualified electronic certificate that identifies the signatory and, allows for the detection of any subsequent change made in the signed electronic data.
In conclusion, it is safe to say that in Turkish law, smart contracts cannot be valid for matters that require a particular format, such as a written format**. On the other hand, on matters that do not require a specific format, smart contracts may be constructed. These smart contracts shall be considered valid and enforceable under Turkish law.
Legal Implications of Different Smart Contracts
Depending on the function a smart contract constitutes, there may be various legal implications to be considered. Smart contracts may be used to mint new tokens such as NFTs, to vest some crypto assets for a period, or to act as a governance instrument in some governance tokens, and etc.
Minting New Crypto Assets and Smart Contracts
Many crypto assets such as NFTs are minted via smart contracts. When producing tokens or Non-Fungible Tokens (NFTs) on platforms like Ethereum, Binance Smart Chain, and others, smart contracts are essential to the minting process. The smart contract for a token or NFT often includes a method for minting (or creating) new tokens. When invoked, this function raises the overall supply of the token and allocates newly produced tokens to a specified address. When new tokens or NFTs are created, the smart contract can trigger events that alert external observers (such as dApps or wallets) about the operation. This can help with real-time tracking and visualization of token creation.
In conclusion, smart contracts included in the minting process must be extensively audited and tested. Because blockchain transactions are irrevocable, any error in the minting process or weaknesses in the contract could result in a loss of cash or other undesirable results. Due diligence and proper security measures are essential.
Vesting Crypto Assets and Smart Contracts
Smart contracts are very crucial in the vesting process for cryptocurrencies and tokens. They can enforce and automate vesting schedules in a transparent and dependable manner. The smart contract will gradually release tokens according to the vesting schedule. These tokens can then be claimed by the beneficiary.
Any smart contract that deals with vesting must, as always, be thoroughly audited and tested. Because blockchain transactions are irreversible and frequently involve vast sums of money, any errors could result in significant losses or legal issues.
Moreover, since there is no form requirement for vesting agreements in Turkey, it is safe to say that smart contracts may be valid and enforceable.
Governance Tokens and Smart Contracts
One of the main usage areas of smart contracts is Decentralized Autonomous Organizations (DAOs). After the establishment of DAOs, the funding process starts. In this period, people across the globe who wish to participate in the DAO purchase the tokens of the said DAO. Sometimes, these tokens are called governance tokens because they enable their holders to participate in the voting procedures of the DAO and, therefore, have a say in its governance.
In DAOs, the rules agreed by the community are applied via smart contracts, voting is done and the codes containing all these rules and operations are made publicly available. After forming its smart contracts and therefore the governing rules and principles of a DAO, tokens of the said DAO are generally offered. With the token offerings people become a member of the DAO which mainly gives its holder the right to vote and to be entitled to profit generated by the DAO.
Smart contracts constitute an essential part of DAOs and their governance tokens. Even though these smart contracts create the necessary infrastructure for the application of DAOs, it is important to note that the legal qualification of DAOs in different jurisdictions may adversely affect the validity of smart contracts. For instance, in the event of accepting DAOs as joint stock corporations, then, many of the governance decisions of such joint stock corporations shall be in written form and include signatures of authorized personnel.
In conclusion, our recommendation is that before executing a smart contract, parties of the agreement shall primarily check if the subject matter of the agreement between the parties requires a particular format.
Legal Risks in Smart Contracts
There have been certain legal issues and risks that smart contracts may constitute. The format and the degree of automation used in smart contracts can influence the potential for legal disputes or complexities to arise associated with their implementation.
Further, it may be difficult to interpret a contract in which the terms are predominantly or solely defined in code which can lead to issues. Also, there is room for mistakes to likely be made when translating contracts from code to a natural language, leading to disputes to arise and confusion in meaning and intent. Since amending code on a distributed ledger may pose to be difficult, rectifying such misalignments can also prove difficulties and broaden the legal risks that are associated.
The “oracle” problem also comes up as an issue to consider in which the performance of a smart contract depends on information from an external database. Here, an external data source malfunctioning or providing unreliable or false data becomes a cause for concern.
Court Decisions on Smart Contracts
The German Federal Court of Justice decided on a case wherein a French bank offered lease agreements for batteries to be used in electric cars. This has been seen as an example of a smart contract used in car lease agreement.
The discussion of smart contracts is seen in the Federal Court of Justice’s assertion that digital intervention in controlling a rental object is equivalent to any physical intervention. Meaning, whether the battery (which later gets blocked) is accessed manually or automatically is not relevant and an automated intervention can be attributed to the technology provided by, in this case the bank, making no essential difference for legal assessment. Thus, this assessment made by the court suggests that using a smart contract to automate a lease agreement can give rise to legal disputes.
Blockchain, Smart Contracts and Future Notarial Services
Public notaries, also known as notary publics, are essential in many legal transactions since they offer services for verification and fraud prevention. Their main responsibility is to serve as unbiased witnesses at the execution of specific types of papers, verifying their validity and the consent of all parties concerned. Furthermore, in many jurisdictions, notaries may act as a formal intermediary between the parties when it comes to issue formal protest and declarations. In some cases, usage of public notaries as an intermediary is even required by law.
Since public notaries generally act as a formal and public record keeper and act confirmatory to various legal transactions and documents, many scholars started to recommend application of blockchain and smart contracts to notary services. The fact that there are various incidents such as misconducts, fraudulent actions and bribery perpetrated by public notaries, even urges people to ask for a more secure and transparent system of notary services.
Some of the prominent features of blockchain technology are its ability to record the transactions securely, immutably, and transparently. Its underlying technology distributed ledger is used to log transactions across numerous computers in a way that prevents changes to the record from being made retrospectively without changing all blocks behind them and receiving network consensus. Therefore, any transaction that is recorded on the blockchain is as a rule may not be altered. Since the data regarding the transaction is distributed amongst various computer systems and databases, it offers quite reliable data protection.
Considering explanations provided above, blockchain technology and smart contracts may effectively be used in record keepings such as notary services. In fact, the World Intellectual Property Organization (“WIPO”) has shown a great interest in blockchain’s ability to protect data. WIPO argues that intellectual property (IP) offices may be able to take advantage of these traits to improve the registration of IP rights by making it more efficient, quick, accurate, and secure.
- Formalizing and Securing Relationships on Public Networks, Nick Szabo, 1997, (Date Accessed: 24.09.2023) https://firstmonday.org/ojs/index.php/fm/article/download/548/469#*[↩](about:blank#fnref1)
- For more information please see our paper on this topic, https://docs.google.com/document/d/1XWkk79LRLfhjWcM6VjV97wlQUv9jbnoO/edit[↩](about:blank#fnref2)
