The Law Commission has published their advice to the Government on 25 November 2021 confirming that the current legal framework in England and Wales is able to facilitate and support the use of smart contracts, without requiring legal reform. The Law Commission said that the flexibility of our common law provides an ideal platform for the perceived complexity and development of smart contracts and in any case, such difficulties could arise in the context of traditional contracts.
What are smart contracts?
"Smart contracts" are legal contracts in which some or all of the contractual obligations contained in the contract are defined in, and/or performed automatically by a computer programme without the need for human intervention. The benefits of a smart contract is that the automation gives certainty that a contract will be actioned. Smart contracts can also use distributed ledger technology ("DLT") (also known as blockchain). However, the Law Commission noted that although a lot of smart contracts utilise DLT, it is possible for smart contracts to use other forms of technology.
A simple example of when a smart contract would be suitable would be an escrow agreement between two parties. Whilst the majority of the contract is written in natural language, there is some element of automation performed by a computer programme e.g. an automated computer programme could be used as a tool to release the funds once the agreed conditions have been met. The Law Commission defined these types of contract as "Form 1: Natural language contract with automatic performance by code".
Whilst the above example is a very simple example of a smart contract (as the automation is only a tool employed to perform a single obligation of a party in a natural language contract), on the other end of the spectrum, there could be smart contracts which are written completely in computer code and there is no natural language in the contract. The Law Commission said that these would be the most difficult types of smart contracts to analyse from a contract law perspective albeit they would seldom be used in the commercial world given the nuances of commercial contracts. The Law Commission defined these types of contract as "Form 3: Contract recorded solely in code".
The Law Commission also defined a third form of smart contract called "Form 2: Hybrid contract" which combines elements of Form 1 and Form 3. These hybrid contracts could be primarily written in code with a few natural language terms setting out the governing law and jurisdiction or vice versa, the majority of the contract could be written in natural language with a few terms written in code.
What the Law Commission concluded
When looking at the compatibility of all forms of smart contracts with existing English law, the Law Commission looked at the basic existing requirements for the formation a contract which are:
- Agreement (offer and acceptance);
- Consideration; and
- Intention to create legal relations.
The Law Commission considered each of the requirements of the above and concluded that smart contracts can meet these requirements and would form a legally binding contract under English law. In their analysis, the Law Commission seems to suggest that the more a smart contract moved away from natural language and more towards code, the more a court may face novel challenges in interpreting whether the formalities of a contract have been met. However, as stated in the opening paragraph, the English common law system provides the perfect platform for the development of these new areas of law.
Whilst not a strict requirement of a contract, the Law Commission did note that there may be additional complexities for the additional formality requirements of a deed. As a deed must be signed in the presence of a witness, the Law Commission said that parties to a deed could not be confident that the current law supports deeds which are wholly or partly defined by code, especially as the current law requires the witness to be physically present when attesting the signature.
Although we are at a very early stage and there is still a lot of development required in the area of law, we now have a clear platform for the development of smart contracts in England. Over time, like all areas of common law, the decisions and interpretation of the Court will make the law clearer. This development is good news for businesses who are looking to utilise the cost and efficiency benefits of smart contracts, as they now know that they have the comfort of knowing they have a legally binding contract. It is also good news for the growing acceptance of distributed ledger technology as an alternative form of transacting business in the commercial world. We would recommend, however, that caution is taken when dealing with smart contracts written purely in code (Form 3) due to the lack of precedent in how a court might interpret such code. To minimise the risk of how a court might interpret a code-only contract, parties can put together a natural language explanation of the code in a separate document agreeing their intention and that such document forms part of the coded agreement.