Smart legal contracts under English law - Part 1: Introduction
The Law Commission has concluded its investigation in to how the current law of contract applies to smart legal contracts. Their report is heartening reading for business. The laws of England & Wales are robust and flexible enough to adapt to the use of smart legal contracts, although there will be a period of adjustment, during which incremental changes and adaptations are required.
This series of posts considers how our clients may best minimise the risks that come with any transitional period, and highlights the particular issues which will necessitate developments of the common law, even though statutory reform is not needed, to ensure that England remains a business friendly jurisdiction.
Norton Rose Fulbright contributed to the Law Commission’s working group, and we discuss why the Law Commission’s recommendations will be considered an important source of guidance on smart legal contracts, and its summary of the existing position used by academics and practitioners.
This initial post introduces the issues and highlights the key points that will need to be considered. Our two subsequent posts consider specific areas of contract law and can be found here:
Smart Legal Contracts 101
What are smart legal contracts?
Smart legal contracts are a subset of smart contracts. A smart contract is a computer program with an element of automaticity: that is, it can run automatically, either completely or partly, without human assistance. A smart legal contract is a smart contract where the code also includes a binding legal contract:
A smart legal contract is “a legally binding contract in which some or all of the contractual obligations are defined in and/ or performed automatically by a computer program.” [1]
The use of smart legal contracts is anticipated to expand as various sectors seek to take advantage of the automation process. In particular, the growth of the Decentralised Finance (DeFi) industry – whose aim is to disrupt conventional banking and capital markets arrangements – would see a wholesale change in the day-to-day mechanics of the finance sector.
Smart contracts are already a well-established part of modern life and, unsurprisingly, the report concludes that simpler automated programs are unlikely to create novel legal issues.
Any obligations in a smart contract follow the classical Boolean logic that underpins all digital computing: if A, then B. Standing orders and other automated payments are common examples of smart contracts (e.g. if it is the first day of the month, then make a mortgage payment).
Smart legal contracts and the blockchain
While smart contracts may be hosted on a blockchain, it is not a necessity (for example, a standing order instruction may be stored on and performed by a bank’s own computers). However, it is anticipated that distributed ledger technology (DLT) will increasingly be used to host smart legal contracts, and this additional layer of complexity may contribute to novel legal issues for English contract law.
Did the Law Commission consider that all smart legal contracts would be a challenge to English contract law?
No. The Law Commission highlighted that certain forms of smart legal contract may create novel legal issues, in particular those contracts which rely on code as the only record of an obligation. This distinction divides smart legal contracts into two sub-categories:
Natural language contracts with automated performance by code
Currently, the majority of smart legal contracts are negotiated and the terms recorded in English or another natural language. These terms are then programmed into the smart legal contract. The code is a tool for performance of the contractual obligations, rather than the basis of the obligations themselves.
Such natural language smart legal contracts do not present wide-ranging new issues for English contract law, although they do present some challenges, particularly in the context of dispute resolution.
Contracts recorded solely in code & hybrid contracts
There is no requirement that a smart legal contract’s obligations be recorded in natural language. Some or all of the contractual obligations contained in a smart legal contract may be defined purely in code. It is also possible that, as well as the terms of the smart legal contract being recorded in code, the underlying negotiations are also conducted either solely or partly in code. For example, two parties may repeatedly exchange iterative versions of the underlying code, with little or no natural language explanation for the changes.
While not currently common, perhaps because the terms of complex commercial agreements are too subtle and nuanced to be recorded solely in code, such smart legal contracts are likely to become increasingly common, as precedent banks of code or market standards are established.
What legal issues might obligations recorded solely in code cause?
The report considered that a smart legal contract that has either all or some of its obligations recorded only in code may raise challenges in respect of the following areas of English contract law:
- Formation;
- Interpretation;
- Remedies;
- Consumer contracts; and
- Jurisdiction and governing law.
The two subsequent posts in this series will discuss the Law Commission’s extensive analysis of each of these potential issues. In some cases, the report suggested potential remedies, while in others the report merely flags the potential issue.
Key Takeaways
The authors’ view is that, while certain issues with smart legal contracts are fundamental, and will go to the core validity of each and every instance of a particular type of smart legal contract, other issues are general risks that can be managed through drafting, until the courts clarify English contract law on these issues.
Particular FinTech and DeFi products will raise specific issues that do not need to be addressed in the wider context of smart legal contracts. Another two Law Commission projects – on electronic trade and digital assets – are ongoing, and will result in further reports.
[1] The Law Commission, Smart legal contracts: Advice to Government - Glossary