Smart contracts: where do they fit into the legal framework?

Your Business’s Rapid-Response Guide to Fake News
July 20, 2020
Think Twice Before Using an Image from Google
July 20, 2020

Smart contracts are agreements that self-execute without any human intervention when the conditions, as specified in digital form, are met. Blockchain, a decentralised digital ledger that records transactions in different participating computers in order to verify and legitimise transactions, increasingly serves as the technological framework for smart contracts. Ethereum is one of the leading blockchain platforms and was designed specifically for smart contracts.

The working of smart contracts can be explained by the “if-then” principle:
If, for example, an insurance company writes its terms, conditions and policies in the form of a smart contract and the event triggering an insurance payout occurs, the pre-arranged conditions of the event are met, then the smart contract automatically executes and for example effects payment into the insured’s bank account, in the agreed amount.

Smart contracting does away with many of the challenges posed by traditional contracting, making it an attractive alternative form of contracting. Smart contracts remove the need for human intervention and trust between the parties – certainty of performance is guaranteed by way of the advanced technology supporting the execution of the contract. Furthermore, the decentralised ledger system in which smart contracts that operate in blockchain are anchored provides smart contracts with accuracy, security, transparency and ensures that the contracts are tamper-proof.

Smart contracts and its supporting technology are not new concepts, but the law regulating it is still in its infancy stage of development – smart contracts have not been tried and tested by courts as traditional contracts have been. Precisely where and how smart contracts fit into our legal framework remains to be unanswered.

The first obvious question that needs to be answered in this regard is whether a smart contract is a contract at all. Arguably a smart contract can be explained by normal rules and principles of contracting and will accordingly be enforceable if it meets the requirements for a valid contract under common law. Reconciling an automated way of contracting with the underlying principles of contract law, which envisages human negotiation and consensus, may however prove to be a difficult task.

In South Africa the Electronic Communications and Transactions Act 25 of 2002 (“ECTA”) allows contracts to be concluded electronically but arguably does not go far enough to regulate the execution of the contract through electronic agents, without any human intervention. ECTA views electronic agents in a passive light and as mere tools of communication. ECTA does not differentiate between electronic agents based on the degree of their autonomy and therefore the complexity of smart contracts may not fit into ECTA’s conceptualisation of contracting. One possibility is that ECTA can be amended to provide for a more complex framework to regulate smart contracts or that new legislation may be passed to provide for a more autonomous method of contracting.
Some scholars argue that smart contracts should not be regulated by the law itself, but that a regulatory code must be built into all smart contracts together with a standardised practice to ensure its technical credibility, and thereby avoiding questions of legal enforcement. While blockchain technology certainly makes internal regulation and resolution possible, it remains difficult to envisage a form of contracting that stands outside of the law. Courts have recognised various values and public policy considerations that may be considered in contract law disputes, and these considerations should be imported to smart contracting to ensure fairness across the board.

Furthermore, smart contracting will still pose challenges and uncertainties which should be answered by some sort of legal framework. Smart contracts are immutable in nature, which raises concerns regarding the automatic execution of performance, in all circumstances, without exception or regard to context. What if a smart contract is concluded as a result of coercion, duress, a mistaken belief or misrepresentation, for example? What if the performance of a smart contract is in fact illegal? A party may wish to prevent the automatic execution of such a contract and will need the help of the law to do so. Furthermore, smart contracts are written in code, not in plain language, which may lead to interpretation, understandability and validity issues to be decided upon by courts.

As both a smart contract and a traditional contract share the same end goal, which is to give effect to the intention of contracting parties in their dealings with one another, the law arguably has the same role to play. Regardless of the method whereby a transaction is concluded, the law must afford protection and recourse to the contracting parties and therefore it is likely that the law will develop in this regard.

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your adviser for specific and detailed advice. Errors and omissions excepted (E&OE).