What happens when a smart contract is breached?

The English legal system is heralded for its ability to keep pace with technological changes.  The common law system has proven, time and time again, that it is well suited to responding to novel legal issues in real time.  Smart contracts, distributed ledger technology (such as blockchain) and cryptoassets are high on the agenda when it comes to anticipating and addressing the legal challenges which might arise as new technologies become increasingly mainstream. 

Understanding what might go wrong is usually a good place to start in determining how to get it right, and the Law Commission's November 2021 report provides useful insights into how the current law on enforcing and remedying breaches of contract might apply in the context of a smart contract.

Avoiding the pitfalls

The good news is that the law of England and Wales is sufficient to address legal issues arising in a smart contract context.  However, key areas which require extra caution include:

• Be aware of the type of smart contract you are dealing with. Broadly speaking, there are two categories of smart contract – those where a contract is agreed in natural language where the obligations are 'translated' into and performed by code, and those where the obligations are defined by code (as well as everything in between). The latter is likely to be more challenging from a legal perspective. Parties should consider whether their needs would be served by recording their contract, or parts of it, in natural language.
• Does the platform through which the smart contract will be recorded and executed meet the parties' needs? A key question to consider here is whether the platform is decentralised, or whether there is a central administrator. Most blockchains are decentralised, meaning that once information is recorded on them, there is no-one with the power to update or remove that information. If there is a central administrator, they may be able to change information recorded on the ledger, but it will be important to understand who the administrator is, where they are located and what they can do. Are they able to amend errors in the ledger (for example, an error in the code which records the terms of the contract), and if so, in what circumstances and how is that practically achieved? Do the parties want that or are they seeking to record their obligations on a truly immutable ledger?
• What happens if the code malfunctions or does not operate in the way the parties envisaged (eg because there was a human error in the coding, or some other unintended consequence)?Thought should be given to these possibilities, and whether any risks can be mitigated from the outset, for example, by including a 'kill switch' in the code which can be deployed if termination is required before the code has fully executed. The parties might also consider whether it is appropriate to negotiate exclusions of liability connected with issues arising with the code.
• Smart contracts are more likely than traditional contracts to be cross-border in nature, for example, because they can facilitate peer-to-peer transactions, cross-border financial activity and supply chain management, to name a few uses, and because the defendants to a claim might extend beyond the contractual counter-party to also include the platform provider, the coder engaged etc.The inclusion of a clear jurisdiction clause is very important and should not be overlooked. It would be prudent for the parties to record that agreement in natural language either in a separate agreement or as part of the code. The same approach should be taken to the choice of governing law ie it should be clearly specified, preferably in natural language, to remove any risk of ambiguity.

See here for more on negotiating smart contracts.

What happens when it all goes wrong?

While smart contracts seem unlikely to require the creation of new causes of action, they do give rise to new fact patterns which require careful consideration and potentially increase instances of defective performance.  The categories of claims that might arise in a contractual context are:

Rectification

If there has been an error in recording the agreed terms of a contract, a party might seek rectification of those terms so that they reflect the parties' actual common intention at the time of entering the agreement.  Instances of this may increase in the context of smart legal contracts, for example:

• where there is a prior natural language contract, which is subsequently converted or translated into code which one or both parties contend does not reflect their common intention
• in cases where contractual obligations are only defined in code, and the standalone smart contract fails to accurately record the common intention of the parties (ie common mistake), or
• a unilateral mistake, eg where the code is produced in draft, one party is labouring under a misunderstanding as to how the code will operate, and the other party is aware of that but does not raise it with the other party, perhaps because the error or misunderstanding works in their own favour. A claim for rectification could arise in that situation because it would be contrary to good faith for a party to enforce a contract which it knew was inconsistent with the bargain that the other party believed was being made at the time of entry into the contract.

Understanding what the coding means and how it would be expected to operate could become an important issue.  If a court can be persuaded to grant an order for rectification, then how is that practically achieved where the code is recorded on a permissionless distributed ledger which is impossible to alter?  The Law Commission report suggests that one option would be for the court to order that the parties agree and implement a new piece of code to counteract the effect of the defective coding.  This would not be rectification in the sense that we currently understand, but it is a work around which could give the same practical effect.

Another issue which may arise in claims for rectification is that smart contracts may auto-execute, and that may give rise to situations where an incorrectly coded contract is performed in a way which the parties did not intend before the error is discovered.  Smart contracts may therefore lead to an increase in rectification claims, particularly where there is no accompanying natural language contract, because rectification might be needed as a precursor to a breach of contract claim.

Claims based on vitiating factors

These are factors which render a contract defective such that it can be said that it never came into force in the first place, or there are grounds to have it set aside.  These include mistake, misrepresentation, duress and undue influence.

The Law Commission does not anticipate that smart legal contracts will give rise to novel legal issues in respect of mistake, misrepresentation, duress or undue influence.  Any issues are likely to arise in the context of pre-contractual interactions, rather than in circumstances unique to smart contracts.  It is, however, worth noting that common law misrepresentation claims might extend to a broader range of persons who provide statements as to how a smart legal contract or particular platform operates – for example, platform promoters or third-party coders.  

Claims founded on mistake might increase in a smart contract context because parties may hold beliefs or assumptions about how the code will perform which turn out to be wrong.  Some examples of the types of mistakes that might arise are noted above.  There could also be instances of smart contracts being concluded by the autonomous interaction of computer programs which lead to unintended consequences. There is no concern that the law on mistake will be inadequate, and the existing principles of mistake are expected to suffice.  It may be prudent for parties to smart contracts to take steps to test the code in simulations to avoid mistakes arising.

Breach of contract

Breach of contract arises where there has been a failure to perform or defective performance. 

Where a contract has been agreed in natural language prior to it being recorded in code, the scope for novel contractual and other disputes is likely to be significantly lower than with contracts which are wholly recorded in and defined by code given that the first step in determining whether a contract has been breached will be to understand what obligations arose under the contract.  The usual principles relating to contractual interpretation and construction would apply to a traditional, natural language contract and be deployed to assess whether an automated code has failed to perform those obligations correctly.

A contract which is only defined by code will give rise to more novel issues as regards interpretation and construction.  There may be a greater reliance on evidence of discussions between the parties in the lead up to the creation of the contract/code (and parties should be mindful of that when they are negotiating terms which will be recorded in a smart contract).  There may also be heavy reliance on expert evidence regarding the meaning of the coded terms both in terms of what they would mean to a functioning computer, and what the terms would mean to a reasonable person with knowledge and understanding of the code.

A party found to be in breach of the contract would be liable under the contract for any failures or defective performance.  The fact that a breach has arisen as a result of the computer code, rather than the actions of a natural person, will not absolve a party of liability for breach.  In practice, parties may seek to agree to exclude liability for breach arising from performance of the code (and the fairness of such a clause would be subject to UCTA or the CRA 2015).

Frustration

Frustration applies where the parties have entered into a contract but a subsequent event has rendered performance physically or legally impossible, or "radically different" from what was contemplated by the parties.

In the case of smart contracts, performance of the code might become physically impossible if there is a technical malfunction or some unforeseen shutdown of the platform on which the code is deployed.  Alternatively, there could be an event which causes the code to execute in a way which is radically different from that contemplated by the contract.  The existing principles of frustration are expected to be sufficient.

Illegality

If the purpose or performance of a contract involves conduct that is illegal, the contract may not be enforced by the court.  There are some concerns that smart contracts could facilitate illegal activity, for example in the decentralised finance sphere, where participants can transact directly, without traditional intermediaries who play a role in detecting illegal activity.   The Law Commission considers that the existing principles of the doctrine will be sufficient but notes that since the coded element of a smart legal contract performs automatically, it seems unlikely that a claim for enforcement would be necessary.  It is more likely that a party would bring a restitutionary claim to recover money or property transferred under a smart legal contract tainted by illegality, and the principles set out in cases such as Patel v Mirza would apply.

What remedies are available and how do they apply to smart contracts?

The remedies available will depend on the nature of the claim, and it is not anticipated that new remedies will need to be created. 

The usual breach of contract remedies of damages, termination and specific performance are available for smart contracts, albeit it is worth noting that their practical application may differ as compared with traditional contracts.  In particular, while the law on termination is expected to apply in the same way as traditional contracts, it may not be possible to effect termination of a partially executed, automated code (a simplistic example would be where an automatic supply of deliverables is followed by automated payment).  One approach could be to agree to deploy additional code which is designed to reverse the effects of the initial contract; however, where parties are in dispute as to whether the contract should be terminated that is unlikely to be an option.  Another approach would be to consider including an 'escape hatch' or 'kill switch' within the code, which can be triggered by one or both parties in certain agreed circumstances.  That could, of course, be subject to abuse and give rise to novel types of breach of contract, but the existing law is expected to be sufficient to address that risk.

There may be an increase in claimants seeking restitutionary remedies. This is because smart contracts might be automatically executed by code before the parties discover an issue which would ordinarily operate to render the contract void or voidable. The purpose of restitutionary remedies is to reverse the defendant's unjust enrichment (which requires the claimant to establish that the defendant has been enriched at the claimant's expense in circumstances which the law recognises as unjust - the unjust factor could be mistake or a failure of basis). 

Where a smart legal contract is voidable due to the presence of a vitiating factor, the remedy may be to seek to set the contract aside (recission).  This can only be granted where the parties can be restored to their pre-contractual positions. The existing legal principles of rescission are expected to be sufficient. However, if the smart legal contract has been partly or wholly performed by code, there is a question of how the parties can be returned to their pre-contractual positions if transactions are recorded on an immutable distributed ledger.  The Law Commission report suggests that the court could achieve “practical justice” between the parties by ordering the parties to enter into an “equal and opposite” second transaction on the blockchain. The first transaction would remain on the blockchain, but its effects would be reversed by the second transaction.

Jurisdiction and conflicts of law

The recent developments relevant to the question of jurisdiction and choice of law (namely, Brexit) are well-documented.  The Law Commission is continuing to review how the rules relating to conflicts of laws will apply to emerging technology including smart contracts and will begin that work later this year.

Given that smart legal contracts can facilitate peer-to-peer transacting, cross-border financial activity and supply chain management, they are likely to give rise to a variety of connections to various legal systems.  There could also be multiple defendants; for example, in the context of a contractual dispute there might be claims against the contractual counter-party, the platform that the contract is hosted on and the coder, all of whom may be based in different jurisdictions.  This means that any claims relating to smart contracts are likely to be ripe for jurisdictional challenges ie applications seeking a determination of whether the court in question is the right court to determine the dispute.   A clear jurisdiction clause is therefore very important and should be included in all smart contracts to avoid uncertainty. 

Similarly, issues may arise in determining the applicable law and parties should consider how the protocol of the platform which hosts their contract will impact the applicable law as well as issues such as the location of any private key.  It would be advisable for parties to expressly record their choice of law. 

In both cases, while it is possible to encode a choice of law and jurisdiction clause, the Law Commission is of the view that parties should record their agreement in natural language to avoid uncertainty.

Going mainstream

The courts of England and Wales continue to be a popular choice for parties seeking to determine disputes which relate to emerging technologies, and rightly so.  The crypto industry has been at the forefront of the most high-profile smart contract disputes which have come before the courts globally, and the courts of England and Wales have consistently demonstrated the virtues of the common law system in terms of its responsiveness to new technologies and factual scenarios. 

The conclusions in the Law Commission report, and the clarifications regarding how existing causes of action and remedies might be deployed are welcome confirmation that parties utilising emerging technologies can be confident that the law can keep pace with technological advancements, albeit that there is clearly an onus on the parties themselves to give proper thought and consideration to the ways in which disputes could arise – both to avoid them in the first place, and to ensure that the parties' choice of governing law and jurisdiction has been clearly recorded.