Smart Contracts

Technological, Business and Legal Perspectives

Marcelo Corrales Compagnucci, Mark Fenwick, Stefan Wrbka, Marcelo Corrales Compagnucci, Mark Fenwick, Stefan Wrbka

• Publisher: Hart Publishing
• Year: 2021
• ISBN:
  9781509937042
• Edition: 1
• Topic: Law
• Subtopic: Science & Technology Law
• Index: Law

This book brings together a series of contributions by leading scholars and practitioners to examine the main features of smart contracts, as well as the response of key stakeholders in technology, business, government and the law. It explores how this new technology interfaces with the goals and content of contract law, introducing and evaluating several mechanisms to improve the 'observability' and reduce the costs of verifying contractual obligations and performance. It also outlines various 'design patterns' that ensure that end users are protected from themselves, prevent cognitive accidents, and translate expectations and values into more user-oriented agreements. Furthermore, the chapters map the new risks associated with smart contracts, particularly for consumers, and consider how they might be alleviated. The book also discusses the challenge of integrating data protection and privacy concerns into the design of these agreements and the broad range of legal knowledge and skills required. The case for using smart contracts goes beyond 'contracts' narrowly defined, and they are increasingly used to disrupt traditional models of business organisation. The book discusses so-called decentralised autonomous organisations and decentralised finance as illustrations of this trend. This book is designed for those interested in looking to deepen their understanding of this game-changing new legal technology.

1

Contracts: Ex Machina^*

KEVIN WERBACH AND NICOLAS CORNELL

I.Introduction

Technological advancements hold the potential to alter our very conception of the law. It is already common to suggest that technologies can operate as a kind of law, regulating the behaviour of users.¹ But, thus far, traditional legal enforcement has generally remained available as a backstop. Is it possible for emerging technologies to displace the law even for enforcement, law’s historically essential province? In this chapter, we examine a significant contemporary example: digitally enforced smart contracts based on the distributed cryptocurrency technology of Bitcoin and the blockchain that facilitates it. Enthusiasts of various stripes believe that smart contracts offer the potential to displace the legal system’s core function of enforcing agreements.²

It has traditionally been assumed that enforceable agreements – the lifeblood of the modern economic and social world – require the backing of a legal system. Nearly four centuries ago, Thomas Hobbes described the impossibility of binding agreements without the law:

If a covenant be made, wherein either of the parties perform presently, but trust one another; in the condition of mere nature (which is a condition of war of every man against every man,) upon any reasonable suspicion, it is void: but if there be a common power set over them both, with right and force sufficient to compel performance, it is not void. For he that performeth first, has no assurance the other will perform after, because the bonds of words are too weak to bridle men’s ambition, avarice, anger, and other passions, without the fear of some coercive power …. But in a civil estate, where there a power set up to constrain those that would otherwise violate their faith … he which by the covenant is to perform first, is obliged so to do.³

Hobbes’s basic idea – that binding agreements require a system to ensure that counterparties can trust one another to perform – is an intuitive and powerful argument for the essential role of the law.⁴

Yet recent technological advances have led to speculation that smart contracts might largely, or entirely, displace the apparatus of contract law.⁵ As one commentator succinctly puts this radical claim, ‘Smart contracts don’t [need] a legal system to exist: they may operate without any overarching legal framework. De facto, they represent a technological alternative to the whole legal system’.⁶ Mainstream legal trade journals wonder whether ‘innovations offered by the Bitcoin 2.0 generation of technology may create a world where … technology renders some contract causes of action obsolete’.⁷ Even world leaders have taken notice: Russian Prime Minister Dmitry Medvedev declared that ‘Smart [c]ontracts represent [a] new challenge to legal regulation. Systems creating such contracts live by their own rules, beyond the boundaries of law’.⁸ In short, smart contracts may offer the hope – or possibly the threat – of circumventing Hobbes’s age-old essential role for the law.

The reaction to these new possibilities runs the gamut, from gleeful triumph to killjoy scepticism. Supporters claim smart contracts will obviate the need for contract law, revolutionise business arrangements, and restructure property ownership.⁹ Sceptics see the blockchain foundation as little more than a Ponzi scheme. Some technologists argue that, despite their name, smart contracts have nothing to do with contracts.¹⁰ One group conspicuously absent from the debate over smart contracts is contract law scholars.

Upon inspection, the story is complex. Smart contracts may or may not transform the world, but they provide real benefits and seem likely to enjoy significant adoption over time. They represent the mature end of the evolution of electronic agreements over several decades. Firms can achieve significant cost savings and efficiency gains when using computers to automate contracting. Smart contracts could greatly extend those benefits, by taking advantage of Bitcoin and the blockchain as open platforms for secure exchange of value without mutual trust.¹¹ As they are adopted, or used in lieu of traditional contracting, smart contracts will force courts, legislatures and other legal actors to confront difficult questions about the application of basic contract doctrines.

They will not, however, replace contract law. While smart contracts can meet the doctrinal requirements of contract law, they serve a fundamentally different purpose. Contract law is a remedial institution. Its aim is not to ensure performance ex ante, but to adjudicate the grievances that may arise ex post. Smart contracts bring this core function of contract law into sharper relief, as they eliminate the act of remediation by admitting no possibility of breach. But, the needs that gave rise to contract law do not disappear. If the parties do not or cannot represent all possible outcomes of the smart contract arrangement ex ante, the results may diverge from their mutual intent. The parties’ expression may also not produce legally sanctioned outcomes, as in the case of duress, unconscionability and illegality. Promise-oriented disputes and grievances will not disappear, but their complexions will shift. In such scenarios, either the parties or the state will seek to reintroduce the machinery of contractual adjudication. Once one properly appreciates what is – and what is not – the function of contract law, it becomes evident that the reports of its death are greatly exaggerated.

The remainder of this chapter unfolds as follows. In section II, we evaluate smart contracts, which have been undertheorised so far, by asking how existing legal categories might apply to smart contracts. In section III, we consider whether smart contracts can serve as a substitute for contract law. We answer this question in the negative, by analysing the larger question of what contract law is for. In section IV, we consider likely responses to the practical and doctrinal questions we raise. Section V concludes.

II.Conceptualising Smart Contracts

A.Are Smart Contracts Contracts?

The first important question that smart contracts pose is: Are they actually contracts? Ultimately, we think the answer is ‘yes’. But this question turns out to be ambiguous, requiring the answer to another question first: What do we mean by a ‘contract’? Different ways of defining contracts, in terms of legal enforceability, intent of the parties, or an exchange of promises, all complicate the analysis of whether smart contracts are contracts at all. After considering such standard definitions, we will suggest that smart contracts should nonetheless be considered contracts because they are agent-generated mechanisms to shift rights and obligations.

According to the standard legal definition, a contract is a promise or an agreement that is legally enforceable.¹² This definition, though widely accepted, has the unfortunate linguistic consequence of implying that agreements that turn out to be unenforceable were not contracts to begin with. Terms like ‘unconscionable contract’, ‘fraudulent contract’ and ‘illegal contract’ all become something like oxymorons. Even commonplace judicial iterations of this standard, like ‘To be legally enforceable, a contract must be supported by consideration’,¹³ become essentially redundant.

We care about whether smart contracts should be understood to be contracts in the ordinary sense, whether they are enforceable or not. So it seems that we need a different definition of ‘contract’ for these purposes. One way to understand the question would be: Do smart contracts constitute promises or agreements that are intended to be legally enforceable? Corresponding to this formulation of the question, another definition of a contract is an agreement intended to be legally enforceable, whether it turns out to be or not. This definition has the advantage of avoiding the issues raised above, because it leaves open the question of enforceability. The unenforceable contract is still, conceptually, a contract as long as the parties thought that it would be enforceable, wrong though they may have been.

Of course, the intent that matters here is objective, not subjective, intent as it is manifested by the actions of the parties. As Judge Hand famously explained:

A contract has, strictly speaking, nothing to do with the personal, or individual, intent of the parties. A contract is an obligation attached by the mere force of law to certain acts of the parties, usually words, which ordinarily accompany and represent a known intent.¹⁴

Still, according to this understanding, a contract exists if and only if the actions of the parties, judged objectively, manifest an intention that an agreement is to be legally enforceable.

When applied to smart contracts, this definition raises a serious issue. Smart contracts are designed to eliminate the need for legal enforcement. The central feature of a smart contract – what supposedly makes them smart – is that legal enforcement will not be necessary, or even possible. In a very real way, smart contracts are not intended to be legally enforceable. This is not to suggest that they are intended to be legally invalid; rather, the question of legal enforcement should never arise. In this sense, smart contracts are not intended to be enforced in a legal proceeding. This lack of intent may lead to the conclusion that, even conceptually, smart contracts are not truly contracts at all. They may look more like so-called gentlemen’s agreements intended to be carried out, but never intended to reach a courtroom.

This appearance would be misleading, however, because it is quite different to intend that a solution will not be needed than to intend that it will be unavailable. I do not intend that my car will be needed as a vehicle for escaping the zombie apocalypse, but if the zombie apocalypse comes, I do not intend to abandon my car and traverse the wasteland on foot. By the same token, smart contracts are not intended to be enforced by a court, but that’s not to say that, if they end up in court, the parties intend them to be unenforceable.

It is better to think of a contract as any agreement that is meant to have practical consequences on the rights and duties of the parties – that is, is not merely aspirational.¹⁵ This avoids the above difficulty, because whether legal enforcement was anticipated is irrelevant.¹⁶ Smart contracts would be contracts as long as they manifest an exchange of concrete obligations. They would be contracts as long as they are meant to alter concretely the normative relation between the parties.

Yet there is still some difficulty with this definition, because this understanding of a contract requires an exchange of promises or obligations. Do smart contracts involve promises or obligations? In a significant sense, no. The smart contract sets in motion machinery that the parties cannot subsequently prevent. The smart contract is not fulfilled by some further action of a contracting party, but rather by the completion of this mechanical process. As an analogy, if Bob balances a pail of water on top of a door, he does not promise to drop water on whoever next opens the door. Rather, he has merely set up the mechanical process by which that will inevitably happen. In a similar way, a smart contract to transfer one bitcoin upon such-and-such event occurring is not really a promise at all. A smart contract would not say, ‘I will pay you one bitcoin if such-and-such happens’, but rather, ‘You will be paid one bitcoin if such-and-such happens’.

Some of the computer scientists working on smart contracts appear to be vaguely aware of this point. For example, Ethereum’s White Paper states that its contracts ‘should not be seen as something that should be “fulfilled” or “complied with”; rather, they are more like “autonomous agents” that live inside of the Ethereum execution environment’.¹⁷ As this suggests, the language of ‘contracts’ is a poor fit, because this sort of smart contract is not an exchange of promises or commitments. Creation of a smart contract – while setting certain events in motion – does not commit any party to do anything or make any prospective promise.

Nevertheless, we believe that smart contracts are, at the conceptual level, still contracts. Though they might not constitute promises per se, smart contracts are voluntary mechanisms that purport to alter the rights and duties of the parties. After all, not all traditional contracts are executory, either. A deal may still count as a contract even though it leaves nothing open to be done or performed. A conveyance, for example, is a contract that alters rights presently, and does not involve any further, open promises. Smart contracts similarly constitute present agreements without further promises to perform. The simple Bitcoin smart contract just imagined is more like a present but contingent conveyance than it is like an executory promise to pay.

Thus, the smart contract somewhat breaks down the traditional line between executory and executed contracts. Like the conveyance, there is no promise left to be performed. Unlike the conveyance, though, the smart contract does not transfer property at the time. It is neither executory, insofar as there is no action left to be performed, nor is it executed, insofar as the result is yet to be accomplished. This causes conceptual difficulty. Smart contracts are both committing to something in the future, but not exactly making a promise. As we discuss below, this hybrid between ex ante commitment and ex post enforcement is novel.

In the end, though, this complication raises more questions about the conventional definitions of contracts than it does about whether smart contracts are contracts. There can be little doubt that smart contracts purport to alter the rights of the parties. The smart contract can explain, normatively as well as descriptively, why the bitcoin belongs to one party and not the other. It constitutes an agreement between the parties, and not an idle one. That, we believe, is the essence of a contract. But it is an interesting conceptual observation – illuminated by the smart contract – that even yet-to-be-executed contracts need not create promissory obligations.

There is one final difficulty to overcome. Are smart contracts really agreements? After all, they are simply a chunk of code. Superficially, they may look nothing like a set of declarations in the form ‘Party X agrees to do such-and-such’. In general, a legal contract...