What are they?
A simple example might assist: a refreshments vending machine! When monies are inserted, an irreversible action is put in motion. Monies are retained and a refreshment is provided. The transaction cannot be stopped in the middle of the process. In a sense, the terms are embedded in the hardware and software which run the machine.
The key characteristics of the modern conception of a Smart Contract (“SC”) are:
- Digital: it is in computer form – code, data and running programs.
- Embedded: contractual clauses (or equivalent functional outcomes) are embedded as computer code in software.
- Performance mediated by technological means: the release of payments and other actions are enabled by technology and rules based operations.
- Irrevocable: once initiated, the outcomes for which a SC is encoded to perform cannot typically be stopped (unless an outcome depends on an unmet condition).
- Many corporate and financial institutions are developing a variety of uses for SCs and its simplest, and perhaps most common, use is for the issuing and transferring of securities. SCs lie on a spectrum, for instance, a contract in code with a separate natural language version or a natural language contract with some encoded performance e.g. the payment mechanism. There may also be a contract which might be written entirely in code.
Today’s SCs are implemented in platforms that often rely on blockchain or on what is known as a distributed ledger technology (DLT). Blockchain and DLT allow parties to a SC to come to an agreement over a shared set of facts.
What are the risks?
Many in the tech industry believe that SCs replace contract law and the Courts with code. The misconception here is that because they perform automatically and performance cannot be intercepted, that they remove the potential for disputes. Of course, this is wishful thinking (at least for now)!
Although potential benefits can be seen; for instance, for reducing transaction costs and increasing security, disputes can and will undoubtedly arise. In fact, new areas of dispute will, and do, arise where contract law and code meet.
Potential and likely issues include:
- The question of ‘is a SC legally binding’? – In many common law jurisdictions, a contract can only be valid if it is entered into by a person (i.e. a human or legal person, such as a company) with legal capacity to do so. In English law, there is also common law authority that a contract cannot arise unless there is sufficient certainty over who the contracting parties are.
- Coding errors may cause unforeseen issues with performance.
- Discrepancies can arise between coding and natural language versions of a Smart Contract.
- Parties may want to terminate the SC for repudiatory breach or undo it on the grounds of misrepresentation, mistake or duress. As per the vending machine example, parties will be prevented from doing this with the current model of a SC.
- Subsequent changes of law or regulation may make performance of the SC illegal.
- It is easy to see how SCs might perform on the basis of an inaccurate data feed.
If you are thinking about transacting by a SC, it is suggested that arbitration clauses are given thought to; such as agreeing a particular clause which enables parties to appoint someone with, for example, an understanding of coding.
In the meantime, it is preferable that while this novel area finds its feet (i.e. law and procedure adapt), that conventional contracts are relied upon so as to avoid the potential commercial ramifications.
For contract advice, our Corporate and Dispute Resolution department are here to assist.