This blog series is based on a chapter for the forthcoming book entitled “Essentials of Blockchain Technology”. The chapter was written together with Martim Taborda Barata, LL.M., Senior Associate at ICT Legal Consulting International, and lawyer registered at the Portuguese Bar Association.
In this second part of the Legal Aspects of Blockchain Technology series, I will focus on contractual law, paying particular attention to smart contracts. Contracts are essentially agreements between parties that preside over their interactions, either over a period of time or on a one-off basis. Contracts can be executed automatically (i.e., where the obligations upon one or more of the parties can be performed without further human intervention, once certain criteria are met), usually with the aid of computers, they can be referred to as “smart contracts”. Smart contracts are automated agreements in which certain tasks are performed
without the need for further human intervention once certain conditions (e.g., payment of a certain price) have been met.
How does the relate to blockchain? Well, blockchain can be leveraged in order to create complex forms of smart contracts which may also be affected by blockchain technology with respect to their formation, performance, and potential breach. Blockchain may also positively impact contract management and litigation costs.
It has been said that smart contracts have gained prominence due to their use in blockchain and related systems. A primary advantage of which is that, due to the distributed nature of blockchain and, in particular, the system to validate entries recorded on blockchain (relying on consensus between several dispersed ‘nodes’ for this validation, rather than a central authority, such as a bank), the need for a trusted third party to implement and take responsibility
for the correct fulfilment of automated transactions is overcome.
It is possible to configure blockchain systems so that they can store contracts in a scripted form, while also allowing the script to automatically execute whenever agreed-upon situations occur (e.g., allowing a certain amount of Bitcoin to be transferred from one individual to another whenever the system detects that a certain price has been paid by the latter to the former). We will now consider the implications which resort to such form of automated agreements may have concerning certain different points of a contract’s ‘lifecycle’.
The phases of a Smart Contract Lifecycle:
Given that both smart contracts and “regular contracts” require parties to agree upon a certain set of rules, their formation occurs in a similar fashion from the legal perspective.
However, where a “regular contract” is typically formed when the parties involved accept these terms, before starting to perform their respective obligations (for instance, by signing a written document to evidence their agreement), a smart contracts’ formation happens at the same time as the contract’s obligations are performed.
The parties involved are all capable of entering into the smart contract under the applicable law (e.g., that the parties are of age and physically/mentally capable of understanding what they are agreeing to), and that the smart contract is not ‘unconscionable’ (i.e., grossly unfair towards one party compared to another) or illegal, without which the smart contract could potentially be found to be null and void (meaning it produces no legal effects from the start), voidable (meaning its legal effects can be interrupted by court order) or generally unenforceable against one or more of the parties (meaning it specifically does not bind those parties).
Just as announcing the availability to enter into an agreement can, under certain circumstances, be considered as a legal offer to enter into such agreement (e.g., where someone offers an item for sale, and sufficiently specifies all the contractual terms needed – item, price, method of payment, and so on), posting smart contract code on a blockchain system may be interpreted as such an offer. Offers to enter into smart contracts can be made under non-negotiable terms or subject to negotiation.
Those in favour of the implementation of smart contracts via blockchain argue that this method represents a much less expensive system of enforcement by allowing ‘finality’ to be encoded into smart contracts. In fact, it is possible to explicitly configure a smart contract to unavoidably and irreversibly perform a certain task once the triggering condition is met (although it is also to build in safeguards to allow one to change one’s mind). This would allow for lowered transaction costs by removing the need to resort to the courts, or other dispute resolution mechanisms, as non-performance would not be an option – once the triggering condition is met, the programmed consequence will take place.
Furthermore, the fact that this approach only allows for the use of specific and precisely defined terms may reduce the possibility for either party to claim that they misunderstood the contents of the smart contract upon accepting it, or that some other mistake was made regarding the interpretation of its rules – ambiguities in the programming world are far less relevant than in the ‘real world’, as humans are presently capable of greater semantic understanding than computers (which may lead to the same
sentence being interpreted in different manners by humans, whereas this would not necessarily be the case with automated performance).
It should be noted that inflexibility is inherent to smart contracts performed over blockchain, preventing easy modifications to agreed terms and potentially offsetting the reduction in transaction costs with an increase in negotiation costs. This is because the parties will be keen to make sure they very specifically define all the terms used in such contracts and foresee all potential cases where modifications may be required in the future.
II. Performance and Modification
The most obvious advantage which is brought by the use of blockchain-based “smart contracts”
seems to be the fact that performance is made automatic. Such contracts are comprised of permanently archived code which will automatically and reliably execute once certain agreed-upon conditions have been met.
The contract’s terms are decentralized and distributed to the various nodes in the blockchain system, granting them nigh-immutability and independence from the contracting parties, who are not able to change their minds or delay performance once conditions are met, as the blockchain will monitor and enable that performance automatically. This is probably the main appeal of this form of contracting, in that it has the potential to lower parties’ costs in monitoring the other’s performance and having the contract enforced by means of
the relevant courts.
However, these characteristics also make it very difficult to make amendments to a blockchain-
based “smart contract” which then increases negotiation costs between parties, which must ensure that all future states of the contract are completely and precisely defined.
In order to preserve the benefits of smart contracts’ self-enforcement, it is necessary to leave no decisions about its performance to humans. The immutable
nature of blockchain-based smart contracts may also pose a threat to situations where the validity of the contract is affected by changes in the applicable regulatory framework. Smart contracts also preclude the use of purposefully ambiguous contractual terms, such as
performance standards, which in ‘regular’ contracts allow parties to enter into a full agreement
without needing to completely define what is considered adequate performance of that agreement, while also not leaving it undefined or potentially wrongly defined, thereby allowing parties, for example, to gain the benefit of certain terms mutually understood terms.
III. Breaches of Smart Contracts
A logical conclusion derived from blockchain-based smart contracts’ automatic performance is their automatic enforcement, given that the two happen at once. By creating a smart contract tied to a blockchain system, its contractual obligations will be executed without deviation,
Given that standard legal enforcement of contracts through courts or alternative dispute resolution mechanisms can be cumbersome, prone to error, lengthy and expensive, the incentive to replace this with automated, “algorithmic enforcement” is understandable.
Given that complete execution of blockchain-based smart contracts typically occurs once the trigger conditions have been met, without any possibility of interruption (even by the courts!), with the distributed nodes within the blockchain system ensuring this performance, after which the transaction becomes irreversibly encoded in the blockchain system, it has been suggested that these smart contracts may come to act as a replacement for the state-based legal system of enforcement.
Summary of Smart Contracts
All of this comes at a cost of another type of flexibility afforded to parties of ‘regular
contracts’ and that is enforcement flexibility.
Some of the benefits brought about by blockchain technology to smart contracts are self-evident and undeniable. These include allowing the secure and immutable archival of smart contracts, the use of specific and well-defined terms (which may reduce frictions regarding interpretation of contractual provisions), and the automated execution of obligations, doing away with the need to take any further actions in order to ensure performance or enforce contractual obligations. This would allow for the lowering of transaction costs in contractual relationships, removing the need for performance monitoring, as well as judicial recourse in order to guarantee that the terms of the smart contract are respected – the blockchain-based smart contract will simply and unavoidably self-execute.
However, the other side of the coin is that what some see as advantages in terms of a reduction of contractual ambiguity, lowering of transactional effort and the encoding of finality, others consider may bring about greater and less intuitive disadvantages. The lack of an easy manner in which to make amendments to a blockchain-based smart contract (or, at least, amendments which were not initially foreseen), the increase in negotiation costs derived from the need for all defined terms to be fully specified and agreed upon and the overall reduction of contractual flexibility afforded to parties may drive parties away from the more rigid blockchain-based systems to the more “traditional” forms of contracting which preserve the fluidity of the underlying commercial relationship.
While it seems that blockchain-based smart contracts may not be appropriate to regulate any and all types of commercial relationships, they may still prove valuable in addressing more straightforward transactions between parties, potentially eliminating the need for intermediaries and allowing each person to automatically receive what they are bargaining for in a deal – a record of which
will be kept, immutably, on the blockchain system.