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Analising Current Regulatory Framework For Smart Contracts

on April 12, 2021

Photo by Tingey Injury Law Firm on Unsplash

We’ve seen a growing trend in the adoption of digital-based contracts in the past decade. Globalization and now – the COVID-19 pandemic – created new barriers to doing business but also presented new opportunities for the increased adoption of blockchain technology. And more specifically – smart contracts.

The main driver behind the adoption of smart contracts lies in the technology that defines them. Through smart contracts, participants on a distributed ledger can enter in agreements, record, and perform the obligations of a legally binding contract. This capacity of smart contracts, sometimes referred to as smart legal, gives them universal utility and applicability across businesses, industries, and markets on a global scale.

With smart contracts, all of the terms are recorded in or performed by a computer program deployed on a distributed ledger. By taking out the human element, they achieve greater efficiency, trust, and certainty in business. We also see increased transparency as well due to the immutable nature of the blockchain on which smart contracts are written. Contracting parties, therefore, don’t need to trust each other as the trust resides in the code of the smart contracts.

While the use of computer programs to automate the performance of contractual obligations is not a novel practice, the regulatory framework for smart contracts and blockchains is still a work in progress. 

In England and Wales, there are certain requirements for a smart contract to be considered legally binding (and therefore legally enforceable) under the law.

The first requirement for the formation of a legally binding contract is an agreement, comprising an offer to be bound on specified terms, and an acceptance of those terms. In keeping with the nature of blockchain technology, which allows for anonymity, there is no requirement under the law of England and Wales for contracting parties to know each other’s real identities. Smart contracts can therefore be established between any two parties who wish to enter into an agreement.

However, this agreement must be “certain and complete” to constitute a contract. The type of smart contract: Natural language contract with automated performance, Hybrid contract, or Solely code contract can have an impact upon when and how it is formed, how it is interpreted and the remedies available to the parties if things go wrong.

If the terms of a smart contract are set out in a natural language document, then the smart contract would satisfy an “in writing” requirement. Where the terms of a smart contract are recorded in a natural language document, the smart contract could be signed in the ordinary way. Where a smart contract consists solely of code, the parties could sign the contract electronically, for example by using a digital signature to authenticate a piece of code deployed on a DLT system.

While there is considerable clarity in the agreement and expectations pertaining to the outcome from it set within the smart contract, the execution is a different story. The principles of contractual interpretation could be applied if a court was asked to interpret a smart contract but the court may face practical difficulties in rectifying coded terms.

Because smart contracts are backed by incredibly complex technology and courts still don’t have in-house blockchain specialists, it is difficult to determine what can render a smart contract void. In the smart contract context, there is a risk that events beyond the parties’ control may affect the execution of the code. The same applies for parties that enter into smart contracts without knowing the real identity of their counterparty. This poses obvious challenges for determining the applicable jurisdiction regime and regulatory framework for smart contracts.

Smart contracts can thus pose certain unique legal challenges when seeking to reinforce them or to mediate a case of not meeting the terms agreed upon. To resolve such jurisdictional difficulties, we will need to see the legal and regulatory framework for smart contracts created in collaboration with specialists to achieve the necessary level of understanding of the new phenomenon.


Regulatory Framework For Smart Contracts and the Allocation of Liability

Allocation of liability.

Many types of deficiencies or mistakes may arise when negotiating, concluding or performing a smart contract. Some of these issues are common to all types of contract, some are additional. 

The following examples of deficiencies or mistakes could involve both smart contract and traditional contracts:

  • misunderstandings of the parties relate to the purpose, content, features of goods;
  • mistakes relating to the party’s authority/capacity to approve a transaction;
  • the contract may violate mandatory legal requirements;
  • problems may arise when things don’t go as planned and parties have not made provision for dealing with the unexpected. 

As said, smart contract may present additional issues:

  • the smart contract software could contain coding errors. The error may cause the program to stop or it may cause a cascade of ever more disastrously wrong trades if the program in question is linked to multiple transactions;
  • smart contract software could contain a bug in the code. Furthermore, smart contract developers need to be aware of the contract’s interaction patterns to mitigate potential losses due to malicious behaviors such as frauds and attacks;
  • smart contract may need to access external data through oracles which are off-chain sources of digital information that translate outside events into smart contract readable data. Although oracles open up numerous possibilities, those data sources may be out-of-date, unavailable, or incorrect; may also reduce security by offering a point of entry;
  • a smart contract can interact with other contracts (e.g., transferring funds to the contract). The interaction of smart contracts can result in an increased number of interconnected contracts over time. Therefore, how to predict the contract behaviors could become challenging.

Parties are called to evaluate the amount of risk they can bear if one of the above points of failure occur, because traditional protections like representations, covenants, and indemnity may be difficult to code into the smart contract. 

It will also be necessary to take into account the technological chain/framework within which one operates to determine the allocation of liability.

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