Law and Autonomous Systems Series: Defining Smart Contracts – The Search for Workable Legal Categories

This blog post tackles the problem of defining smart contracts. In particular, it reviews the existing definitions of smart contracts in some of the main laws enacted and scholarly articles published so far, proposes its own definition, and then moves on to consider the extent to which new legal categories are warranted to deal with this new way of forming legally binding agreements.

The Need for a Common Legal Definition of Smart Contracts

Several scholars have started to investigate the topic of smart contracts. To be sure, the notion has been in circulation for several years, long before the current blockchain revolution to which its revival is linked. In fact, the original meaning of ‘smart contract’ is different from that which it has acquired in connection with blockchain technology. This can give rise to some confusion and as such, there is the need to provide some baseline clarification on the meaning of (decentralized) smart contracts.

Precision in this definition is important, since it will inevitably have consequences for the legal analysis of smart contracts; at the same time, a definition that is too strict would inevitably be inadequate for such a fast-moving field. Therefore it is necessary to find a precise but elastic definition, one that is capable of adapting to the next evolution of these technologies.

In order to do so, it is necessary to first consider the technology underpinning smart contracts, i.e. blockchain technology. I will then review the main legislative and doctrinal definitions of (decentralized) smart contracts that have been put forward so far, and propose my own version. Subsequently, I will briefly discuss the current legal framework governing smart contracts. In the final paragraphs, I offer my concluding remarks on the question of whether this breakthrough technology also implies a legal revolution: do smart contracts require entirely new legal avenues to be developed, or can existing legal categories be adapted to the new reality?

Defining the Blockchain and (Decentralized) Smart Contracts

A useful definition of blockchain, provided by the UK Government Chief Scientific Adviser, describes it as “a type of database that takes a number of records and puts them in a block (rather like collating them on to a single sheet of paper). Each block is then ‘chained’ to the next block, using a cryptographic signature. This allows block chains to be used like a ledger, which can be shared and corroborated by anyone with the appropriate permissions”.

Turning to the definition of smart contracts, as has been observed, “a search of the term smart contract uncovers a myriad of definitions” and “a consensus definition […] for smart contracts has yet to be reached”. More than 20 years ago, Szabo defined smart contracts as “a computerized protocol that executes the terms of a contract” and argued that “the general objectives of smart contract design are to satisfy common contractual conditions (such as payment terms, liens, confidentiality, and even enforcement), minimize exceptions both malicious and accidental, and minimize the need for trusted intermediaries. Related economic goals include lowering fraud loss, arbitration and enforcement costs, and other transaction costs”.

According to another definition by the same author, a smart contract is “a set of promises, including protocols within which the parties perform on the other promises. The protocols are usually implemented with programs on a computer network, or in other forms of digital electronics, thus these contracts are ‘smarter’ than their paper-based ancestors. No use of artificial intelligence is implied”.

More recently, other scholars and legal operators have defined smart contracts as:

  • “self-executing electronic instructions drafted in computer code”;
  • “a piece of computer code that is capable of monitoring, executing and enforcing an agreement”;
  • a piece of “software, [in] which computer code binds two, or a multitude, of parties in view of the execution of predefined effects, and that is stored on a distributed ledger”;
  • “digital contracts allowing terms contingent on decentralized consensus that are self-enforcing and tamperproof through automated execution”;
  • “[…] event-driven programs, with state, that run on a distributed, decentralized, shared and replicated ledger (blockchain) and that can take custody over and transfer assets on the ledger”.

Recently, Arizona approved a bill which contains a legal definition of a smart contract as: “an event-driven program, with state, that runs on a distributed, decentralized, shared and replicated ledger and that can take custody over and instruct the transfer of assets on that ledger”.

Hence, we can define a decentralized blockchain-based smart contract as any digital agreement which is a) written in computer code (thus, software), b) runs on blockchain or similar distributed ledger technologies (thus, decentralized), and c) automatically executed without any need for human intervention (thus, smart).

The Current Legal Framework

There is currently no international or domestic legal framework specifically tailored for blockchain technologies and smart contracts. However, the fact that there is limited specific regulation does not mean that general principles of law are not applicable to blockchain technologies and smart contracts, or that these are completely unregulated.

The Need for Workable Legal Categories (but not New Ones)

What then is the legal nature of smart contracts? Do they fall within traditional legal categories? I will focus my analysis on the following 3 questions, which I consider fundamental. That is, are smart contracts:

a) “Goods” protected by intellectual property laws?

b) A form of pre-emptive “self-help”?
c) Just ordinary contracts in a new medium?

Once again, the possible answers depend on the chosen definition.

a) With regard to the traditional categories of intellectual property law, generally speaking smart contracts (and blockchain) fall within the sphere of protection of copyright given that, as observed above, they are indeed pieces of software.

Moreover, provided that such technologies are new, involve an inventive step and are capable of industrial application, protection under patent law should also be considered possible – as shown by the rising number of patent applications  relating to these technologies – at least in those countries that allow the patentability of software and those that recognize as patentable inventions assisted by software.

In addition – even though the answer is probably negative – one may wonder whether the blockchain per se may be protected as a database, either through copyright protection if they “by reason of the selection or arrangement of their contents constitute intellectual creations” (TRIPS Art 10(2)) – in the EU – through a sui generis right granted by Directive 96/9/EC on the legal protection of databases if “there has been qualitatively and/or quantitatively a substantial investment in either the obtaining, verification or presentation of the contents”.

The reality however is that there is high uncertainty as to who owns blockchain for the purposes of characterizing and protecting smart contracts under intellectual property law.

b) Another possibility is that smart contracts are simply a new form of self-help measures, which parties to a contract adopt in order to ensure the performance of their agreements without the need for judicial enforcement. In fact, what usually happens is that two parties reach an agreement and translate (part of) it into a smart contract, thereafter leaving its execution to the computer.

It would, therefore, appear to be necessary, if such contracts begin to be adopted in day-to-day trading practice, for a separate but connected agreement to be adopted between the parties that establishes, among other things, the applicable law and courts of jurisdiction in case of need of judicial enforcement related to the general agreement itself, or to the smart contracts depending upon it.

c) Finally, with regard to the idea that smart contracts are “legally-binding agreement[s]”, it has been suggested that smart contracts do not create obligations in the true legal sense.

This conclusion, though, seems difficult to agree with. Firstly, smart contracts, as some scholars conclude, are indeed “agreements between the parties” expressed in digital code, and I believe that they should be considered as self-sufficient legally-binding agreements. In fact, smart contracts can, at least theoretically, meet all the requirements set forth under different national contract laws to be considered as contracts in the legal sense of the term. For example, in Italy a contract is defined as “the agreement between two or more parties to establish, regulate or extinguish a patrimonial legal relationship among them” and its requirements are: a) the agreement between the parties, b) the causa, c) the object and d) the form (only when prescribed under penalty of nullity). Such requirements, in practice, are quite easy to meet with traditional oral and/or paper-based contracts, and the same must be said with regard to digital agreements in the form of smart contracts. On this basis, smart contracts are subject to contract law.

Moreover, smart contracts do clearly create obligations which stand independently from their digital code: if, for example, there is a bug in a smart contract between A and B, and A has undertaken to transfer her property in exchange for an agreed sum of money to B, she would still be obliged to transfer her property to B even if the smart contract does not work (similarly, if a vending machine does not deliver the chosen good after the insertion of the coin, it is clear that the owner of the selling machine is still obliged to perform and deliver the good).

In any case, by entering into a smart contract, parties undertake to perform (or to let the computer machine perform on their behalf) the obligations therein encapsulated. In addition, since smart contracts will likely be a translation into digital code of a precedent agreement already reached, the parties would, at the very least, have contractual obligations to start the execution of the smart contract (i.e. to press the button that starts to operate the smart contract).

Generally speaking, in spite of the conceptual dissimilarities, there actually do not appear to exist too many differences between the functioning of a smart contract and that of a mechanical vending machine, or that of software that suspends the supply of a service in case of missing payment (e.g. Netflix allows users to legally stream videos in exchange for a monthly payment; in case of missing payments, the software will simply suspend the service, not allowing users to log in). The fact that the interruption is performed by humans, by software, or by smart contracts with a record in the blockchain, is not legally relevant under contract law.

I therefore agree with those scholars who conclude that “independently from being digitally expressed, every [smart] contract is ruled and guaranteed by the law and the parties will be free to file [to] the Court for compensation in case a void agreement has been performed or execution has been spoiled by a malfunctioning due to a system bug” and that “smart contracts do fall within existing contract law principles”. In other words, as O’Shields notes, “smart contracts will not require any special set of new laws or regulations. Instead, existing legal principles will be adapted and perhaps modified, either statutorily or judicially, to deal explicitly with smart contracts and other emerging technologies-albeit most likely with a substantial lag time between adoption of the technology and adjustment of the law”.

To sum up, smart contract will not replace contract law as some scholars have suggested. The existing contract law framework is more than adequate to accommodate even this revolutionary form of deal-making, without the need to create new legal categories that, contrary to an emerging view among regulators and policy-makers, are not truly warranted in this case.

About: Shawn

Shawn is an expert legal analyst, lawyer, and journalist.

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