This blog delves into the legal enforceability of smart contracts, how they function, their potential benefits, and the challenges they pose in a real-world legal context.

WHAT IS A SMART CONTRACT?

A smart contract, despite its name, is not a "contract" in the traditional legal sense. Rather, it is a self-executing contract where the terms of the agreement are written directly into lines of code. The code itself automatically enforces the contract's terms when specific conditions are met. For example, a smart contract might automatically release funds from one party to another when goods are delivered and verified.

However, smart contracts are still relatively simple in nature, and they are best suited for tasks that follow clear, objective rules, such as transferring assets or enforcing payment upon delivery. For instance, transferring cryptocurrency or other tokenized assets on a blockchain is relatively straightforward, but applying subjective legal concepts like "best efforts" or "reasonableness" is still beyond the current capabilities of smart contract technology.

HOW SMART CONTRACTS WORK

Smart contracts follow an "if-then" structure. If pre-defined conditions are met, then the code automatically executes the corresponding action. The contract cannot be altered or reversed once coded and initiated. Additionally, smart contracts are executed on a blockchain, making them decentralized and immutable.

An example of a basic smart contract could be the automatic transfer of cryptocurrency between two parties once certain predefined conditions, such as the delivery of goods, are verified. The contract would remain open until both parties meet their contractual obligations.

While smart contracts offer exciting possibilities for automation and reducing transaction costs, their complexity increases depending on the number of variables or conditions coded into the contract. Additionally, since a smart contract relies solely on its programming, it may not be adaptable to changes in business needs, unforeseen circumstances, or new laws.

LEGAL ENFORCEABILITY OF SMART CONTRACTS

In the U.S., contracts are governed by state law, and all contracts, including smart contracts, must meet certain criteria to be legally binding. A legally enforceable contract requires (i) an offer; (ii) acceptance of the offer; (iii) consideration (payment or something of value); (iv) mutuality of obligation; (v) legality; and (vi) competency and capacity of the parties.

Smart contracts can satisfy these criteria, but their enforceability depends on the circumstances surrounding their creation. For example:

1. Offer and Acceptance: A smart contract can formalize the offer and acceptance through coded conditions.
2. Consideration: Both parties must provide something of value, whether it's payment in cryptocurrency or another asset transferred through the blockchain.
3. Mutuality of Obligation: Both parties must be bound to perform. This is easily programmable in smart contracts but may become complex in cases involving subjective performance.

Smart contracts are legally recognized as valid in the U.S., especially with the advent of the Electronic Signatures in Global and National Commerce (ESIGN) Act and the Uniform Electronic Transaction Act (UETA). Both legal frameworks allow electronic contracts and signatures to hold the same legal validity as traditional contracts, enabling smart contracts to meet the "signed writing" requirement under the statute of frauds.

However, many state-level laws have not fully adapted to blockchain-based contracts, and courts may face challenges when interpreting the intentions behind the code.

CHALLENGES OF SMART CONTRACTS

While smart contracts provide a high level of automation and transparency, they are not without limitations:

1. Programming Complexity: Writing accurate, bug-free code is a challenge, especially for multi-step transactions. Companies must ensure that smart contracts are correctly programmed, often requiring technical expertise.
2. Lack of Subjectivity: Smart contracts cannot make subjective decisions. A court may need to evaluate the code and its outcomes to determine the intent of the parties.
3. Oracle Dependency: Smart contracts rely on "oracles," which are third-party sources of data or information (such as pricing or delivery confirmation) to feed into the contract. This introduces an element of trust in a process otherwise designed to be trustless.
4. Difficulty in Amending Contracts: Traditional contracts allow for flexibility and amendments. Smart contracts, however, are rigid and require extensive coding to accommodate changes. This can complicate business relationships where subjective adjustments are often necessary.

FINAL THOUGHTS: THE FUTURE OF SMART CONTRACTS

Smart contracts hold tremendous potential to revolutionize various industries, from finance to supply chains. However, while the technology can automate straightforward contractual actions, it still lacks the sophistication needed for complex, real-world legal agreements.

For now, companies may find that supplementing smart contracts with traditional legal agreements is the best way to ensure clarity and avoid disputes. By combining the efficiency of automation with the flexibility of traditional legal frameworks, businesses can take full advantage of smart contract technology while protecting themselves from potential pitfalls.

As blockchain technology continues to evolve and regulatory frameworks adjust, smart contracts could become a powerful tool for automating transactions. However, for now, it’s crucial to approach them with caution and a full understanding of their limitations.

Source: This blog draws on legal insights from Securities Law Blog: Are Smart Contracts Enforceable?, discussing the enforceability of smart contracts under U.S. law and various challenges faced by businesses using blockchain technology for contractual agreements.