Smart Contract Series – Legal implications for consideration, Part 1: Definition and enforceability

I. Introduction

This article kicks off a series that will explore legal issues relating to smart contracts. No doubt, smart contracts have become a hot topic, as more use cases for them emerge in various industries (from food and agriculture, to financial services and insurance). This heightened interest has shone the spotlight on a number of legal issues that arise from the intersection of blockchain technology on which smart contracts are based, and the legal framework for contracts. These issues include enforceability, dispute resolution mechanisms and remedies, which will be addressed in this and forthcoming articles.

II. What is a smart contract?

What is a smart contract? Nick Szabo, who pioneered the smart contract, defined a smart contract as “a set of promises, specified in digital form, including protocols within which the parties perform on these promises”.1

More specifically, a smart contract is an automated application that runs on blockchain technology, without third party enforcement or verification. It is designed to result in a particular, agreed upon outcome based on a set of “if-then” premises that put actions into motion once certain conditions are met.2 Because blockchain records information in a manner that is described as immutable, the execution of a smart contract is often irrevocable, which means that once a certain action is in motion, it cannot be undone.3 Additionally, smart contracts lie on a spectrum: some are written entirely in code, while others are linked to a natural language contract (known as a “Ricardian contract”).4

Are they “smart”? Smart contracts are not a form of artificial intelligence and are not capable of machine learning. They perform only the actions they are coded to perform.

Are they “contracts”? This is a difficult question that has not yet been decided by any court in Canada. The likely answer is: it depends. Followers of the “code is law” doctrine may argue that smart contracts are properly enforceable contracts at law. However, it is more likely that a smart contract—whether entirely in code or a Ricardian contract—will need to satisfy all requirements of a legally binding contract to be enforceable at law. These requirements are addressed in more detail below.

III. Examples

A recent example of a smart contract in action is Fizzy AXA. AXA is a French airline insurer taking flight insurance to the blockchain. With Fizzy, if a customer’s flight is delayed by more than two hours, automatic compensation is issued for the delay; the delay of more than two hours is the triggering event that sets in motion the irrevocable action, an automatic deposit compensating the customer.5

In the financial services industry, there is also R3’s Corda,6 through which HSBC and ING Bank recently executed a live trade finance transaction for an international food and agriculture company using the Corda scalable blockchain platform.7

Smart contracts are getting a lot of attention from various industries for their ability to self-execute and automate certain performances, theoretically saving time and cost. These are enticing commercial reasons for taking an interest in using smart contracts. However, consideration should be given to legal issues to ensure that smart contracts are valid and enforceable in the event of a dispute, and that there are appropriate dispute resolution mechanisms available.

IV.  Are smart contracts enforceable?

Whether a smart contract is a legally-enforceable contract will depend on whether a smart contract meets the legal requirements of a valid contract. This will depend on what law applies and the jurisdiction in which enforcement is sought. In Canada, contract law is nuanced and complex, but the fundamental elements of a valid contract are: (i) an offer and acceptance; (ii) consideration; (iii) an intention to create legal relations; and (iv) certainty as to the terms of the contract. A contract does not need to be written (for example, oral agreements can be enforceable).

Since smart contracts are relatively new, they have not been tested by Canadian courts. However, their enforceability should not be ruled out simply because they are written entirely in code or automated. As noted, oral agreements without supporting written documents can be enforceable, and other types of automated or digital agreements have been found to be binding in Canada.

For example, Canadian courts have upheld automated internet contracts, entered into by users clicking, “I agree” to website terms and conditions (commonly referred to as “clickwrap agreements”). In those cases, Canadian courts in any public discussions to date have held that online contracts can be enforceable, but should provide sufficient notice so that there is an opportunity to consider and decline the contract. Indeed, in one Ontario case, the court ruled that when a user clicked, “I agree” to website terms and conditions, it constituted a valid internet contract because the user had a chance to review it before agreeing to the terms.8These cases, however, address online contracts written entirely in natural language.

Since smart contracts are written in code, it may be difficult to determine and enforce the agreement if there is no natural language contract setting out the terms, especially in circumstances where the code contains an error or carries out an action contrary to the parties’ intentions, or fails to carry out an action required and expected by the parties. Further, it is not clear that “if-then” statements enshrined in computer code will necessarily meet all of the requirements of a contract. These issues relating to the certainty of the terms in a contract may be addressed by Ricardian contracts, which link a natural language contract to the underlying code. Ricardian contracts may be the best way to bridge the gap between technology and law for the time being.

Even where a smart contract exhibits all of the requirements of an enforceable contract, there will be other questions that could affect enforceability, such as whether the smart contract is otherwise unlawful (for example, for the sale of an illegal good), or whether the smart contract is for the sale of security tokens, which might engage securities regulations.

V. Conclusion

The use of smart contracts presents interesting and new issues in law and technology. In addition to the legal issues concerning the formation and enforceability of smart contracts, there are other legal issues that relate to the enforceability of smart contracts. These additional issues include what type of dispute resolution mechanisms are (or should be made) available, and what types of remedies could or should be available given the immutable nature of the blockchain technology on which they are based. The upcoming installments in this series will further address other legal issues that arise when working with smart contracts.

For more information about smart contracts, please contact Chloe Snider or another member of our Venture and Technology group. Julia Ji is a co-author of this article.

1 (Nick Szabo, Smart Contracts: Building Blocks for Digital Markets 1996). (para 2, sentence 2)  (second and third headers)
8 Rudder v. Microsoft Corp. 1999 CarswellOnt 3195, ONSC.

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Chloe Snider

About Chloe Snider

Chloe Snider is a partner in Dentons’ Litigation and Dispute Resolution and Transformative Technologies groups. Her practice focuses on litigating complex commercial disputes and assisting clients manage risk. She is a strategic and critical legal thinker who works efficiently to develop practical solutions for her clients.

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