Law Commission concludes English law supports smart contracts

Towards the end of 2021, the Law Commission published a report entitled "Smart legal contracts: advice to Government". It concluded that the law of England and Wales can facilitate and support smart legal contracts without the need for reform. 

There are, however, a couple of significant caveats, and businesses would do well to take note of them.

What are smart contracts?

The report defines a "smart contract" as "Computer code that, upon the occurrence of a specified condition or conditions, is capable of running automatically according to pre-specified functions", adding that they are usually deployed on distributed ledger technology. It also defines a "smart legal contract" as "a legally binding contract in which some or all of the contractual terms are defined in and/or performed automatically by a computer programme". Essentially, a smart contract automates performance of a contractual agreement, with the provisions locked into a blockchain. 

For example, a smart contract might be set up so that when a confirmation of receipt of payment is logged on the blockchain by a seller's bank, a notification will automatically be sent to the seller's distribution depot to ship goods to the buyer. 

For some smart contracts, the coding will represent the entire contract between the parties, while for others it will be part only. For instance, terms and conditions for the sale of goods might cover issues beyond the payment and shipping arrangements (such as liability, warranties, insurance, or governing law). Some provisions might turn on obligations that are not well suited to being expressed or performed through binary computer code, such as those involving discretion or best endeavours. These other provisions might need to be incorporated into a traditional contract that sits alongside the smart contract to record the complete arrangement. 

Can a smart contract be legally binding?  

In 2019, the UK Jurisdiction Taskforce (UKJT) concluded that smart contracts can (in principle) meet the requirements for valid formation of a binding and enforceable contract. 

It then fell to the Law Commission to consider whether the existing legal and regulatory framework is sufficiently certain to accommodate smart legal contracts and, if not, to highlight uncertainties and/or propose new or updated laws.

What were the Law Commission's findings?

The Law Commission is unequivocal that the existing law of England and Wales can accommodate and apply to self-executing smart legal contracts without the need for reform: 

"… the current legal framework in England and Wales is clearly able to facilitate and support the use of smart legal contracts, without the need for statutory law reform … Current legal principles can apply … in much the same way as they do to traditional contracts... Although some types of smart legal contract may give rise to novel legal issues and factual scenarios, existing legal principles can accommodate them."

In particular, the absence of human performance is unlikely to pose an issue for the majority of contracts. The report highlights that automated performance of contractual obligations exists already, for example with bank payments and online shopping. 

However, novel questions are more likely to arise where a smart legal contract is expressed wholly or partly in code: for example, as regards interpretation of coded provisions (a programme may not always perform in the way in which a reading of the code might indicate). Courts should interpret coding by reference to what a reasonable person with knowledge and understanding of code – a "reasonable coder" – would understand it to mean. 

As regards the essential requirement of consideration (that is, a promise – or performance – by one party given in exchange for a promise from the other party), the Law Commission noted that it might be more difficult to identify the consideration for promises defined by code. It agreed with consultees' suggestions that developing smart contract platforms that combine coding and natural language "would be useful in removing the scope for any potential disputes regarding consideration".

While some smart contracts will be capable of meeting the conditions required for contract formation under English law – namely agreement, consideration, certainty and an intention to create legal relations – practical challenges arise in the context of meeting the additional formalities required for the valid execution of deeds. 

Governing law and jurisdiction are also identified as further challenging areas: "Deeds and private international law are the two areas where we think further work is required to support the use of smart contract technology in appropriate circumstances." 

Deeds

While most contracts need not be made in any particular form, in some areas the parties' arrangements must take the form of a deed. Deeds must be in writing, signed and witnessed. 

"In writing" is defined in legislation as including all modes of “representing and reproducing words in a visible form”. The Law Commission notes that not all types of coding are readable by humans but concludes that if a contractual term is defined in a coded smart contract, it can be considered "writing" if it can be read by a person with knowledge of the relevant programming language and subsequently translated into words. That said, whether this requirement is satisfied in any given scenario is dependent on whether the terms of a smart legal contract are said to reside in code, rather than words.

As regards signature and witnessing, electronic signatures can be used in contracts, unless prohibited by relevant legislation, case law, or contract. Accelerated by the pandemic, electronic signatures are now common and do not present a material issue in most circumstances (as we have discussed previously). However, questions remain about incorporating an electronic signature into a smart contract.

Finally, a deed must be signed in the presence of a witness who attests the signature. Witnessing can be accommodated by electronic signature systems, but the witness must still be physically present when the party signs, and the witness's attestation must be incorporated into the smart contract (along with the party's signature). 

Fundamentally, the execution formalities for deeds were designed around the traditional form of a "wet ink" signature on paper in the physical presence of a witness. Overall, it is not surprising that the Law Commission concluded that parties cannot "be confident that the current law supports the creation of deeds which are wholly or partly defined by code. Deeds are documents executed with a high degree of formality and there is some uncertainty as to whether smart contract technology can facilitate compliance with the various formalities that apply to deeds". 

Consequently, as the law currently stands, it would not be advisable to use a smart contract to undertake contracts which must be entered into as a deed (for example, conveyances of land or interests in land, mortgages, powers of attorney, and agreements made without consideration). 

Governing law and jurisdiction

As we have discussed before, smart contracts pose unique jurisdictional challenges, in particular identifying the location of counterparties, dealing with breaches and recourse to remedies. These issues are particularly apparent where a smart contract concerns a digital asset.

When jurisdictional issues arise in "traditional" cross-border contracts which fail to identify the applicable law and jurisdiction, existing rules apply to determine which courts have jurisdiction. The problem of "digital location" is cited by the Law Commission as a significant challenge in applying those rules to smart legal contracts. This involves ascribing real-world locations to digital assets and to digital actions that occur on a distributed ledger which has no single "original" version but can exist in multiple locations with equal validity. 

To mitigate uncertainty regarding the place of formation of a smart legal contract, the Law Commission recommends including a jurisdiction and choice of law clause in the agreement. This will provide clarity as to the parties' obligations and the consequences of any breach. It may also provide certainty in relation to the parties’ intention to create legal relations. While we are seeing case law that touches on these issues, it is always advisable to deal with them expressly in the relevant contract to remove doubt (and reduce the potential for later disputes). 

These issues have driven the development of the UKJT's digital dispute resolution rules, and may help to boost their adoption. Separately, the Law Commission has identified the issue of "digital location" as one to be tackled, and potential solutions proposed, in its planned future project on conflicts of laws in the context of emerging technology. 

Osborne Clarke comment

The Law Commission's findings will be welcome news for those employing or contemplating smart legal contracts. The fact that no new legislation is needed to accommodate them will further boost confidence in this fast-evolving area and should accelerate adoption of the technology. 

That said, businesses deploying smart legal contracts will need to consider carefully whether any of the practical challenges outlined in the report are applicable to their particular use case and, if so, ensure that they are appropriately addressed. The findings in the report emphasise that in most cases it will be sensible to have a traditional contract sitting alongside the coded smart contract. The traditional format can be used to record in clear language the key aspects of the agreement between the parties, to remove uncertainty over the issues identified by the Law Commission, and to contain any more complex or nuanced clauses. 

If you would like to discuss any of these issues further, please do not hesitate to contact the authors or your usual Osborne Clarke contact.