2 March 2022
Smart contracts – 1 of 5 Insights
In Part one of this series, we considered the various use cases for so-called "smart contracts" within financial services. As a recap, a smart contract is a piece of computer code which executes a function (if x, then y) to bring about a certain effect.
Whilst the UK may not be renowned as a "crypto-friendly" jurisdiction, recent legal developments have highlighted the potential role of the law of England and Wales in the development of financial services utilising blockchain technology. A key question that should be at the front of investors' minds when looking at (for example) DeFi opportunities is: "what happens if it all goes wrong?". From a legal perspective, certainty is important, so the fact that English law is recognised as being able to accommodate smart contracts generally means that where a smart contract is governed by English law the parties to that contract should have some comfort. In addition, the Law Commission's report sets out considerations for contracting parties, which will be of particular interest to those operating within the DeFi space.
In November 2021, the Law Commission published its advice to the UK Government on the legal status of smart contracts. Its report set out a detailed analysis of the application of existing law to smart contracts, considering a number of scenarios and feedback from industry stakeholders, and the legal community.
The Law Commission concluded that the legal framework in England and Wales is able to support and facilitate the use of smart contracts. The report addresses in particular "smart legal contracts". A smart legal contract is a legally binding contract in which some or all of the contractual obligations are defined in and/or performed by the execution of code in a computer programme. We should note that a smart legal contract is not necessarily programmed on a distributed ledger (although the use cases considered in part one of this series, and the Law Commission report, concentrate on distributed ledger technology ("DLT").
The Law Commission considered three categories of smart legal contract:
The Law Commission's report addresses in some detail the aspects below.
Under English law, there are a number of requirements for a legally binding contract to be formed: agreement (an offer to be bound on specified terms, and acceptance of that offer), consideration, certainty and completeness, intention to create legal relations, and compliance with formalities. The Law Commission concluded that all of those requirements could be met by a smart legal contract. As with "standard" contracts, each contract would be assessed on its facts, and we highlight the following:
Generally, there is no need for most contracts to be made in a particular manner. However, there are certain types of contract which must be made in writing and signed. Under English law, writing includes "representing and reproducing words in a visible form", so smart legal contracts where the terms are set out in a natural language document clearly meet this requirement. In the Law Commission's view, smart legal contracts which are solely in source code are capable of being read by a person with knowledge of the relevant programming language, and so could be considered to be made in writing. Equally, smart legal contracts which are solely in code may be signed electronically, for example, by using a digital signature to authenticate a piece of code deployed on a DLT system.
So far, so good. However, deeds are a different matter. A deed is a type of contract which does not require consideration, but is required to be signed in the presence of a witness who attests to the signature. For smart legal contracts which are natural language contracts executed by code, this does not pose a particular problem. However, the situation is less clear for hybrid smart legal contracts, or smart legal contracts written and executed solely in code, where it is not clear how a digital signature might be attested (as the signature and attestation must form part of the same document). This will be of particular interest in certain lending transactions.
In interpreting contracts which are subject of a dispute between parties, the courts will consider what the language would mean to a reasonable person, with all of the background knowledge available to the parties at the time at which the contract was made. In the Law Commission's view, even smart legal contracts consisting solely of code should be subject to interpretation, as there may be a divergence between what code means, and what it does when it is executed: there is a distinction between meaning and effect. The addition of code into the interpretive mix is likely to give rise to interpretive difficulties. The Law Commission suggests that the test used should be a version of the "traditional" test: what would a person with knowledge and understanding of code understand the coded term to mean? This is, the Commission says, consistent with the existing approach to contractual interpretation.
The Law Commission suggest a number of natural language aids that parties may consider including in smart legal contracts to assist with contractual interpretation, including:
There are various remedies which parties to a traditional contract might seek, and the Law Commission has considered how these remedies might apply to smart legal contracts. There are various issues which might arise in this area, many of which are practical rather than legal. For example, it is not possible to amend a smart legal contract which has been deployed on an immutable distributed ledger, so in order to achieve rectification a court might need to order a party to deploy an amended contract onto the ledger. Parties should be careful to consider, and draft for, the event that the code for a particular smart legal contract does not perform as expected or as assumed. From a legal perspective, if a smart legal contract is solely in code, it may be particularly difficult to establish a breach of contract due to the interpretive constraints described above, but once interpreted, courts should be able to apply existing principles to determine whether a breach has occurred.
In addition to the considerations above, where a smart legal contract is a business to consumer ("B2C") contract, consumer protection must be considered. This will be of particular concern to financial services firms providing services to consumers via smart legal contracts. Where a smart legal contract is solely coded, or even hybrid, firms will need to ensure that there is a clear natural language explanation which accompanies the coded contract, and that any consumer right to termination of the contract is practically possible.
The Law Commission concluded that the use of smart legal contracts can pose some unique jurisdictional challenges. When jurisdictional issues arise with cross-border contracts (i.e. when clauses on governing law and/or choice of court are absent) standard rules under private international law apply for the purposes of determination which courts have jurisdiction to hear disputes and which governing law shall apply.
Whereas usually the place of formation of a contract, or physical location of the defendant could be used as factors to determine which court has jurisdiction to hear disputes arising from a particular contract, treating smart legal contracts in this way can be challenging. Given that DLT based systems rely on information processing performed by multiple components (nodes) located in physical locations that can be spread across different jurisdictions, it is hard to identify a particular physical place of contract formation. Further, participants in DeFi protocols usually interact with each other on a pseudonymized basis, which makes it difficult (but not entirely impossible) to determine the identity and physical location of a contracting party. However, where a smart legal contract is made by/through an agent located in England and Wales this can be a factor based on which it can be more easily determined that the English courts have jurisdiction.
The Law Commission has recommended that the parties to a smart legal contract should include appropriate jurisdictional and governing law clauses in their contracts in order to mitigate legal uncertainty that can arise in their absence.
The findings of the Law Commission, and recent cases such as AA vs. Persons Unknown, have confirmed that the law of England and Wales has sufficient flexibility to adapt to new concepts, technologies and business practices in changing times. This means it is likely to be a popular choice of governing law for international businesses seeking to use smart legal contracts to regulate their contractual relationships.
The Law Commission's report will be covered in an update to the second edition of the guidance produced by the Law Society, in collaboration with the Tech London Advocates Blockchain Legal and Regulatory Group, which sets out key legal issues in considering DLT-related matters.
In areas of financial services where English law has been a governing law of choice for several decades now, like derivatives, syndicated loan markets, and trade-finance, the Law Commission’s advice comes as a welcome confirmation that, should participants seek to take advantage of the new technology available to them, that it is possible to create and enforce legally binding smart contracts.
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