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Smart legal contracts: An explanation and practical advice

Confused by the terminology? Sally Mewies, Head of Walker Morris’ Technology & Digital Group, explains what a smart legal contract is and sets out some of the practical legal considerations for commercial parties to keep in mind. You can also view Sally’s brief explainer video here.

How we can help

Please contact Sally if you have any queries about the points covered below or need any advice or assistance. Our Technology & Digital experts are well placed to advise on all aspects of commercial agreements, disputes involving blockchain and other technologies and any concerns from a regulatory perspective.

What is a smart legal contract?

A smart legal contract is a contract which creates binding legal obligations on the parties, but which is wholly or partly written as a computer programme.

The computer programme is written so that instead of a party to a contract having to take steps to exercise certain rights or comply with certain obligations, the computer programme executes those elements automatically without human intervention. Often this will be done on a prompt from data or information received by the computer programme from a trusted source. There will be many commercial contracts, for example services agreements, where only part of the contract can be executed as a computer programme because other obligations need to occur in the physical world.

Smart legal contracts come in three forms: (i) a contract which is entirely written as a computer programme but also has a complete natural language version; (ii) a contract which is partly written in natural language and partly as a computer programme; and (iii) a contract which is entirely written as a computer programme.

An example of a smart legal contract might be a cloud services agreement with a service level regime. Certain terms governing the contract could be in the natural language version, but the service level regime could be written as a computer programme. Data from a trusted source would tell the computer programme if there had been a service level breach that entitled the customer to receive a service credit, and the service credit would be paid automatically without the supplier taking any action or issuing any instruction.

Access to the cloud services could also be governed by a computer programme, in that payment could trigger the access and non-payment could terminate the access. Clearly issues relating to termination/ suspension of use of cloud services can be business impacting in a commercial agreement and this binary operation of access might not work in all cases, which is where the natural language version plays a role. For these reasons, smart legal contracts are likely to be hybrid i.e. partly code and partly natural language in many business scenarios.

The role of Blockchain

Smart legal contracts in theory are technology neutral, but currently are made possible by distributed ledger technologies (DLTs). Blockchain and Ethereum are both examples of DLTs. DLTs are often generically referred to as the more familiar term “Blockchain” which we use in this article (see our brief explainer video here).

Blockchain has special properties which mean that records, data or information written on the Blockchain can be trusted as being accurate. Blockchain creates a trusted shared record between parties who do not know each other or who cannot trust each other. Parties to a wholly or partly coded contract need to trust the underlying system that enables that computer programme to execute, and want to be sure that neither party (or a third party) can unilaterally amend the contract in an unintended way. Some Blockchains have the technology to support these requirements and that is why they are ideal for supporting smart legal contracts.

Smart legal contracts are written on the Blockchain and are programmed to execute commands and actions depending on the terms of the contract.

Practical legal considerations

The Law Commission recently concluded that smart legal contracts are compatible with existing English law principles and are therefore legally binding and enforceable. However, the application of common law principles and case law to smart legal contracts needs careful consideration by the parties and in most cases will necessitate part of your smart legal contract being in a natural language, i.e. a hybrid smart legal contract.

Setting up a smart legal contract requires different considerations from a entering into a wholly natural language contract and initially most are likely to be a combination of natural language and code.

Clearly it will be necessary for the parties to work with a programme coder and select the correct Blockchain for the relevant smart legal contract, but there is the legal side to consider too and this involves looking at how certain legal principles may play out in an automated situation.

Here are some practical legal considerations that will need to be thought about and agreed by the parties at the outset, and included in the natural language part of any smart legal contract. Issues that are not necessarily spelt out in detail in the natural language contract because they are compatible with the natural language contract and work with it, may need additional provisions/explanation where a contract is partly written in computer code:

  • If a conflict arises between the coded part of the smart legal contract and the natural language part, how will that be resolved? This will need to be dealt with in the natural language part.
  • Sometimes there are mistakes in a natural language contract that require rectification. This is reasonably easily resolved in a natural language contract and can often be rectified before performance of the relevant term is needed. This could be more challenging in a piece of computer code that executes automatically, and therefore the parties may need to agree and stipulate how this will be resolved. In time we would expect that the courts will formulate methods for dealing with these situations so that there is certainty around the process for rectification.
  • Contracts can be found to be void or voidable and this can result in the contract being deemed never to exist. The nature of Blockchain is that it is immutable and cannot be changed so the parties will need to agree how this kind of issue will be resolved between them and how the computer code can be “turned off” or “nullified”. This probably comes down to the nature of the Blockchain deployed and its governance mechanism.
  • If the contract is terminated by one party then the coded part of the smart legal contract will need to stop performing. There are also issues relating to breach of contract. Can there in fact ever be a breach of a programme that is coded to perform certain tasks? It could be that corruption to third party data sources results in the computer code not performing correctly which leads to a breach by one party. In time it is likely that rules will be developed by the courts to cover these scenarios, but until then the parties might need to define what constitutes a material breach and set out the remedies depending on how that breach occurred; a trend that parties have shied away from in many natural language contracts because of the complexity of defining every scenario.
  • The coded element of the smart legal contract may execute an activity in a way not intended by one of the parties and this may come down to how the computer programme or programmer has interpreted an instruction or a data source. English case law has extensive rules for interpreting natural language contracts, but there are no legal rules for interpreting a piece of code. The courts will no doubt adopt principles around what a “reasonable coder” might have intended or understood, but in these early stages of smart legal contract development it would be sensible for the parties to consider how these kinds of issues will be resolved.
  • If the smart legal contract involves consumers then the business party will need to find a way of explaining in plain English what the terms of the smart legal contract mean, including the parts that are written as computer programmes, in order to satisfy consumer law requirements.
  • And, last but not least, don’t forget data! If data is gathered and stored in the smart legal contract then it may constitute valuable commercial information/knowhow and the parties should be clear about how that can be used. If personal data is stored on the Blockchain then data protection laws must be complied with. The challenges of complying with data protection laws on immutable technology is a conversation for another time!