Smart Contracts: Double-edged Sword

July 30, 2017

Smart contract technologies embody the ideology that a
transaction or part of a transaction can be automatically executed and
performed by electronically utilising software code to implement part or all of
the transaction. The theory of ‘computer-controlled’ contracts has been around
for decades but the development of Blockchain technology has brought about a
recent increase in use of so-called smart contracts, which has in turn resulted
in an increased legal development.

The primary benefits are clear; smart contracts have the
ability to increase the efficiency of transactions, reducing human interaction
and scope for human error. The disadvantages are more subjective and less
easily defined but stem largely from the inevitable confusion that arises from
the name smart contract. The natural implication from the title is that smart
contracts are legally enforceable. However, smart contracts are neither smart
nor contracts.

Nevertheless, this may be changing and there are a number of
legal developments taking place globally that could result in some smart contracts
having direct legal effect.

What is a blockchain?

In short it is a ‘ledger’ or a database of transactions that
is both maintained and developed by a network of participating computers and
users. The fact that the ledger is publically maintained means that it is
incredibly difficult (and some might argue impossible) for any individual ‘block’
to be hacked. The blockchain records who owns what element of the transaction,
whether they be tangible, theoretical or electronic currencies like Bitcoin. Users
are identified by way of an electronic key which is based on code unique to
them. Transactions are dictated by code inputted into the blockchain and
regulated by the applicable rules of the blockchain and the other users/onlookers.
The blockchain is therefore both an anonymous record and a public record. In
theory, the blockchain negates the use for outsider influence and removes scope
for opinion and interpretation, leaving a definitive automated transaction.

The death of lawyers?

There has been an inexorable increase in the use of smart
contracts that utilise blockchain for straightforward transactions. This has
resulted in businesses investing further in the technology behind smart

These developments have led to many predicting that smart
contracts might lead to the demise of the legal profession. The suggestion
appears to be that smart contracts negate the need for lawyers, by bringing in
self-governing transactions.

If we turn to look at a practical example, there might be a
smart contract for the transport of goods which could be programmed so that
electronic funds are released when a transport arrives at a set destination
(perhaps by utilising RFID tags). The suggestion is that this avoids commercial
lawyers drafting a supply agreement and avoids the requirement of disputes
lawyers if non-payment occurs.

However, the claims that such smart contracts will negate
the requirement of lawyers highlights a misunderstanding – the vast majority of
smart contracts are not actually contracts at all. As such whilst the ‘smart
contract’ may be set up to provide certain functionality there is still the
requirement of a legal agreement (whether that be written verbal or implied) to
govern the underlying transaction.

By way of illustration, in the example above, the vehicle
might arrive at the location but what happens if items are missing, damaged or
not as described. Whilst one discrete element of the transaction might be
governed by the ‘smart contract’ a broader supply agreement will still be
required. However, some jurisdictions are now beginning to look at legal
developments that might give some smart contracts direct legal effect.

Land registry – economic accelerator

Land registry projects originated in Georgia, Sweden and Ukraine
are underway globally and many consider blockchain technology could be
utilised, at least in part, to effect property transactions, with the aim of
streamlining the process and boosting property sales.

The initial investigations have focused on ensuring the
seller has good title to the property, without which no sale can be achieved.
The theory provides that each user and individual transaction will be
identified by way of a unique code or ‘hash’. Provided an up-to-date record of
all users and transactions was accurately retained through the blockchain and
made publicly available, the argument is that this would, at least to an
extent, reduce the need for many land registry searches and fees. The eventual
aim is to produce a supply chain blockchain, where all parties concerned have
real-time visibility for each step ahead and behind them. Supporters believe
this will avoid the agonizing delays usually experienced during a property
purchase, deter fraud and improve the overall transparency of the process generally,
increasing confidence in and in turn volume of property transactions.

US developments

Many US states, including Vermont and Nevada, have already passed
smart-contract legislation, making it possible for block-chain registered
digital records to be administered and considered in court. Additionally
Arizona enacted a Smart Contract Bill earlier this year, House Bill 2417, which
amended the Arizona Revised Statutes Relating to Electronic Transactions and
recognises the legal status and enforceability of smart contracts in certain
circumstances.  More recently Arizona have
taken an ‘opt-out’ approach, whereby they effectively make provision and
legislate providing for scenarios that are to be excluded from being legally
enforceable, specifically the new House Bill 2216 approved in April which prohibits
the use of blockchain technology both to locate and control firearms.

Delaware commenced the Delaware Blockchain Initiative (DBI),
essentially an investment program dedicated to the development of blockchain
and smart contract. The DBI’s primary focus to date has been on the
simplification of the ledger technology where companies are required to file
their documents. Very much mirroring land registry developments, the aim is for
a single record of transactions to be retained and validated, ensuring an
undisputed audit trail is retained that anyone can access and view. DBI predict
that the required law will be enacted later this year and will dramatically
increase the efficiency of corporate transactions.

Not so smart after all?

To date the majority of smart contracts are not intended to
be legally enforceable and do not conform to the legal formalities dictated by
contract law. As such, users will experience problems seeking relief in the
event of a breach of contract or change in position or even an unforeseen
circumstance. The chances of these scenarios being comprehensively reduced to
code in the near future are low. Code is not capable of mirroring judicial
discretion, required in many cases – for example, where a contract provides for
‘reasonable endeavours’ or ‘satisfactory quality’. Such a standard evidently cannot
be translated and determined by code alone. Additionally, blockchain reduces
the nature and terms of the agreement to such an extent that it would be
extremely difficult to ascertain the parties’ intentions. This may lead to a
hybrid lawyer/coder role that may arise in the drafting of smart contracts in
the future. 

Some US courts have radically chosen to elevate the legal
status of smart contracts, attempting to circumvent these inevitable issues by
limiting the scenarios where legal status can be applied to smart contracts.
This approach may work, however, it is difficult for legislation to be enacted
that provides for or excludes all of the foreseeable problems. 

With every cloud…

It is evident that as technology develops the utilization of
smart contracts will inevitably increase, empowering businesses to make decisions
faster and more efficiently. This will naturally lead to developments in the
legal sector and the potential for these so-called smart contracts to be built
into legally binding agreements (or built alongside them) allowing the legal
contract to determine the parties intentions and provide for triggering events
upon which the ‘smart contract’ could come into play. However, at this stage it
appears unlikely that formal contractual drafting will be redundant. On the
contrary, smart contracts will revitalise contract law, even if the format of
future contracts becomes conjoined with software coding itself. These changes
will compel all lawyers to review the true nature of contracts and carefully
consider where forthcoming developments in the legal infrastructure may lead in
the future.

Katie Simmonds is a solicitor at Shoosmiths LLP

Jonathan Smart is a Senior Associate at Shoosmiths LLP