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Smart Contracts & Legal Approaches

Writer's picture: Rita ShethRita Sheth

In November 2021, the Law Commission published its advice to the UK Government, providing a comprehensive analysis of the legal framework for smart contracts. This landmark report addressed “smart legal contracts,” defined as legally binding agreements in which some or all obligations are expressed in and/or performed by code. The advice categorised smart legal contracts into three main types:


  • Natural Language Contracts with Code-Based Performance: Traditional contracts with some obligations automated via code.

  • Hybrid Contracts: Contracts where obligations are split between natural language and code.

  • Code-Only Contracts: Agreements entirely recorded and executed in code.


The Law Commission affirmed that English law, with its principles rooted in common law flexibility, can accommodate all three categories.


Key Legal Aspects of Smart Contracts


The formation of smart contracts must satisfy the same basic elements as traditional contracts namely, there must be an agreement (offer and acceptance), there must be consideration (value exchanged), there must be certainty and completeness, there must be an intention to create legal relations, and appropriate compliance with legal formalities.


The Commission concluded that these requirements can be fulfilled by smart contracts and made some key observations on this in relation to smart contracts.


Firstly, that offer and acceptance can be in code and parties can indicate their agreement through the deployment or interaction with code, eliminating the need for natural language negotiations. Where ambiguities in the legal arrangement may arise, the courts will interpret such ambiguities using established principles of English law (i.e to give a contract its natural or normal meaning'). Further English law’s definition of “writing” includes “visible representation of words,” a requirement met by natural language documents accompanying smart contracts. These principles allow for smart contracts to be well-adjusted to an English law contractual framework.


Interpretation


When disputes arise, courts apply standard contractual interpretation principles to determine the parties' intentions. For smart legal contracts, additional complexities may emerge due to the inclusion of coded terms.


Courts may need to address the divergence between what the code ostensibly “means” and its real-world effect when executed, however the Law Commission proposed that interpretation should consider what a person with knowledge of coding would understand the coded term to mean, aligning with existing approaches for specialised technical terms and areas of interpretation. This has parallels to another well-established English law concept of looking at legal interpretation and jurisprudence filtered through the lens of a 'reasonable person', 'skilled person in a certain industry' or otherwise considering the overall reasonableness of an interpretation.


Remedies


In traditional contracts, remedies for breaches include damages, specific performance, and rectification. Smart contracts introduce practical complications in relation to rectification in particular because changes to a deployed smart contract on a distributed ledger may not be possible. Courts may need to order parties to execute a separate rectifying contract on-chain.


Jurisdictional and Governing Law Challenges


The borderless nature of smart contracts introduces significant complexities:


  • Distributed Ledgers: With nodes spread across multiple jurisdictions, pinpointing the physical location of contract formation is difficult. This may mean that smart contracts need to be mindful of jurisdiction or insert a neutral way of resolving disputes through ADR.

  • Anonymity and Pseudonymity: The pseudonymous nature of blockchain participants complicates identifying parties and their physical locations and also enforcement of remedies. This may be magnified where there is no corporate legal entity because another structure has entered into the contract such as a DAO - which themselves are in a process of flux in a legal sense.


The Law Commission recommended including jurisdiction and governing law clauses within smart contracts to mitigate these uncertainties.


Governing Law


Determining the governing law for smart contracts without explicit clauses may involve novel considerations, such as:


  • The digital location of private keys,

  • The domicile of a central administrator (if applicable), or

  • The ledger's permissioned or permissionless nature.


These factors highlight the need for evolving legal concepts to address the unique characteristics of smart contracts.


Legal and Industry Progress Since 2021


Since the Law Commission’s advice, the UK has seen notable strides in addressing smart contract challenges:


1. Expanded Guidance


  • Law Society Reports: Updated guidance from the Law Society in 2023 emphasised the need for clear drafting of hybrid and code-only contracts, focusing on practical implementation and risk mitigation.


  • International Collaboration: The UK has actively participated in global discussions to harmonise legal approaches to blockchain and smart contracts.


2. Emphasis on Code Audits


  • As disputes over coded terms become more likely, industry stakeholders are advocating for robust code audits to ensure clarity and minimise the risk of unintended outcomes.


3. Development of Standards


  • The adoption of industry-wide standards for drafting and deploying smart contracts is underway using protocols in certain areas and for certain industries.


Potential Areas for Future Legal Development


1. Digital Asset Location


The location of digital assets and acts on distributed ledgers remains a contentious issue. Clear rules are required to establish where a smart contract or transaction "exists" for legal purposes.


2. Enhanced Dispute Resolution Mechanisms


On-chain dispute resolution mechanisms, such as arbitration integrated into smart contracts, or unique blockchain based dispute resolution tribunals may become wider recognition in English law.


3. Liability and Consumer Protection


As smart contracts move into mainstream consumer applications, legal frameworks must address liability issues, particularly in cases of code malfunction or fraud.


Conclusion


The adaptability of English law makes it well-suited to address the challenges posed by smart legal contracts. By accommodating new technologies within its existing legal framework, the UK has the potential to become a leading jurisdiction for blockchain-based services. However, continued guidance, industry collaboration, and judicial consideration are essential to solidify this position.


Smart contracts represent not only a technological revolution but also an opportunity for the legal system to showcase its resilience and innovation. English law’s ability to evolve alongside these advancements will be critical in establishing confidence and trust among businesses and users worldwide.


If you are navigating the complexities of smart legal contracts, consulting with legal experts can help ensure compliance and mitigate risks in this rapidly evolving space.

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