Smart legal contracts – the Law Commission’s advice to the Government

10/12/21 – On 25th November 2021, the UK Law Commission published its advice to the Government on smart legal contracts. The advice expands on the UK Jurisdiction Taskforce’s legal statement on cryptoasset and smart contracts – see my post here.

The Law Commission concludes that current legal principles can be applied to smart contracts in much the same way as traditional contracts, with relatively minor developments required in certain contexts. It does, however, identify two specific problem areas that will require further work: the execution of deeds, and determining the geographical location where smart contracts are formed or breaches are committed (and therefore which jurisdiction’s laws apply), particularly where the smart contract concerns a digital asset.

This article considers some of the key observations and findings set out in the Law Commission’s advice.

1.  What is a ‘smart legal contract’?

Considering the generally accepted definition of a smart contract as a computer program which run automatically, in whole or in part, without the need for human intervention, the Law Commission suggests that where a smart contract is used to define and perform legally binding contractual obligations it is helpful to refer to it as a ‘smart legal contract’. The Law Commission then defines a smart legal contract as ‘a legally binding contract in which some or all of the contractual obligations are defined in and/or performed automatically by a computer program’, and divides smart legal contracts into three different types, depending on the role played by the computer program code, i.e. the degree of automation of the performance of the contract:

• Natural language contract with automated performance
• Hybrid contract
• Solely code contract

The Law Commission suggests that: ‘Automation should be considered on a spectrum. Smart legal contracts which involve elements of standard automation, such as payment by way of direct debit, have been in use for many years and are therefore unlikely to give rise to novel legal issues. However, a smart legal contract drafted primarily or solely in code […] is likely to give rise to novel legal questions; the automation in question takes the contract out of the realm of legal familiarity‘.

Although it had originally suggested (in its call for evidence) that a smart legal contract must, by definition, be deployed on a distributed ledger technology (DLT) system, the Law Commission has decided that DLT should not be an essential feature, and that a better approach is for smart legal contracts to be technology neutral.

2.  What are the legal issues with smart legal contracts?

As stated, natural language contracts with automated performance via code have been in existence for a long time, and do not raise any new issues. However, where the terms of the contract are written in code, whether partly or wholly, new challenges arise in relation to contract formation, interpretation and remedies.

The Law Commission believes that contract terms expressed in computer code can, and should, be ‘susceptible to contractual interpretation‘. It suggests that the appropriate test should not be the traditional ‘what a reasonable person would understand the (coded) terms to mean, having all the background knowledge’ test, but instead a ‘what a person with knowledge and understanding of code would understand the coded terms to mean’ test – what the Law Commission calls the ‘reasonable coder‘ test. The court should ask what a person with knowledge and understanding of computer code what they understand the coded terms to mean, similar to the way that a court would ask for expert evidence in the case of a contract written in a foreign language.

The Law Commission also suggests that there is an increased risk of disputes during the lifecycle of a smart legal contract, given the likelihood of code performing ways that that the parties did not intend or expect, as well as other risk factors such as inaccurate input data, system upgrades, the code being hacked, and normal bugs and errors. The Law Commission notes that the usual legal remedy of rectification (where the court ‘corrects’ the terms of a contract) may in practice prove difficult to obtain where a computer program runs on an immutable DLT system.

3.  How should businesses using smart legal contracts address these issues?

In Appendix 3 of its advice, the Law Commission helpfully provides a (non-exhaustive) list of issues that parties proposing to enter into a smart legal contract may want to consider and provide for in their contract. These include:

• Confirming the role of the code in the contract and, in particular, whether the code is intended to define contractual obligations or just perform the obligations. Where contractual terms are expressed in both natural language and in code, confirming which term takes precedence in the event of a conflict.
• Using natural language aids to help with the interpretation, e.g. a business process document or term sheet, and/or a natural language explanation of the code, or natural language comments within the source code itself.  Making it clear that the business process document or other explanation forms parts of the parties’ agreement so that the document or explanation can be used by the court when interpreting the contract.
• To satisfy the Consumer Rights Act 2015 requirement that traders’ written terms are ‘transparent’ (i.e. ‘expressed in plain and intelligible language, and be legible‘) in B2C contracts, providing consumers with a clear and informative explanation of the code in natural language.
• Allocating risk amongst the contracting parties in relation to the smart legal contract-specific risk factors mentioned in the previous section.
• Incorporating a ‘kill-switch’ in the smart legal contract to enable suspension or termination of the performance of the code.

4.  The problem areas

The Law Commission considers that further work may be needed to support the use of smart legal contract technology in following areas:

• To be validly executed, the signing of a deed must be witnessed and attested. The Law Commission is unable to see how these requirements could be satisfied for deeds which are wholly or partly defined by code, although it acknowledges the possibility of technology being developed to enable a witness to record in a smart legal contract that they have observed the execution of the deed.
• It may be difficult to determine the jurisdiction and applicable law for some smart legal contracts, particularly where the smart legal contract is defined solely in code or performed via the interaction of two or more computer programs.  In addition, digital location, i.e. ascribing real-world locations to digital actions and digital objects, also presents difficulties for smart legal legal contracts, particularly when deployed on DLT system. The Law Commission strongly recommends that parties to smart legal contracts stipulate both their choice of law and jurisdiction.

The Law Commission has agreed to undertake a separate project considering the rules around conflict of laws in the context of emerging technology, including smart legal contracts, which is expected to begin in the middle of 2022.

5.  Looking to the future

The Law Commission points out that smart legal contracts are already used to some extent in a number of sectors (including insurance, finance, DeFi, and peer to peer), but have the potential to revolutionise the way businesses engage across all sectors.  It anticipates that the market will develop established practices and model clauses that parties can use for their smart legal contracts, and hopes that work in this area will be led by LawtechUK and the UK Jurisdiction Taskforce.