The Problem With Smart Contracts

Smart contracts—computer-encoded sets of instructions that ‘self-perform’ when certain pre-determined criteria are met—are poised to revolutionise the legal landscape in years to come.

In our first article in this series, we explained the basics of blockchain technology and its application in smart contracts. Far more than a fleeting or niche innovation, smart contracts may have applications in sectors as far reaching as financial services, supply chains, car sales importation, real estate and insurance. However, although they pose exciting opportunities for a great range of businesses, there may be some significant legal challenges on the horizon.

A square peg in a round hole: difficulties in applying the law

One issue, yet to be considered by the courts, is the extent to which these smart contracts are valid and enforceable under contract law. Parties to a smart contract effectively cede control over an aspect of performance of a contractual obligation to a digitised process, which (once enlivened) cannot be reasoned with or influenced.

Utilising the more ‘pure’ types of smart contract, consisting only in machine-readable code, means that the identity of the party is unknown; as such, there is no way to assess their capacity to enter the contract. Moreover, certain contractual principles such as frustration, duress, undue influence, unconscionable dealings or force majeure, by their very nature, require subjective interpretation of judgement on a case-by-case basis—something not countenanced by self-executing instructions.

It will be necessary for lawyers to keep their finger on the pulse in this regard; although certain dealings could render a smart contract void at law, the activated contract may be unstoppable in the digital world. It will be interesting to see how the law develops and adapts to this problem, noting that practically speaking most modern remedies could be swept away, leaving mere damages.

Another issue will be determining how rights and entitlements recorded ‘on the chain’ accommodate rights and entitlements that arise ‘off the chain’. For example, what happens if share ownership is recorded on a blockchain as vesting in one entity, but surrounding circumstances place equitable ownership in another? Or if a transfer of ownership of property is recorded on a blockchain but is sought to be set aside under the Corporations Act as a voidable transaction? The immutability of a blockchain system raises some interesting questions in this regard.

Challenges in litigation

The nature of the blockchain system means that the players involved will most likely be ‘distributed’ around the globe. Parties intending to implement or utilise a blockchain system should therefore give advanced thought to which laws should apply and what type of forum is most appropriate to resolve disputes. It might be beneficial to have an arbitration dispute resolution cluses rather than relying on the enforcement of a court award from a local court system.

The governance position of public blockchain systems also poses an interesting challenge from a litigation perspective. While terms of use can be communicated to users of a public blockchain, such terms may be difficult to enforce as no single entity controls the system. The question also remains as to who will bear the liability for any faults in the technical code and who has the right to enforce against them.

Interestingly, there have been several suggestions applications such as “JUR” and “Jury.Online” which offer a ‘decentralised’ dispute resolution mechanism. In such systems, members can open a dispute and the blockchain community effectively vote on the issues in question. While these dispute resolution mechanisms sit outside the current legal framework, it will be interesting to see whether such mechanisms gain traction amongst blockchain users or whether users will rely upon traditional legal dispute resolution mechanisms.

It is clear that the explosive uptake of blockchain technology has the potential to disrupt centuries of settled legal principles. While this may create a headache for lawyers, it is an exciting opportunity to rethink the way we transact in an increasingly globalised and digitised economy. “It will be an ill-wind that blows no lawyer no good”; so watch this space.

If you’d like to discuss how distributive ledger technologies might impact your business, feel free to get in contact with Shaneel Parikh in our Business team.

Written by Shaneel Parikh with thanks to Bryce Robinson.