Smart contracts – a closer look at the legal framework in England and Wales

Monday 13 December 2021

Catalina Diaconeasa
Debevoise & Plimpton, London
cdiaconeasa@debevoise.com  

   

Emerging technologies, such as distributed ledgers, are being promoted as a way to create ‘smart contracts’ which raise new legal challenges when it comes to applying English contract law to the same. In the words of the Law Commission,[1] the ‘nascent state of the technology means there are few, if any, tested solutions to the legal issues to which smart contracts give rise, and it may be that the common law can develop to accommodate smart legal contracts without the need for reform.’[2] There is therefore a compelling case for reviewing the current legal framework in England and Wales to ensure that it facilitates the use of smart legal contracts.

The Law Commission is currently undertaking a scoping study on smart contracts in order to provide an accessible account of the current law and set out how it will or may apply to smart contracts.

The first step in the smart contracts scoping study is a call for evidence further to which the Law Commission is seeking views about, and evidence of, ways in which smart contracts are being used, and the extent to which the existing law can accommodate them.

The Law Commission’s call for evidence on smart contracts was published on 17 December 2020 and closed on 31 March 2021. The Law Commission is currently analysing the responses received from consultees and will use these to inform their scoping study, which they intend to publish later on in the year. Although the scoping study itself will not offer formal recommendations for reform, it will be interesting to review the Law Commission’s findings on smart contracts and the outcome of the scoping study.

Smart contracts are widespread and can be used in a variety of contexts. For example, they can perform transactions on decentralised cryptocurrency exchanges, facilitate games and the exchange of collectibles between participants on a distributed ledger and run online gambling programs. Smart contracts can also be used to record and perform the obligations of a legally binding contract. The latter category (sometimes referred to as ‘smart legal contracts’) is the focus of the scoping study.

In particular, for the purposes of the study, the Law Commission defined a smart contract as a legally binding contract in which some or all of the contractual obligations are recorded in or performed automatically by a computer program deployed on a distributed ledger. Distributed ledger technology (DLT) is a method of recording and sharing data across a network. It comprises a digital database (a ‘ledger’), which is shared (‘distributed’) among a network of computers known as ‘nodes’. Examples of DLT systems include the Bitcoin blockchain and Ethereum.

Unlike other shared databases, the DLT ledger is not maintained by a central administrator. Instead, the ledger is maintained collectively by the nodes on the network; any proposed change to the ledger data must be approved by all the nodes via a process called the ‘consensus mechanism’. Smart contracts that use this technology are expected to increase efficiency, trust and certainty in business and reduce the need for contracting parties to trust each other, given that the trust resides in the code itself.

For the purposes of the study, whether a smart contract is legally binding will be analysed through the lens of the laws of England and Wales. Therefore, a smart contract will be legally binding if it meets the relevant requirements under the laws of England and Wales, namely:

  • The existence of an agreement. A contract cannot be legally binding unless there is an agreement comprising an offer to be bound on specified terms and the acceptance of those terms.
  • Consideration. Contractual promises cannot be made ‘gratuitously’ under the laws of England and Wales, with the exception of a promise made by deed. Contracts require consideration to be legally binding.
  • Certainty and completeness. To constitute a valid contract, an agreement must be both certain and complete under the laws of England and Wales.
  • Intention to create legal relations. There is a presumption under English law that parties intend to create legal relations when they make an express agreement in a commercial contract.  
  • Formality requirements. Generally, contracts do not have to be made in any particular form, although some statutes do require certain contracts to be made ‘in writing’ and ‘signed’. Moreover, deeds are subject to additional formality requirements.

Smart legal contracts create novel challenges in terms of whether the contract at issue is legally binding and the legal requirements listed above are satisfied. This also depends, in part, on the type of smart contract. In particular, there are three forms that a smart legal contract (see below) can take and the Law Commission will analyse all three as part of its scoping study:

  • A natural language contract with automated performance (ie, the negotiations and terms are in natural language while the performance of the contract is in code);
  • A hybrid smart contract (ie, the negotiations take place in natural language, the terms are a mix of natural language and code and the performance is in code); or
  • Solely code (ie, the negotiations are in natural language and/or code and the terms and performance are both in code).

The call for evidence has asked consultees to explain whether they foresee any potential uncertainties in applying these legal requirements to smart contracts. The Law Commission has given some preliminary indications that at least some of the above requirements regarding when a contract is legally binding may be less easily satisfied in the context of smart legal contracts:

  • For example, identifying an agreement may be more difficult where there is limited or no natural language negotiation or communication between the parties and their conduct may be the only evidence of an agreement between them.
  • Moreover, establishing an intention to create legal relations may be more difficult where the parties’ agreement is made as a result of interaction on a distributed ledger and the agreement is inferred from the parties’ conduct rather than as a result of an express agreement. In these types of cases, the presumption that the parties intended to create legal relations may not apply, so it might be necessary to prove that the parties actually intended to create legal relations. This may, in turn, be difficult to prove if, for example, the shared understanding of participants on a DLT system is that transactions on the ledger are not intended to be legally binding.  

Smart legal contracts raise a number of other interesting legal questions which the Law Commission is currently analysing further to the call for evidence. In particular, these relate to:

  • Contractual interpretation. A court may be asked to interpret a contract if the parties disagree as to the meaning of its terms. Various novel challenges may arise when applying the principles of interpretation to smart legal contracts. For example, one question that arises in this regard is whether the existing principles of contractual interpretation can be used to interpret terms recorded in computer code. Another question is that of how a court should approach inconsistencies between different terms of the same contract; this is particularly relevant to hybrid smart contracts given that they include both a natural language element and a code element.
  • Remedies. Again, various problems and novel challenges may arise in relation to the remedies sought by the parties and the way in which a court might award those remedies in practice. For example, if the coded terms of a contract do not reflect what the parties had in fact agreed, would the English law remedy of rectification be available to the parties? Even if rectification were to be available, the court may the face practical difficulties in rectifying coded terms. Similarly difficult questions also arise if, for example, the parties held mistaken beliefs or assumptions about how the code would execute. In that case, would the contract be rendered void under English law if one or both of the parties laboured under a mistake when entering into a contract?
  • Consumer law. New challenges may arise, for example, in the business to consumer smart contract context in that consumers may be required to agree to a trader’s standard terms and conditions without actually understanding what they are asked to agree to because they are not code literate. There is already legislation in place for traders and service providers to ensure that terms of a consumer contract are ‘transparent’. Moreover, unfair terms and commercial practices are not enforceable under English law. In the context of a smart contract where the terms are either wholly or partly in code, traders may now have to consider taking further steps to comply with the legal requirements designed to protect consumers.
  • Jurisdiction. Challenges may also arise in the context of a cross-border contract where the parties have not included a choice-of-court clause in the agreement. Some of the factors which are used by the court to determine whether the courts of England and Wales will have jurisdiction to hear disputes under those contracts will be particularly difficult to apply. For example, establishing the domicile and presence of contracting parties may be difficult given that the pseudonymous nature of some DLT systems may make it more common for parties to enter into smart contracts without knowing the real identity of their counterparty.  Similarly, it may also be more difficult to identify the geographical location of performance, actions and enrichment in the context of a smart contract where the obligations are performed on a distributed ledger rather than involving a physical performance in the real world.

As it can be seen from the above, the application of English law to smart legal contracts is not a straightforward exercise and it may be that further legal tools need to be developed to ensure that English law facilitates the use of smart legal contracts. The findings of the scoping study which the Law Commission intends to publish in late 2021 are awaited with interests by practitioners and academics alike. 

 

[1]    In England and Wales, the Law Commission is an independent law commission set up by Parliament by the Law Commission Act 1965 to keep the law of England and Wales under review and to recommend reforms.

[2]      See the Law Commission’s comments on page 16 of the Law Commission’s Annual Report 2020–2021, which can be found here.

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