What is a smart contract?

What is a smart contract and what are the legal implications?

A smart contract is a self-executing contract created as a software program and stored on a distributed ledger, such as blockchain. A smart contract is essentially software operating an “if/then” program based on predetermined conditions. 

The evolution of contracts

  1. Oral or paper contract.
  2. Electronic contract: An electronic contract encapsulates any contract created electronically and shown in an electronic or digital form.
  3. Digital contract: A digital contract is a type of electronic contract. A digital contract may be signed online (e.g. ticking a box, e-signature) and subsequently executed by computer software. For example, purchasing tickets online.
  4. Smart contract: A smart contract is translated from natural language to computer code and stored on an unchangeable blockchain. It automatically performs the contract when the terms are met, or returns the assets if the contract isn’t performed. The level of automation depends on what elements of the contract are digitally represented in the platform (for example: property titles, licenses, assets). A smart contract can also be programmed to interact with the Internet of Things (physical objects embedded with technology), such as digital car keys.

The key difference between a smart contract and a digital contract is that the smart contract does not involve a third-party overseeing the terms and execution of the contract, such as a lawyer or banker. 

A simple example

Car sharing is an easily understandable example of a useful smart contract. A centralised car rental company requires a range of vehicles and staff to operate and have limited pickup/dropoff locations. Vehicles, staffing and property leasing costs are then covered by higher car rental costs/fees. A peer to peer car sharing model means that individuals could lease their car through a decentralised system. Cars are then located throughout a city/area and could be parked within set limits of the city/area. This removes the costs of staff and property leases and means cars can be rented for a lower cost which is based on accurate rental time periods. 

By using smart contracts, this model can be securely implemented. The blockchain means car details (registration, mileage, number plate) and driver details (license, insurance, payment method) are securely stored. By embedding the rental cars with keyless car technology, the renter can receive a remote key through their smartphone and the car can continually record its location, fuel level etc. The payment might be by the minute, per hour or daily. 

In practice, this means a conveniently located car could be rented through an app, the keys to the car are granted through the app, the driver selects payment by the minute, the period of the rental is recorded until the driver finishes the trip and locks the car at which point payment to the car owner is automated. An alternative contract may require payment to be made in advance and held in escrow on the blockchain until the trip is completed.  

The benefits of smart contracts

The key benefits of smart contracts are that they do not involve a third party in the transaction, meaning parties can negotiate and transact directly. Transferred money is also controlled by the smart contract until the terms are met and it is transferred to the relevant party – removing third-party additional fees. The unalterable nature of smart contracts means the terms can never be changed or tampered with. The storage of smart contracts on a distributed ledger means that everyone on the network validates the outcome of the contract and can detect an attacker and mark the attacker invalid, making them highly credible and secure. The automation of smart contracts also makes them more efficient. Overall, smart contracts are meant to be cheap, efficient and secure. 

What are the disadvantages of smart contracts?

A fatal issue with smart contracts is that they are relatively inaccessible for non-technical parties. While removing a third-party to facilitate the transaction, they may add a third-party coder who the non-technical party must rely on to verify the contract’s terms are accurately reflected in the software. 

Additionally, the automated and objective nature of smart contracts is both a benefit and detriment. While it ensures the contract is swiftly performed according to the terms, it also removes any subjectivity in performance. For example, where a company may be willing to waive a fee or continue a contract in special circumstances even though a term has been breached, the objectivity and automatic nature of the smart contract removes this option for flexibility. 

Are smart contracts enforceable?

Although it remains uncertain how the contract law may apply to smart contracts, it is clear that smart contracts must abide by contract law to be legally binding and enforceable. The elements of a contract are:

  • Offer and acceptance: A good/service is offered by one party and that offer is accepted by the other party
  • Consideration: An exchange of value (money or other) for the good/service
  • Intention to create legal relations: May be inferred by the relationship between the parties and the nature of the agreement. In an arms-length commercial deal, it will generally be presumed the parties objectively intended to create legal relations.
  • Certainty and completeness: All essential terms must be agreed on and the agreed terms must be sufficiently clear and certain so that the parties understand their rights and obligations.

A key legal concern arises when a party’s identity cannot be determined or a party’s capacity to enter into the contract is unknown. Another issue is whether a party understands the contract terms when they are converted into code. These issues could lead to allegations of misrepresentation and misleading and deceptive conduct. For example, there may be issues with interpretation where a party asserts that the code does not reflect the terms of the contract or it does not perform as it is intended to – this could occur if there is an error in the data input. 

Additionally, court orders for injunctive relief will need to deal with the post-execution position of the parties as the smart contract cannot be prevented from performing. 

Ultimately, the legal ramifications of smart contracts are still relatively unknown, so parties should tread carefully when entering into smart contracts to mitigate liability. 

Takeaway

A smart contract is a software operating on an “if/then” program to automate performance when certain conditions are met. It is stored on a distributed ledger and considered to provide a cost efficient and secure alternative to the standard contract which removes the middleman (lawyer, banker). The automation of a smart contract is a double-edged sword as it removes flexibility in the performance of the contract. Although the law around smart contracts is uncertain, for any contract to be legally enforceable and binding, it must have the key elements of a contract and not be affected by issues such as capacity (age; mental capacity) and consent.

About Brigid Nelmes

Brigid NelmesBrigid is a legal intern at OpenLegal, working with our legal content team. She is currently completing her Bachelor of Laws and Bachelor of Arts (International Studies) at the University of Technology Sydney. Her interests are in digital/privacy and startup law.