Law commission

Law Commission finds English law supports smart contracts

Businesses can take comfort that smart contract technology can create legally binding agreements, but should be aware of remaining areas of uncertainty

Towards the end of 2021, the Law Commission published a report entitled “Smart legal contracts: advisor to Government”. He concluded that the law of England and Wales can facilitate and support smart legal contracts without requiring reform.

There are, however, some important caveats, and companies would do well to take note of them.

What are smart contracts?

The report defines a “smart contract” as “Computer code which, upon the occurrence of a specified condition or conditions, is capable of automatically executing according to predefined functions”, adding that they are typically deployed on distributed ledger technology. It also 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”. Essentially, a smart contract automates the execution of a contractual agreement, with the provisions locked in a blockchain.

For example, a smart contract can be set up so that when a payment receipt confirmation is recorded on the blockchain by a seller’s bank, a notification is automatically sent to the seller’s distribution depot to ship the goods. to the buyer.

For some smart contracts, the coding will represent the entire contract between the parties, while for others it will be just one part. For example, terms and conditions for the sale of goods may cover matters other than payment and shipping terms (such as liability, warranties, insurance, or applicable law). Some provisions may relate to obligations that do not lend themselves well to being expressed or performed in binary computer code, such as those involving discretion or best efforts. These other provisions might need to be incorporated into a traditional contract that accompanies the smart contract to record the full arrangement.

Can a smart contract be legally binding?

In 2019, the UK Jurisdiction Taskforce (UKJT) concluded that smart contracts can (in principle) meet the valid formation requirements of a binding and enforceable contract.

It was then up to the Law Commission to consider whether the existing legal and regulatory framework is secure enough to accommodate smart legal contracts and, if not, to highlight uncertainties and/or propose new or updated laws. up to date.

What were the findings of the Law Commission?

The Law Commission is unequivocal that the existing law of England and Wales can adapt and apply to self-executing smart legal contracts without the need for reform:

“…the current legal framework in England and Wales is clearly able to facilitate and support the use of smart legal contracts, without the need for statutory law reform…Current legal principles may apply …in the same way as they do for traditional contracts… Although certain types of smart legal contracts may give rise to new legal issues and factual scenarios, existing legal principles may take them into account.”

In particular, the lack of human performance is unlikely to be a problem for the majority of contracts. The report highlights that automated fulfillment of contractual obligations already exists, for example with bank payments and online shopping.

However, new questions are more likely to arise when a smart legal contract is expressed wholly or partially in code: for example, regarding the interpretation of coded provisions (a program may not always work the way a reading of the code might say ). Courts should interpret coding by reference to what a reasonable person knowing and understanding the code – a “reasonable coder” – would understand.

With respect to the essential requirement of quid pro quo (i.e., a promise – or performance – by a given party in exchange for a promise from the other party), the Law Commission noted that it might be more difficult to identify the counterpart of code-defined promises. He agreed with suggestions from those consulted that the development of smart contract platforms that combine coding and natural language “would be helpful in removing the scope of any potential disputes over consideration”.

While some smart contracts will be able to fulfill the requirements for contract formation under English law – namely agreement, consideration, certainty and intention to create legal relationship – practical challenges arise in the framework of compliance with the additional formalities required for the valid execution of acts.

Applicable law and jurisdiction are also identified as other difficult areas: “Deeds and private international law are the two areas where we believe further work is needed to support the use of smart contract technology in appropriate circumstances.”

Acts

While most contracts do not need to be made in any particular form, in some areas the parties’ arrangements must take the form of a deed. The deeds must be written, signed and attested.

“In writing” is defined in the legislation to include all modes of “to represent and reproduce words in a visible form”. The Law Commission notes that not all types of coding are human-readable, but concludes that if a contract term is defined in a coded smart contract, it can be considered “written” if it can be read by a person. knowing the relevant programming. language and then translated into words. That said, whether this requirement is met in any given scenario depends on whether the terms of a smart legal contract are meant to reside in code rather than words.

With regard to signature and testimony, electronic signatures may be used in contracts, unless the legislation, case law or contract in this area prohibits it. Accelerated by the pandemic, electronic signatures are now commonplace and do not present a hardware problem in most circumstances (as we discussed earlier). However, questions remain about incorporating an electronic signature into a smart contract.

Finally, an act must be signed in the presence of a witness who attests to the signature. Testimony can be supported by electronic signature systems, but the witness must still be physically present when the party signs, and the witness attestation must be embedded in the smart contract (along with the party’s signature).

Basically, the formalities for the execution of deeds were designed around the traditional form of a “wet ink” signature on paper in the physical presence of a witness. Overall, it is not surprising that the Law Commission concluded that the parties cannot “being satisfied that current law supports the creation of deeds that are wholly or partially defined by the code. Deeds are documents executed with a high degree of formality and there is some uncertainty as to whether smart contract technology can facilitate compliance with the various formalities that apply to acts”.

Therefore, as the law currently stands, it would be inadvisable to use a smart contract to conclude contracts that must be concluded in the form of a deed (for example, transfers of land or interests in land, mortgages, powers of attorney and agreements entered into without consideration).

Applicable law and jurisdiction

As previously mentioned, smart contracts pose unique jurisdictional challenges, particularly identifying the location of counterparties, managing breaches, and seeking remedies. These issues are particularly apparent when a smart contract relates to a digital asset.

Where jurisdictional issues arise in “traditional” cross-border contracts that do not identify the applicable law and jurisdiction, the existing rules apply to determine the competent courts. The issue of “digital localization” is cited by the Law Commission as a significant challenge in applying these rules to legal smart contracts. It involves assigning actual locations to digital assets and digital actions that occur on a distributed ledger that does not have a single “original” version, but can exist in multiple locations with equal validity.

To alleviate uncertainty about where a smart legal contract is formed, the Law Commission recommends including a jurisdiction and choice of law clause in the agreement. This will clarify the obligations of the parties and the consequences of any breach. It can also provide certainty as to the intention of the parties to create legal relations. While we see case law that touches on these issues, it is always advisable to address them expressly in the relevant contract to remove doubt (and reduce the risk of subsequent litigation).

These issues have led to the development of the UKJT’s Digital Dispute Resolution Rules and may help drive their adoption. Furthermore, the Law Commission has identified the issue of “digital localization” as an issue to be addressed, and potential solutions proposed, in its planned future project on Conflict of Laws in the Context of Emerging Technologies.

The Law Commission’s findings will be good news for those employing or considering legal smart contracts. The fact that no new legislation is needed to incorporate them will further build confidence in this rapidly evolving field and should accelerate technology adoption.

That said, companies deploying legal smart contracts will need to carefully consider whether any of the practical challenges outlined in the report apply to their particular use case and, if so, ensure that they are handled appropriately. The report’s findings point out that in most cases, it will make sense to have a traditional contract alongside the coded smart contract. The traditional format can be used to record in plain language the key aspects of the parties’ agreement, to remove uncertainty about issues identified by the Law Commission, and to contain any more complex or nuanced clauses.