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Smart contracts: are smart contracts legally effective agreements?

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2 December 2016

Blockchain and smart contract technology are emerging as among the fastest growing technology innovations in recent times. They continue to attract widespread attention and significant levels of investment.

In this, the second of a special series of three articles, Henry Davis York's technology expert, partner Matthew McMillan examines whether smart contracts are legally effective agreements and looks at what smart contracts will - and won't - be able to achieve.

Are smart contracts legally effective agreements?

The answer to the fundamental question as to whether smart contracts are legally effective agreements will depend upon how our legal and political systems decide to treat smart contracts. But in my view the answer is: quite possibly, but not always.

Why do I say that?

First of all, we need to ask ourselves how these smart contracts fit within our common law understanding of contracts.

To be an enforceable contract at law, the elements of contract formation still need to be satisfied. There needs to be:

  • an offer;

  • acceptance of the offer;

  • consideration passing; and

  • an intention by the parties to enter into the contract.

If these elements are satisfied, a smart contract may well be capable of being considered a contract at law.

It does not necessarily matter what form a contract actually takes; it is the substance that counts. For example, a verbal agreement or a series of emails can become a contract at law if these fundamentals are established.

Is code rather than English a deal breaker?

The requirements of the Electronic Transactions Act 1999 (Cth) (ETA) are likely to respond to validly formed smart contracts.

The ETA permits almost all legal requirements for writing to be satisfied electronically. And, according to the Acts Interpretation Act 1901 (Cth), "writing" includes: "any mode of representing or reproducing words, figures, drawings or symbols in a visible form".

The ETA also permits most legal requirements for signature to be met by electronic means provided the electronic signature:

  • identifies the signatory and indicates his/her intention in respect of the information that is communicated; and
  • is as reliable as appropriate for the purposes of the electronic communication, in the light of all the circumstances.

Where will smart contracts be most prevalent? 

For now, smart contract technology is most suited to simple, process-driven contracts, which are capable of automation, like the option agreement referred to above.

Indeed, a lot of work is currently being undertaken to exploit the technology's potential to create standard rules for basic and repeatable transactions, like derivative trades.

Another potential use case is the sale of a car between two private parties, where contract negotiation is not generally the norm. A standard form smart contract could be used to simply input the agreed price and vehicle registration details. The smart contract code would then execute the agreement by:

  • verifying that the seller is the owner of the vehicle;

  • transferring the cash, and

  • re-registering the vehicle in the name of the purchaser.

Whilst the technology is currently suited to simple agreements, the breadth of smart contracts will likely expand over time, with the increase in sophistication in the level of conditional logic that may be expressed in code.

Smart contracts are not a panacea

Why do I say that?

Firstly, the key advantage of smart code - the fact that it is certain and not open to misinterpretation - is also one of its key weaknesses.

Not all terms of a traditional contract are deterministic in nature. And for good reason.

Take for example:

  • an agreement which sets out a governance process for managing project decisions throughout the lifecycle of a project; or

  • a right for a party to terminate an agreement in the event of a "material adverse event".

Provisions such as these are often intentionally drafted this way to allow for flexibility and an element of human discretion.

It also not uncommon for traditional contracts to use concepts which have been developed over many, many years through precedents and our common law system; concepts such as:

  • the reasonable person; and

  • negligence.

Concepts like these still require cerebral interpretation and are not capable of being easily translated into code.

Secondly, smart contracts will not be appropriate for complex or long-term contracts. These types of contracts are often amended by way of future variations, either because the parties recognise that something is wrong or that circumstances have changed (for any number of reasons) and, therefore, changes ought to be made. The fixed nature of smart contracts, on the other hand, means that there is no "escape hatch" to enable such changes.

Thirdly, indemnities are a common feature of many contracting arrangements. Yet it is hard to envisage how it would be possible to code an indemnity  into a smart contract. Unlike the transfer of digital property, an indemnity is not something that is capable of self-execution on a blockchain.

On the contrary, it is a contractual mechanism known to the law and is ultimately subject to interpretation and enforcement by a court in the event of a contested dispute.

Take, for example, a manufacturer of goods which enters into a smart contract with a retailer. It may be possible to code in the payment terms and have the smart contract automatically execute the transfer of payment to the manufacturer at the point that delivery is made to the retailer.

The retailer may nevertheless want protection against the goods being defective, and insist that the manufacturer indemnify it against any losses in such circumstances.

What may start to emerge, in time, is a hybrid model of contracting - where a commercial transaction is defined by a combination or amalgam of:

  • code, for those rights and obligations which are fixed and capable of self-execution on a blockchain; and

  • ordinary English language, for those rights and obligations which are not.

At the end of the day, there is no 'one-size-fits-all' when it comes to smart contracts. The legal effectiveness of smart contracts will depend on a broad range of factors, including the nature and type of agreement that is under consideration.

In the third and final article in this series, Matthew will take a close look at the potential benefits and risks of smart contracts and the interesting - and challenging  - legal and regulatory issues they raise.

Matthew McMillan

Partner

61 2 9947 6727

61 437 571 910

matthew.mcmillan@hdy.com.au