An Introduction to Smart Contracts and the Law

What are smart contracts?

There is no one definitive answer to the question “What is a smart contract?” Depending on who you ask a smart contract could be either considered lines of executable code existing on a blockchain or an autonomous agreement. In the context of the legal industry, a smart contract is defined as an agreement between two or more parties to the exchange of information or assets; based on one or more conditions being met; which is self-enforcing, autonomous and operates as a computer program.

Such smart contracts are not written or oral contracts but are instead programs executed and stored, most commonly, on a trusted and independent blockchain (a decentralized public ledger). Smart contracts do not necessarily have to be executed on the blockchain (such as a simple transaction processed by a vending machine), however, the use of secure blockchain technology ensures that both parties are able to trust that their smart contract cannot be changed or reversed by any party. The use of blockchain technology ensures that both parties are able to view and access the code of a smart contract and also allows for smart contracts much more complex than simple automated transactions.

The purpose of smart contracts is to prevent parties, to a contract, from failing or refusing to fulfill their agreements. Since smart contracts are written into code and executed independent of both parties, it is impossible for any party to renege on their agreement. Essentially smart contracts create trustless environments where parties to a contract do not have to rely on each other nor fallible and centralized institutions (such as law firms or the government) to enforce contracts.

How can smart contracts be used?

There are numerous practical applications of smart contracts. One common application of a smart contract is for betting. Parties to a betting agreement will all send their assets to a smart contract which then waits for a condition to the bet to be fulfilled (for example whether or not a winner has been declared for the Mayweather v. McGregor fight) and then based upon the result, the assets of the losing parties are redistributing to the winning parties. In this example, while the smart contract still relies on a third party to decide the winners, it is impossible for the parties to the contract to renege on their agreements by refusing to pay the winners.

A more complex application of smart contracts is insurance policy. Smart contracts are now being used to autonomously execute insurance payouts, without the policyholder having to make a claim. Instead, payouts can be automated if verifiable and public information (such as if the policyholder had died, or if a natural disaster had affected their home) is found by the contract. Such an application would significantly reduce the possibility of insurance fraud, as well as saving the time of both policyholders and insurers in making and verifying claims.

The possible applications of smart contracts are extensive and varying from simple transfers of assets to complex financial operations. The trustless, self-enforcing and public nature of smart contracts has also opened up the possibility of their use by governments and the legal industry. In many countries and in the US, governments are considering using smart contracts in elections. This fact demonstrates the increased importance of both blockchain technology and smart contracts and, in the context of the law, the need for definitive legislation and research on smart contracts.

Are smart contracts legal?

Smart contracts are not inherently legally binding and recognized contracts, however, that does not mean smart contracts cannot be legal. The legality of a smart contract is dependent upon the nature of the agreement, the conditions of the agreement and whether parties to the contract are consenting. It is also dependent on a legal system’s definition of what is and is not a contract.

The primary issue with the legality of smart contracts is that unlike traditional contracts, smart contracts are neither written text nor oral communication (which is a requirement of contracts in most legal systems). Smart contracts are solely code and while the code of a smart contract is supposed to be accessible to both parties, code is not a natural language or even a language for that matter.

One notable case that demonstrates the risks of recognizing code as a legal contract is the DAO incident. In the DAO case, a smart contract known as the Decentralized Autonomous Organization was supposed to raise money from investors who would then use the smart contract to fund other blockchain projects that they liked. It was essentially a democratic Kickstarter for blockchain projects. The DAO eventually raised over $150 million USD, however, due to a bug in the code of the DAO smart contract, hackers were able to steal over $50 million dollars. Although to the code of the smart contract this was a completely legitimate transaction, the intended and implicit agreement between the participants of the smart contract wouldn’t have allowed for such an action. This case demonstrates the problem with treating code as the rule of law in smart contracts.

One solution offered to this problem is that smart contracts, if intended to have the protection and recognition of the law, should be accompanied by written agreements that would supersede any faults in the code of smart contracts. In such cases, the legality and rules of the smart contract would be clear to both participants and to the law. Outside of cases where smart contracts are not accompanied by written contracts, there exists a large legal gray area. In certain US states such as Arizona, Nevada, and Vermont, legislation has been introduced that legally recognizes smart contracts. However, in other states and countries, there is no definitive legal position on whether code alone is considered legally binding. 

While there are very obvious cases where smart contracts would not be recognized by the law, such as an assassination smart contract or smart contract that trades state secrets for fiat, in more innocuous cases such as betting there are questions over just how much participants are protected by the law. Such questions over the legality of smart contracts will likely depend on future state legislation and an increase in use-cases for which the legal industry can begin to evaluate.

What is the future of smart contracts and the law?

As the use of smart contracts for financial operations increases, so will the desire for definitive legislation on smart contracts. Despite some proponents of smart contracts arguing that they will remove the need for contract lawyers, cases such as the DAO demonstrate that for now, code is not law. Smart contracts do make many common operations and contracts much cheaper and efficient and this may limit the responsibilities of many lawyers, but such contracts will still require the protection of the law.

While the self-enforcement of smart contracts seemingly eradicates the need for contract law enforcement, the DAO shows that when smart contracts fail to enforce their intended agreements, that failure can have significantly detrimental and sometimes irreversible consequences that can only be prevented and reversed by the human element of the law. The legal industry will also play a significant role in assessing the legality of different smart contracts and possibly attempting to supersede the self-enforcement of such contracts when they circumvent laws and regulations (i.e. tax law, gambling laws). Smart contracts are a tool that when used in accordance with the law and with the protection of the law, can provide a great deal of value to its users. However, when such contracts fail to act as intended or attempt to circumvent the law, contract law will definitely be required to overrule smart contracts.

In conclusion, smart contracts will not in the near future be replacing contract law enforcement. There is no doubt that smart contracts will not only require legal oversight to protect consumers but will likely increase the role of law in contracts. The law will be needed to prevent the misuse of smart contracts and the exploitation of smart contract code, for the protection of both consumers and the law.