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Do Smart Contracts Represent Legal Contracts?

When industry players use the term “smart contracts,” they may mean different things. Words matter, as any contract lawyer will be able to explain. Is the word “contract” a technical overstatement, or does it trigger actual legal bindings?

The industry needs to agree on the consistency of its terminology. What exactly is a smart contract? Does it have any legal implications? When attorneys and technologists use this terminology, do they understand each other?

Our article will provide a short analysis, enabling readers to develop further studies on the matter.

A Quick Smart Contract Overview

Smart contracts are essentially programs that execute when we meet specific criteria on a blockchain. They usually automate the execution of an agreement so that all parties may be confident of its conclusion right away.

The real innovation of this technology is the removal of any intermediaries or time waste. Smart contracts can also automate a workflow, starting when the system verifies the application of a set of conditions.

If you are not particularly familiar with coding, nothing prevents you from understanding the basic logic of a smart contract. The whole concept follows the verification of several states that lead to the trigger of an operation.

The most straightforward smart contract we can think of is the one controlling tokens investment. When a trader buys a cryptocurrency, a contract will automatically collect liquidity and transfer a token to a wallet. While doing so, several other operations may happen.

Think, for example, of those cases when each transaction comes with a tax. The smart contract will trigger the taxation system and transfer liquidity to other wallets.

Developers can code smart contracts, but businesses are increasingly helping non-technical clients with them. They do so by providing templates, web interfaces, and other online tools to make smart contract construction easier.

Different Forms of Smart Legal Contracts

Smart legal contracts can take many different forms with different degrees of automation. A recent study by the UK Law Commission defined three categories:

Natural Language Contracts with Code Automatization

This is a natural language contract in which the code of a computer program performs the contractual responsibilities automatically. The code does not establish any contractual duties, as it is a tool that parties use to fulfill such commitments.

Because the code is beyond the scope of the parties’ legally enforceable agreement, we are talking about an “external” contract. In the context of contract formulation or interpretation, this type of smart contract does not present any new legal concerns.

In other words, we have a natural language base that clarifies all the parts of the agreement. The code of the contract simply takes care of the agreement’s execution.

Hybrid Smart Legal Contracts

From now on, the matter becomes trickier and trickier. A hybrid smart legal contract presents both natural language and code in the statement of the parties’ obligations.

The code performs some or all of the contractual responsibilities automatically. However, if some of its conditions are only present in the code, the contract becomes harder to read.

The legal bindings of the smart contract appear to depend on this matter. The more complex its readability, the easier it will be for parties to ignore its content. This aspect is sufficient to prevent a hybrid smart contract from being legally binding in most countries.

Coded Smart Legal Contracts

This is a contract in which the issuer states all of the contractual terms in computer code. In other words, there is no natural language in the smart contract.

From the standpoint of contract law, this smart legal contract poses the most significant identification difficulties. If you have followed our reasoning on readability, you won’t be surprised to learn that most countries may be against them.

Are Smart Contracts Legally Enforceable?

Only a few regulators have tackled the matter of smart contracts’ legal enforceability. There appears to be interesting professional literature in the United States, as we explain below.

First, nothing in the U.S. legal system prevents a contract from executing automatically. For example, the country has already publicly accepted this sort of payment on travel insurance.

At this point, the U.S. Law makes a fundamental distinction:

  • Contract: a written agreement between two or more parties that is legally binding due to its contents and components.
  • Agreement: an informal agreement between two or more parties that is not legally binding.

The whole enforceability matter comes down to the definition of a smart contract. If the system recognizes it as a contract, this decision triggers legal bindings. The opposite is true in the case of an agreement.

However, there are cases in which an agreement can have legal implications. In Lumhoo vs. Home Depot, we find a clear stance of the Court on the matter. With sufficient evidence that both parties know the clauses of the smart contract, we find ourselves in this case.

If we try to leave the U.S. legal sphere, we understand the powerful implications of the decision. The general legal guidelines point toward the legal recognition of natural language smart contracts. When the readability of a contract becomes harder, its enforceability is less likely.

However, judges in the U.S. have enlarged the application of smart contracts enforceability. Anyone aware of the clauses of a code-only smart contract has legal obligations. Note that, lacking a specific blockchain policy, all we mention are experts’ interpretations from past rules.

What to Expect from the Future of Smart Legal Contracts?

Once again, we may want to go back to the existing literature on the matter. Smart contracts are a good illustration of “Amara’s Law,” a popular rule among IT experts. In short, we have a dual fallacy:

  • In the short term, human beings tend to overestimate the revolutionary power of new technology.
  • In the long term, humans will often underestimate the potential of new technological tools.

Smart contracts indeed have a long way to go before entering a mass adoption regime. Many crypto enthusiasts are pushing this technology as if it could revolutionize the world economy in a short time.

At the same time, some crypto pundits may find it hard to show the same confidence in the long term. This paradox comes from the idea that technology has always had a fast propagation.

The actual smart contract revolution will come from innovations that we have yet to discover. In the meantime, the legal implications of smart contracts appear to vary across different countries.

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We will see whether, in the future, world policymakers will react to the IMF call for a global crypto policy. While we wait, all we can do is trust the experts’ application of old rules to new technology.

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