Law commission

Increase in legal smart contract litigation expected following Law Commission review

The Law Commission delivered an opinion to the UK government on November 25, 2021, concluding that the current legal framework in England and Wales can facilitate and support the use of legal smart contracts without the need for legislative reform. In an article first published in Legal Brief, Andrew Robson, Martin Walsh and paralegal Abi Barrett examine the Law Commission’s advice and potential issues with smart legal contracts.

The Law Commission says smart legal contracts can be supported within the current legal framework and that issues relating to them should be tested in the English courts as new factual issues and scenarios arise. It therefore seems inevitable that we will see a flurry of cases as the judiciary seeks to apply long-established legal principles in this new context.

Law Commission guidelines may lead to the use of expert coders to assist courts in contractual interpretation, which could increase complexity and costs for parties.

Background

In November 2019, the UK Jurisdiction Taskforce published its legal statement on crypto-assets and smart contracts. She concluded that smart contracts can give rise to binding legal obligations, enforceable in accordance with their terms.

Following this, the Department of Justice asked the Law Commission to undertake a detailed analysis of the current law as it applies to legal smart contracts.

What are smart legal contracts?

The Law Commission defines a “smart legal contract” as a legally binding contract in which all or part of the contractual terms are defined and/or executed automatically by a computer program.

There are basically three forms that a legal smart contract can take depending on the role played by the computer program code, namely:

  1. A “natural language” (or “external”) contract in which all or part of the contractual obligations are performed automatically by the code of a computer program. The code itself does not define any contractual obligations (because it falls outside the scope of the parties’ natural language contract). Instead, the code is simply a tool that parties use to perform their obligations. This form of smart contract seems to be the most commonly used today and does not raise any new legal issues;
  2. A “hybrid” contract in which some terms are defined in natural language, and other terms are defined in the code of a computer program. Some or all of the contractual obligations are performed automatically by the code; or
  3. A “only code” contract in which all contract terms are defined and executed automatically by the code of a computer program. There is no natural language version of the agreement. This type of contract presents the most challenges from a contract law perspective.

The Law Commission notes that while one can classify a smart legal contract into one of the three forms listed above, it is not always necessary (or even possible) to do so.

Examples of potential legal issues with legal smart contracts

Smart legal contracts are expected to revolutionize the way we do business, including increasing efficiency and transparency and reducing transaction costs. Contracting parties are increasingly looking to them as a way to automate specific processes within conventional contracts, from managing supply chains to paying claims.

However, some of the issues with legal smart contracts identified by the Law Commission may include the following:

The degree of automation

Smart legal contracts can have varying degrees of automation. The Law Commission considers that automation should be considered on a spectrum.

At one end would be automated bank payments (such as direct debits and standing orders) and online purchases, which involve elements of automation at the request of one or both parties. These are unlikely to give rise to new legal problems due to their familiarity and extensive use in practice.

At the other end of the spectrum, a legal smart contract can be written primarily or solely in code and then deployed to a distributed ledger system (“DLT”). A DLT system is a registry shared by a network of computers and may be available to others who can approve and possibly synchronize additions to the registry through an agreed mechanism. In those cases, where the automation in question takes the contract out of the realm of legal familiarity, new legal issues may arise.

Interpretation

New problems of interpretation are unlikely to arise when the terms of a smart legal contract are recorded exclusively in a natural language contract, and the code simply automates the execution of those terms.

However, when the terms of a smart legal contract are defined partially or only in code, this potentially poses difficulties in contractual interpretation.

Code does not reflect natural language contract/does not work as expected

Parties can first enter into a natural language contract that spells out the terms of the transaction. The natural language contract is then translated into code, but errors can occur during this translation process. Similarly, disputes over coded terms can arise when the result of the code does not become apparent until after the code has been deployed.

In such cases, the parties may seek to rectify or reverse the effects, but this may depend on the complexity of the transaction. Also, it may be nearly impossible to change the code if it was saved on a DLT.

The problem of the “oracle”

When the execution of a legal smart contract is tied to information from a third-party database (i.e. an “oracle”), problems can arise if that external data source malfunctions. For example, a travel insurance policy in the form of a smart legal contract could be linked to a global air traffic database relaying flight data to the computer program. As soon as a flight is delayed, this information is relayed to the computer program by the oracle, triggering an automatic payment to the insured.

While this process can save time and money, if this external data source does not provide reliable and timely data, the legal smart contract may not perform in the manner intended by the parties.

What did the law commission conclude?

The Law Commission informed the government that:

  • The current legal framework is robust and adaptable enough to facilitate and support the use of smart legal contracts;
  • The flexibility of our common law means that the jurisdiction of England and Wales provides an ideal platform for business and innovation, without the need for statutory law reform; and
  • We should seek to identify and, if necessary, remove any fundamental legal impediments to the use of smart contracts.

Appendix 3 of the document helpfully includes a non-exhaustive list of steps parties to a legal smart contract can take to help reduce the risk and scope of potential litigation.

Deeds and private international law are the two areas where the Law Commission considers that future work is needed to support the use of smart contract technology in appropriate circumstances. Future law reform projects are underway in both areas.

What does the future hold?

Role of the expert coder

Although some types of smart legal contracts may give rise to new legal issues and factual scenarios, existing legal principles may accommodate them. For example, the Law Commission has indicated that an appropriate test for interpreting a coded term in a dispute would be for the court to ask what the term would mean to a person knowing and understanding the code, i.e. a “coder”.

An expert coder could help the court by translating the code in the same way as any other contract written in a language unknown to the court and give their reasoned opinion on what the code appears to be ordering the computer to do. The court would then determine what the terms (as translated) would mean to a reasonable person, applying the principles of contractual interpretation.

English courts are used to hearing expert evidence from foreign solicitors when seeking to interpret contracts under foreign law. However, it is common for such issues to become hotly contested points in business. The suggestion of expert evidence as to the “reasonable coder” gives rise to the possibility of an additional layer of complexity and cost, even in English law cases.

Potential increase in litigation

The Law Commission’s findings and recent case law on cryptocurrency fraud show that English courts are currently well equipped to handle disputes arising from emerging technologies such as smart contracts and digital assets. However, new regulations may be needed in the future as the technology becomes more complex.

Legal smart contracts are already widely used in the finance and insurance industries, and the Law Commission’s guidance should give other industries the confidence to explore the potential benefits of using legal smart contracts. That said, as the use of smart contracts increases, it seems inevitable that an increase in related litigation will follow.