Legal Challenges of Smart Contracts in the Context of Contract Law

Smart Contracts were mentioned in my first post as one of the most trending buzzword right now. In this post, I will write about the legal challenges for the Smart Contracts.

As mentioned in my first post, A smart contract is a line of code stored on a blockchain that is executed automatically when the determined terms and conditions are met. The lawyer Josh Stark defines smart contracts as “the use of code to articulate, verify and enforce an agreement between parties”. These contracts are mainly used in business collaborations when the parties want to enforce some type of agreement where all participants can be sure of how the outcome will be. The smart contracts are thereby ensuring that what was agreed upon is executed without the requirement of a trustworthy third party to enforce the terms and agreement. Since these smart contracts are basically a coded version of the physical contracts and agreements we have been using for a long time, and the fact that they are decentralized, we need to discuss possible infringements of smart contracts and, the, possible enforcement and challenges in terms of current contract law. But first of all, I will briefly explain how a smart contract is built.

In the picture above, the mechanisms of the smart contracts are illustrated. Every smart contract is placed in a block och the blockchain. The smart contracts are based on lines of code that specifies trigger conditions and response rules which is basically the terms and agreements of the contract. The contract then connects to external data sources to perform the responses when specific conditions are met in the contract. This allow these contracts to be executed without any interaction from a third party.

So back to the legal context of these contracts. The contract law concept in Europe do not have any common law, it is up to every member state to have their own contract law and provisions. There are, however, several initiatives from EU that helps to create a common viewpoint for understanding some areas related to contract law issues. Even though laws and terminology vary between the member states, there are common basic rules that have been identified in the formation of a contract. The main idea of a contract is to establish a situation where the parties are bound by their agreement and obligated to perform their promises. These promises are built by an offer and an acceptance, and it is important to specify when a party is bound the promise given through an offer or an acceptance. Based on these fundamentals of a contract, the major principles can be portraited in the following way:

A binding offer is not the same as a promise that must be kept. Before a party is bound the promise, there must be an acceptance so that both parties are bound, i.e. an established contract. The contract is binding for both parties when the offeree no longer can rescind the acceptance. This occur at different stages depending on which national law that is applicable. According to Swedish law for instance, there are no specific requirements of how to enter a contract, as long as there exists an offer and an acceptance. There are, however, some specific agreements that require contracts signed on paper, when it comes to real estates for example. The most common way to initiate a smart contract is by sending messages over the internet using “PKI”, Public Key Infrastructure. This would mean that there are no limitations on entering a smart contract through PKI in a country like Sweden.

There may also be requirements that a contract must be written in a language which all involved parties can understand. Since the smart contracts are written in code, it must be decided whether computer code is to be considered such language or not. If not, it must also be decided how these contracts should be translated to human language. 

Smart contracts can also be used to make E-Commerce more efficient and transparent. Today, EU have their own E-Commerce Directive with the purpose to ensure “a high level of community legal integration in order to establish a real area without internal borders for information society services” (Directive on electronic commerce, 2000). Article 10 of the Directive was created to coordinate information requirements to make the electronic contracting procedure harmonised. According to the first paragraph, following information must be provided clearly by the service provider prior to the order being placed: technical steps to follow to conclude the contracts; whether the concluded contract will be filed by the service provider and if it will be accessible; technical means for identifying and correcting input errors prior to the placing of the order; languages offered for the conclusion of the contract. The third paragraph says that the terms and general conditions must be provided to the consumer so that it allows him to store and reproduce them. The fourth paragraph tells us that the first paragraph is not applicable to contracts being concluded exclusively by exchange of electronic mail or other equivalent individual communications. The first paragraph of article 11 of the Directive require that service providers must provide the consumer the receipt of the order without any delay. The second paragraph specifies that the consumer must be able to identify and correct input errors prior to the placing of the order. As in article 10, the third paragraph tells us that the first and second paragraph is not applicable to contracts being concluded exclusively by exchange of electronic mail or other equivalent individual communications.

After reviewing the current contract laws in Europe with smart contracts in mind, there are some gaps in the regulations that needs to be cleared out. The concluded challenges are written with a common EU approach in mind in order to discuss them in the context of the internal market.

First of all, it must be decided if the smart contract should be considered to be a part of the traditional legislation or not. If the contracts do not meet the requirements of a traditional contract, there are no active legislation for how they can be created, entered or used. When considering the principles of entering a contract with the mechanisms of a smart contract, it can be found that there is not much space for discussions regarding the parties’ ability to rescind their offer. As soon as a smart contract is written, it cannot be changed or edited anymore, it will be a part of the blockchain and execute the responses as soon as the conditions are met. This also means that there is no possible way for the parties to make any changes to the contract if the off-chain conditions change. Off-chain conditions in the law, regulations, business environment or other areas will probably change after many smart contracts have been entered. 

There must be a common framework for how to view the code in terms of language. There need to be regulations for how the programmers translate agreements into executable code, there cannot be any situation where they interpret the agreement wrong, because once a smart contract is a part of the blockchain, it cannot be changed. Policymakers should also reflect if there should be a fixed determined coding language for these contracts so that we know how to interpret what is written, and if the code must be translated into a specific human language before interpreting it.

Before discussing how the smart contracts can be used in E-Commerce, we need to define if KPI is considered an electronic mail or other equivalent individual communications or not. Otherwise the E-Commerce Directive cannot be used for setting rules for how they can be written, and there needs to be a new framework that addresses the smart contracts specifically.

As a final note, this post is only a small insight into the legal aspect of the technically complicated smart contracts. There are several grey areas and gaps in the current legal framework that needs to be developed before smart contracts can be fully implemented into our way of doing business and to develop E-Commerce. These are not the only legal challenges we are facing with the smart contracts, there are other challenges that effect other laws and regulations related to the specific use of the smart contracts. This paper have only touched a few of those that are related to contract law, there are more complex processes involved in smart contracts and blockchain technology in general that needs to be reviewed in a legal context to make sure that the parties’ are protected and knows what to do when something does not go as planned.

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Until next time,

Teodor

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