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Farrer & Co | The legal status of “smart contracts”: a guide to the conclusions of the LawTech Delivery Panel

The use of “smart contracts” to generate and record contractual relationships is becoming increasingly mainstream, having moved beyond the realm of tech start-ups into the practices of large multinationals such as AXA who, in 2018, launched their blockchain-driven insurance product “Fizzy”.

The growth in the use of smart contracts has so far been achieved within a jurisprudential vacuum. There is very little to no case law, legislation or regulation which addresses – or even considers – the legal implications of this rapidly developing technology. The resulting lack of certainty as to their legal status was noted in responses to a consultation carried out by the LawTech Delivery Panel throughout 2019 and may have inhibited the more widespread adoption of smart contracts. 

It is these concerns which the LawTech Delivery Panel sought to address through the publication of its “Legal Statement on cryptoassets and smart contracts” in November 2019. The Panel was established by the UK Government, the English Judiciary and the Law Society. Whilst its official Legal Statement is not a binding authority on the subject, it is nonetheless likely to be regarded by both commercial parties and the courts as highly influential and capable of being relied upon as valuable advice.

One of its key conclusions is that smart contracts are capable, in principle, of forming binding contracts which will be upheld under English law. Effectively the Legal Statement gives the green light to the use of this technology in the UK. This is an extremely significant development, both in terms of providing certainty and also because it may mark the beginning of a new era for the adoption of smart contracts and the scope of legal principles in contract under English law.

In the second of two briefings, Kate Allass (Farrer & Co) and Hazem Danny Al-Nakib (Sentinel Capital Group) summarise the key conclusions of the Legal Statement in relation to smart contracts. Their first briefing addresses the implications for cryptoassets.

  • A smart contract is essentially a self-executing contract, where the terms of the agreement are written as lines of computer code which may automatically monitor, execute and/or enforce performance of the agreed terms. Unlike a traditional contract which would be physically signed using pen and paper, a smart contract can be carried out between two anonymous or pseudo-anonymous parties. Smart contracts are also often accompanied by several other characteristics, such as being created on a networked system that is decentralised, subject to a consensus model, cryptographic authentication, and on a distributed ledger.

    The simplest form of computer code will take the form of “if X occurs, then Y occurs. To take AXA’s “Fizzy” flight delay insurance product as an example, customers pay a premium and then are automatically paid compensation if the flight is delayed by more than two hours.

    A smart contract is performed (at least in part) automatically, without the need for human intervention once the code has been mapped. In some cases, this means that once the automated transaction has taken place, it is unlikely that the smart contract can be modified or reversed and there is no central body which oversees or governs the transaction, particularly in a decentralised network. This may reduce the scope for disputes, in that the technology may prevent intentional non-performance, or limit disputes about the interpretation of contractual terms, but it may also make it more difficult to take action in response to non- performance.

    This was reflected in the Statement through the identification of the key attribute of smart contracts being “automaticity, and a common characteristic of the network being decentralised.

  • The Legal Statement concludes that, in principle, the ordinary rules of English contract law should apply to smart contracts. There is no reason to distinguish them from traditional contracts for as long as the three key features of contract formation are present. 

    In particular it must be clear that:

    1. agreement has objectively been reached between the parties as to terms that are sufficiently certain;
    2. the parties objectively intended to be legally bound by their agreement; and
    3. unless the contract is made by deed, that each party to it has given something of benefit (ie consideration) to one another, in order to make the contract enforceable.

    In fact, the Statement goes further in suggesting that smart contracts may be a separate category of contract where the terms of the agreement – the computer code – are unambiguous, giving rise to a special type of contract whose terms are readily apparent. The assumption of the existence of unambiguous terms may however overlook the reality of the commercial arrangements and the disputes which are likely to arise from them.

    Each smart contract will be assessed according to its individual characteristics, in each case the key question being “what did the parties actually intend?”. This analysis might produce a wide variety of outcomes. For example, the parties may have intended that their obligations would be defined by computer code, and that they would honour the obligations which the code produces. Alternatively, they may have contracted on the basis that the code would be used to implement their agreement, but not define it. They may have agreed some form of hybrid, through which some obligations are defined by the code, others are merely implemented by the code, and some obligations do not involve code at all.

    The Panel took the view that analysing the parties’ intentions and extrinsic factors – even in the context of a smart contract – was an “entirely conventional matter” which is “precisely what judges do on a regular basis”. 

    Realistically, as the technology becomes more widespread, judges and counsel will need to upskill and develop a greater familiarity with coding languages. The Statement also acknowledges that some forms of smart contract mark a significant departure from familiar territory, particularly where an agreement exists solely in code and there is no natural language at all.

    Even then, the Panel thought that there should be “no difficulty” in identifying the terms of the contract or the consideration exchanged, which would usually be apparent and readily identifiable from the source code itself or the code’s behaviour. The only point on which the code might not assist was demonstrating that there was agreement between the parties and that the parties intended to be legally bound; however, this could be answered by reference to external evidence of intention.

    The Statement does highlight that, in a bilateral or multilateral contract, at least one party will be operating “blind” and accepting the smart contract proffered by other party. In which case, there is a possibility of being misled or misinformed. This eventuality arose in the Singapore case of B2C2 Ltd v Quoine Pte Ltd [2019] where B2C2’s trading algorithm included a value of a cryptoasset 250 times greater than its market value at the time. However, the programmer had not been aware of the discrepancy, nor did they intend it. Accordingly, the Singapore International Commercial Court found that there had not been a unilateral mistake, and the smart contract which governed the execution and enforcement of the transaction was held to be valid.

  • The Panel had “no doubt” that a smart contract between anonymous or pseudonymous parties can in principle give rise to binding legal obligations. There are potential practical difficulties, however, for example in identifying who can be sued if the contract is breached and in what jurisdiction. 

    Where a contracting party deploys code to a distributed ledger platform, it may be picked up by an unknown party who then interacts with the code rather than the code writer in order to participate in a transaction eg, the transfer of a digital asset at a particular price. The Panel analysed this in terms of a unilateral contract, through which terms have been offered to the users of the distributed ledger platform, one of whom has accepted those terms.

    The Panel also considered the legal status of a Decentralised Autonomous Organisation - an organisation represented by rules encoded as a computer program, which is controlled by smart contracts and its members and does not have a central executive (a “DAO”). Someone may deploy a code to set up a DAO but may have no intention of participating in it or entering into any legally binding agreements with any of its users. That party is simply creating a platform through which others can interact in accordance with the terms of the code running the DAO, being the rules of the DAO.  The Panel took the view that a DAO could be analogous to an unincorporated association, with each member of the association contracting with the membership as a whole. The members’ intention to be bound would be evidenced by their decision to join the organisation with an awareness of its rules, whether or not they are aware of any of the other members of the DAO, nor the creators of the DAO.

  • Certain statutes require contracts to be “signed” and/or made or evidenced “in writing”. The Panel noted that the requirements of each individual statute would be the starting point for determining whether a smart contract consisting of code might fulfil its requirements. 

    However the Panel also expressed the view that, in principle, where the code could be said to represent or reproduce words and be made visible (on screen or on a printout), the requirement for the contract to be “in writing” would probably be fulfilled, notwithstanding that the code may be incomprehensible to the uninitiated.

    Similarly the Statement concluded that a private key (ie a form of digital signature) could be used to authenticate a contract in lieu of a traditional signature. This was true even where the signature itself is comprised solely of a signed message using signature authentication software to confirm the validity of the signature. This is the case, according to the Panel, notwithstanding the fact that the parties may remain anonymous or pseudo-anonymous while authenticating the agreement using their private key.

  • The Statement acknowledges that the scope for legal intervention in smart contracts may be considerably narrower than traditional contracts. In most cases the code will simply do what it has been programmed to do in executing the transaction, reducing the scope for intentional non-performance.

    There will always be risks, however. For example the risk that performance of the smart contract is affected by an event external to the code, such as system failure, or events internal to the code such as errors, bugs or ambiguities within the code causing it to operate in an unexpected or unintended way, or an intended way hidden from one or more of the contracting parties. The Panel considered that the English court and legal framework would be capable of resolving any resulting dispute, including rectification, but that interpretation may not be available due to the unambiguous nature of computer code. As with any other contract, the court could also be expected to intervene in cases of duress, fraud and misrepresentation.

Conclusion

The Statement is a confident statement on the part of key stakeholders in the English legal system of their willingness to support developing technologies and their ability to handle disputes arising out of them. Whilst it acknowledges that every case will be fact specific, it is universally positive in its recognition of the potential validity of various forms of smart contracts. This is a positive mark in bridging the law’s application to and possible interconnectedness with code. Clearly the intention is to promote England and Wales as a technology-friendly and technology-neutral jurisdiction, as a result of which growth in the sector and in innovation is likely to follow.

If you require further information about anything covered in this briefing, please contact Kate AllassHazem Danny Al-Nakib or your usual contact at the firm on +44 (0)20 3375 7000.

This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.

© Farrer & Co LLP, February 2020

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