Smart Contracts, Part 2: The Legality

This is part 2 of a 3-part series on smart contracts — if you missed it check out part 1: The State of Security.

The legality of smart contracts is often ambiguous — regulations need to be clarified, and a smart dispute-resolution system must be created. The past few years have seen a global spike in the excitement over smart contracts and the blockchain technology that supports them. But not everyone has gotten carried away, Wharton Legal Studies Professor Kevin Werbach is one such person.

In a recent podcast, Werbach said, “Even though we think machines can render contracts effectively, there are lots of situations where they cannot.” This is a good rejoinder to those who proclaim that smart contracts have ‘solved’ contract law or that we can build a future without traditional government or legal systems.

“Even though we think machines can render contracts effectively, there are lots of situations where they cannot.”

People who take a hyperbolic stance on smart contracts tend to be ideologically driven and believe they can radically improve the nature of society. So, what’s driving the excitement?

1. The potential to remove the human element from transactions and realise the monumental efficiency gains therein.
2. The potential to remove corruptible centralised authorities (mainly government institutions) from their current powerbroker positions.

Smart contracts are also gaining in popularity because they promise cheaper, more secure and more efficient commercial transactions. Governments have also jumped on the bandwagon, in some cases investing heavily in the technology.

Part 1 of this series focused on smart-contract security. In Part 2, we’ll dive further into the legal issues that surround them and answer questions such as are smart contracts legally enforceable? And how might smart-contract disputes be resolved?

A Word About Definitions

Words matter. The consistency of language is vital if clear lines of communication are to be achieved, and this is particularly true with technology evolving as quickly as blockchain is.

The term ‘smart contract’ is itself a misnomer, since smart contracts are not smart nor do they always qualify as contracts. Smart contracts are not flexible or adaptable and have no inherent intelligence. In reality, they’re only as smart (or dumb) as the person coding them — like digital servants marching to the orders of their creators.

They may also not even meet the criteria to be considered a contract, which, in a legal sense, has an exact meaning: an agreement between private parties creating mutual obligations enforceable by law.

“Smart contracts are really just programmatically executed transactions (PETs). They’re not agreements — they’re technology for enforcing agreements.”

Agreements often have a good deal of subjectivity to them. They live in people’s minds, not on a hard drive, and even when committed to paper, can always be arbitrated, should the need arise. Smart contracts, in contrast, have little space for ambiguity or negotiation. As Andrew Glidden of Blockchain at Berkeley puts it, “Smart contracts are really just programmatically executed transactions (PETs). They’re not agreements — they’re technology for enforcing agreements.”

The term ‘smart contract’ has also turned into something of a catch-all that gets applied to things that are fundamentally not contracts.

Source: Digital Chamber of Commerce

On one side, there is the idea that ‘code is law’ and contracts can be fully expressed without complex natural language. And on the other is the idea that a smart contract is nothing more than the digitised performance of business logic.

Although we may more accurately think of smart contracts as something like an automated escrow, value scripts or Nick Szabo’s OG definition, for the purposes of this article, we will define a smart contract as simply computer code programmed to execute transactions based on predefined conditions.

Are Smart Contracts Legally Enforceable?

Use cases for smart contracts touch on a wide variety of legal domains and if you consider them cross-jurisdictionally, answering questions such as the above becomes highly convoluted.

“[It’s] a false conclusion to think that legal systems cannot intervene in a disagreement about the outcome of a smart contract.”

It’s a common misconception to think that, due to their automatically executing nature, smart contracts can act as a stand-in for most contractual processes. It’s also a false conclusion to think that legal systems cannot intervene in a disagreement about the outcome of a smart contract.

Even if the contract executed its logic autonomously, this is not necessarily a situation of a fait accompli.

Factors Determining the Legality of a Smart Contract

Whether or not a smart contract can act as a legally enforceable contract depends on the specifics of each case. In common law, the likes of voluntary offer and acceptance, as well as consideration, are fundamental elements of a contract. In most cases, contracts can be established in a variety of forms: orally, in writing, or through actions such as clicking on an ‘agree’ button. Some smart contracts exhibit these characteristics and others don’t.

Another part of deciphering a smart contract’s legality is determining what role code plays in the contract. Below is a decision tree that illustrates this point:

Source: Cloud Legal Project

A research paper by law firm Perkins Coie summarises it this way: “A smart contract may represent all, part, or none of a valid legal contract under the law. Thus, even where a smart contract represents the entirety of an enforceable legal contract, it remains subject to the same body of contract law as any other contract written in natural language.”

“Even where a smart contract represents the entirety of an enforceable legal contract, it remains subject to the same body of contract law as any other contract written in natural language.”

The specifics of each party to the contract, how it’s written, advertised, and whether or not its code matches its natural-language description are all further factors in the enforceability determination of a smart contract. If there’s a conflict between two parts of a contract (code vs description, for example), a judge will need to determine which clause prevails by looking at the contract as a whole and trying to establish the true intent of the parties.

The bottom line is this: determining the legality of a smart contract depends on the factual matrix within which it operates, and the applicable law determining the issue.

The DAO as an Example

In some cases, smart contract developers have added ‘hierarchy’ clauses to their websites to try to head off any uncertainty. This is language stating that, in the event of a conflict between the description and the smart-contract code, the code prevails.

In the case of the DAO (a series of smart contracts intended to function like a user-directed VC fund), matters were taken a step further and it was made clear that the only thing the contributors were agreeing to was the code. But according to Dave Michels, researcher with the Cloud Legal Project at Queen Mary University of London, this approach generally doesn’t hold up: “The problem with this is that code is not law. Law is law. So, in the case of a conflict, a judge will need to determine whether such a term is legally binding.”

“[For] an ordinary consumer, a judge may find that simply referring to machine-readable code does not provide sufficient notice of contractual terms to be binding.”

Michels continues: “If the counterparty is an ordinary consumer, a judge may find that simply referring to machine-readable code does not provide sufficient notice of contractual terms to be binding.” On the other hand, “if the counterparty is a Solidity expert, a judge might find that the human-readable terms of the agreement legitimately deferred to the machine-readable code.”

A final point on enforceability: many jurisdictions will take steps to address power imbalances between contracting parties (landlord-tenant, employer-employee, etc), and if a smart contract does not include the ability for a consumer to withdraw or request a refund, it may conflict with some consumer-protection laws.

How will Smart Contract Disputes be Handled?

Smart contracts present some unique resolution and enforceability issues that are likely to challenge existing legal systems in the future.

The range of issues they raise is truly novel, and include the following:

• Smart contracts can be executed pseudonymously, so determining who to bring a claim against, should the need arise, could present a problem.
• Determining the jurisdiction and applicable law under which a disagreement should be settled can be difficult, due to the cross-border nature of blockchain networks.
• Where a smart contract executes automatically, and its results are written to a decentralised blockchain, parties may struggle to find a simple method of rescinding the contract.

The legal framework(s) governing smart contracts needs to be further elaborated to address these kinds of issues.

According to Dr Mateja Durovic, commercial-law professor at King’s College London, “Traditional arbitration methods that are lengthy and include delayed execution are inadequate. Creating a smarter dispute-resolution system is key and will require cooperation between lawyers on the one side and computer, mathematical and cryptography experts on the other side.”

“It may be possible to incorporate logic for unwinding a transfer into the smart contract at the outset.”

The previously cited Dave Michels also lays out the possibility of smart-contract arbitration: “In theory, it may be possible to incorporate logic for unwinding a transfer into the smart contract at the outset. For instance, multi-signature contracts could be structured to allow for arbitration by a third-party adjudicator with their own private key.”

Although the need for an arbitration clause is apparent, introducing such a backdoor to a smart contract brings with it a number of other considerations. Michels acknowledges this: “It would need to be agreed explicitly by both parties when entering the contract as it reopens the need to trust a third party and adds a further layer of complexity to the code, increasing the potential for bugs or security breaches.”

Regardless of that, having some method of arbitrating the outcome of a smart contract is likely to prove important because no contract is error-free or can be created to address every contingency. Although some notable pilot projects are underway, what smart contract arbitration will look like in future practice is unclear.

What is clear, however, is that the system smart contracts will spawn must be reliable and efficient. This may take the form of tribunals or pre-selected adjudicators, and some technologists are even looking at the idea of decentralised arbitration via which disputes are randomly assigned to selected arbitrators and their decision is then recorded on the blockchain.

Final Thoughts

Smart contracts are an important access point for understanding what contract law does for us. And if you think of contract law as merely a mechanism for ensuring a certain kind of result, then it appears smart contracts can serve this function, and serve it much more efficiently.

It’s not hard to imagine a future dominated by smart contracts. If nothing else, their value for reducing litigation by clarifying basic obligations and automating performance is undeniable. Before mass adoption, however, the legal status of smart contracts needs to be broadly assessed in order to choose the model most suitable for a particular jurisdiction.

Solutions to some of the issues raised in this article will need to be addressed before they can be used at scale. As time passes, smart contracts will be tested in the courts, precedents will be set, and people will develop a common understanding of their legality.

“There may be many barriers to the adoption of smart contracts, but legal uncertainty need not be one of them. Courts need not upend extant jurisprudence to accommodate smart contracts.”

Looking to the future, smart contracts will not operate in a legal vacuum, and nor will they replace lawyers. Contract law is a human enterprise, and not easily translatable to code alone. It will be the noble task of the legal profession to find new solutions with old instruments and tools.

To borrow a phrase from the Georgetown Law Technology Review, “There may be many barriers to the adoption of smart contracts, but legal uncertainty need not be one of them. Courts need not upend extant jurisprudence to accommodate smart contracts.”

Contract law has always displayed an inherent ability to adapt to new situations without the need for major revisions of its underlying principle. There’s little reason to think smart contracts will be any different.

Code Must be Watertight

The consequences of using imperfect or faulty code can be devastating, and slightly comical. In February 2003, a computer software mistake at St Mary’s Medical Center in Grand Rapids, Michigan led to 8500 patients being declared dead despite being alive and kicking. The system notified insurance companies and the patients themselves about the ‘deaths’, causing a lot of confusion and a lot of admin.

Two years later in 2005, the Michigan Department of Corrections released 23 prisoners early due to a programming glitch. All relatively minor sentences, inmates had their time reduced by anywhere from 39 to 161 days, while others were kept in jail beyond their release dates. Code may make our lives easier, but getting it wrong can be costly.

This article was written by Colin Adams of The Research Institute and it originally appeared in the Binary District Journal.

The field of emerging technologies is by no means bereft of ideas or inspiration; however, these alone do not equate to innovation neither do they drive technological advancement — quality Research and Development does. The Research Institute takes a practical approach to technological development and seeks to redress the balance between ideas and viable solutions.

Illustrations by Kseniya Forbender