Blockchain, also known as distributed ledger technology (DLT), is everywhere right now. The technology and its various applications are increasingly being seen as a way for the financial services industry, in particular, to realise operational efficiencies and cut costs.
Although the new technology sounds exciting, some elements, such as smart contracts, are still in an early development stage. There is real lack of agreement among the legal community on what a smart contract is and the extent of its role in the financial services market, as well as how it might interact with existing legal standards and documentation.
So what are the legal implications of using smart contracts? Could this technology ultimately replace an existing legal contract in its entirety, or will it only automate the execution of certain actions specified within the contract?
There are many competing opinions about what a smart contract actually is. Computer scientists tend to think of smart contracts more in terms of a code, while, for lawyers, the term ‘contract’ means a very particular legal relationship of obligations. There is no single universally accepted definition of a smart contract, however, the fundamental essence of all smart contracts appears to be the automation and self-execution (enforcement) of a pre-set conditional action.
A critical point to recognise is that a smart contract is not the same thing as a legal contract, and the use of smart contracts can lead to various issues and legal implications for all parties concerned.
Identifying the situs or location of an asset is one relevant area of concern when using smart contracts. Under various legal regimes it is necessary to identify the location of an asset, for example, to assess whether a proprietary right has been created. In the case of dematerialised financial assets, where ownership is recorded on a register, it is often the place where the register is held, or where the registrar is situated that is deemed to be the situs of that financial asset. Distribution of the register across the nodes of a worldwide digital net in multiple jurisdictions, raises the problem of trying to identify the location of an asset under current legal principles.
Smart contracts also have some problems from a contractual perspective, since not all clauses are susceptible to automation and self-execution. Non-operational clauses, which relate to the wider legal relationship between parties, for example, a jurisdictional clause providing a dispute resolution mechanism; are less susceptible to being machine-automated on a pure ‘yes’ or ‘no’ basis. Even where a clause could technically be automated, it might not always be desirable to do so.
Certain legal terms cannot be formally expressed in the non-ambiguous computerised ‘true’ or ‘false’ or ‘yes’ or ‘no’ language used by smart contracts, because of their subjective nature. For example, if a contract requires that a determination is made in ‘good faith’ and a ‘commercially reasonable manner’, it is clear that these terms have a legal meaning and they should not be subject to yes/no interpretation. In addition, different legal regimes will have different ways of interpreting what these terms might mean, and the understanding is often heavily contextual and driven by facts and circumstances.
The automated yes/no approach also ignores all the possible scenarios that might occur in the future with respect to a legal relationship between parties. The nuances of complex relationships between parties can be difficult to define and words can mean different things to different people.
Even if the contract is self-executing, in the sense that the pre-specified action happens automatically, it does not necessarily mean that the relevant action will be legally final in all circumstances. For example, it may turn out that performance of a contract has become illegal, or that a payment should be set aside on insolvency grounds. It will not always be possible to make an automatic assessment as to whether an act was illegal or an entity was insolvent at the time of the relevant action. The applicable information might not yet be available.
The multiplicity of programming languages used in smart contracts is another area of contention. In practice, it may be very difficult, if not impossible, to pick any one language to interpret the terms. In addition, it may be extremely difficult for the average lawyer to pick up a piece of code in a programming language and understand exactly what it is seeking to do.
It remains to be seen how this technology will evolve and what new challenges it will present. While smart contracts may well be the way of the future, using them now means taking significant risks regarding their legality and enforceability if something goes wrong. Businesses may not wish to act as pioneers in establishing the legal position with all the delays and costs that could involve.