Smart Contracts: Legal Side (p.1)

Most likely the best thing the Blockchain brings is decentralized technology allowing all the connected participants to have access to existing information records (in case of public Blockchain) and be well informed when it comes to transparency issues. Thanks to decentralized system there is no need to have intermediaries in many transactions, and using Blockchain you save time, money, and benefit of more secured system than traditional ones. Based on aforementioned new technology smart contracts have appeared, bringing a new evolution step in enforcement of the matter was negotiated eliminating third parties and intermediaries.

I. Definition of Smart Contract

Smart contracts are self-executing electronic instructions drafted in computer code.[1] Smart contracts self-execute the stipulations of an agreement when predetermined conditions are triggered.[2] The parties “sign” the smart contract using cryptographic security and deploy it to a distributed ledger, or blockchain.[3] According to another opinion, a smart contract is a computer protocol intended to digitally facilitate, verify, or enforce the negotiation or performance of a contract. Smart contracts allow the performance of credible transactions without third parties, at the same time, transactions are trackable and irreversible[4].

Considering both information technology and legal aspects of the smart contracts’ nature, the smart contract application issue frequently rises many complex questions currently being unregulated in most of jurisdictions.

II. How do Smart Contract work?

Among various questions regarding the nature and features of smart contracts is whether they are really contracts, what are their utility and how do they work? In this regard, we would like to note that smart contracts are software programs that run on distributed ledger technology (“DLT”). Smart contracts are usually part of an application running on DLT, rather than standing alone as a DLT application, being governed by the event functionality principle. In event that coded command occurs (usually triggered by external data or event) smart contracts will become functional and will carry out modification of other data. The tool which connects the real world with smart contracts are “oracles”. In this way the external data can be delivered by “oracles” triggering the mechanism of smart contract to act in some way it was originally coded.

In this regard oracles play a major role in smart contracts functionality despite not all types of them need oracles to be fully operational. Once the information is provided by oracles, a smart contract enforces a particular command showing that certain condition was met. Smart contract runs based on principles “if” a condition is met, “then” a certain action occurs.

Smart contracts are distributed because they exist as software running on a DLT protocol that itself is distributed across a variety of network nodes, at the same time acting in autonomous manner, and executing contemplated transactions.[5]

III. Types of Smart Contracts

Most of the smart contract types are running on the Ethereum blockchain being compliant with technical standard ERC-20. ERC-20 contracts come with several functions and actions. The basic differences in each contract is in number of mentioned functions and actions. Usually smart contracts are used for dealing with tokens. Tokens are issued within Initial Coin Offerings (“ICO”) to raise funds for financing start-ups, but we will refer to tokens’ their legal side, types and utility in our upcoming blogs. Basic types of Smart Contracts are following:[6]

Basic Token Contract – a token contract is a smart contract that contains a map of account addresses and their balances. The balance represents a value that is defined by the contract creator.

Crowd Sale Contract – is a program for the development and distribution or sale of the project’s tokens. Crowd sale contract is needed for the token sale. That contract takes Ethereum and generates tokens.

Mintable Token Contract – consider the case when the number of tokens issued at the beginning of crowd sale have been completely consumed and you still have investors coming in for your crowd sale, you need to mint tokens now. Minting is only available during crowd sale.

Terminable Contract – contract that can be killed by owner. This terminates the contract and sends any Ethereum held by the contract back to the owner. To terminate a contract, you need to call self-destruct (address).

Refundable Crowd Sale Contract – During an ICO, in case the soft cap decided at the beginning of your crowd sale is not reached, you need to refund your investor’s money. Contract does it by creating a refund vault, which stores money while the crowd sale is in progress. It refunds money if the crowd sale fails.

IV. Legal issues

The concept of smart contract was introduced by Nick Szabo in 1996, conceived as “a set of promises, specified in digital form, including protocols within which the parties perform on these promises”[7] The main question regarding smart contracts if they are really agreements per se. It is well known that a contract has to meet a number of conditions to be valid from legal perspective as: at least two parties, capacity of the parties to conclude a contract, mutual consent, will of both sides to conclude a contract.

4.1. Form of smart contract

Given to lack of specific regulation regarding smart contracts, such an agreement shall meet all classical requirements applicable to paper-based contract in order to be enforceable and valid. A special attention in case of smart contracts must be paid to the mutual consent which according to law can be manifested in writing or orally. Traditionally mutual consent is based on the concept of offer and acceptance by the parties to the contract.

4.2. Lack of regulation

As stated before, smart contracts have close ties with tokens sold in ICOs, usually they govern almost all lifecycle of that tokens. Despite some authorities across Europe have undertaken certain steps to regulate tokens given to some categories are treated as securities, in most of cases smart contracts are still unregulated. At the moment in European Union only Malta has fully adopted legal framework related to smart contracts, blockchain and tokens. One more country which embraced the legal regulation of everything is related to crypto is Belarus, a former soviet country.  

4.3. Jurisdiction

By its decentralized and global scale nature blockchain rises a lot of jurisdictional questions, as the nodes on a blockchain can be located anywhere in the world. Due to this fact a every transaction could potentially fall under the jurisdiction of the location where the node in the network is located. This can generate a number of complex legal issues with a special focus on governing law, taking into account that every jurisdiction has own specific contract law principles and identification of appropriate legal regulations is quite important.

4.4. Enforceability

Smart contracts are blockchain based mechanisms which are automatically executed when specific circumstances or conditions coded into the smart contract are met. When conditions are fulfilled the execution of the smart contract happens automatically without being enforced by the third party. This creates a new level of development in contract law but at the same time brings new challenges due to its new and unregulated field. In case any disputes will arise related to the enforceability of smart contracts it might be complicated to identify the proper jurisdiction which has to trigger the enforcement of the contract and guarantee fulfillment of obligations between parties.

4.5. Lack of judicial practice

The lack of comprehensive judicial practice given the early stage of DLT development and the insufficient number of business decisions based on aforementioned legal practice makes difficult creation of a legal framework related to this field. Certain central and national banks of a number of countries, including the European Central Bank and the US Federal Reserve System, note that the regulation of smart contracts is inextricably linked to the regulation of DLT.[8]

4.6. Technical errors

One of main risks when it comes to the smart contracts are eventual technical errors. Errors might occur accidentally, and their elimination will be more difficult to perform due to the interrelation of various elements within the distributed ledger.[9]

P.S.* This blog is the first part of a series of articles related to smart contracts’ technical and legal side:

Part I:

Definition of Smart Contract

How do Smart Contract work?

Types of Smart Contract

Legal issues

Part II:

Structure of Smart Contract

Language for writing Ethereum Smart-Contract: Solidity

Stages of Smart Contracts creation

Technical requirements for realizations of Smart Contract(s).

Part III:

Regulation of Smart Contracts

——————————————————–

References*

[1] SAMUEL BOURQUE & SARA FUNG LING TSUI, A LAWYER’S INTRODUCTION TO SMART CONTRACTS 4 (2014).

[2] Reggie O’Shields,Smart Contracts: Legal Agreements for the Blockchain, 21N.C. Banking Inst.177 (2017). Available at:http://scholarship.law.unc.edu/ncbi/vol21/iss1/11

[3] INST. OF INT’L FIN., GETTING SMART: CONTRACTS ON THE BLOCKCHAIN 2 (2016).

[4] https://en.wikipedia.org/wiki/Smart_contract

[5] https://www.virtualcurrencyreport.com/wp-content/uploads/sites/13/2017/05/Perkins-Coie-LLP-Legal-Aspects-of-Smart-Contracts-Applications.pdf

[6] http://inaword.ru/blokchejn/pishem-smart-kontrakt-ethereum-eto-prosto-chast-7-ico/

[7] Szabo, N. (1996). Nick Szabo — Smart Contracts: Building Blocks for Digital Markets. [online] Fon.hum.uva.nl. Available at: http://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/CDROM/Literature/LOTwintersc hool2006/szabo.best.vwh.net/smart_contracts_2.html

[8] https://www.cbr.ru/Content/Document/File/47862/SmartKontrakt_18-10.pdf

[9] Ibidem

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