Smart contracts from a legal standpoint and their use in Blockchain

Definition

A smart contract is a decentralized running program that provides services to users. The source code of a smart contract and all its data are stored in the blockchain cryptocurrency platform.

Informally

A smart contract is created by its creator and its source code is subsequently uploaded to the blockchain. A smart contract is a program, which offers users clearly defined services. The user can make use of services if he sends out a transaction in which he says what service he wants to use and at the same time sends data, which he wants to process. The services of a smart contract are usually for a fee.

An example analogous to escrow attorney services

A simple example of a smart contract is the transfer of cryptocurrency money for the use of a depository, an analogy to escrow attorney services in the real world. The contract has participation of three parties: the transferrer, recipient, and depositary. 

The transferrer first sends the cryptocurrency to the multi-signature escrow address (multisig). For the release of funds from the escrow address, it is necessary to obtain at least two of the three possible (recipient, transferrer, depositary) signatures. The recipient promises performance, usually in the real world. 

If the recipient fulfills his promise, then the transferred together with the depositary sign the transaction, which transfers the money from the escrow address to the address of the recipient. If the transferrer refuses to sign the transaction, then the depositary will decide. If he accepts that the transferrer refused to sign the transaction for good reason because the recipient failed to fulfill the promised performance, then the depositary will together with the transferrer sign a transaction, which will return the funds from the escrow address to the transferrer. However, if the transferrer refused to sign the transaction without cause, then the depositary will together with the recipient sign a transaction to the benefit of the recipient.

 

Compared to classic attorney escrow services a smart contract has the two following advantages:

  1. If there is no dispute the transferrer and recipient, the depositary has no work handling the escrow since his approval is not necessary for the release of funds.
  2. The depositary cannot steal the funds if he decides to do so since he must have the approval of either the transferrer or recipient in order to perform the transaction.

 

Example of a game of chance

Another simple smart contract could be a game of chance with a coin toss. This smart contract will provide a single service. Wagering on whether the coin toss lands heads or tails. The coin toss will be completely random (and this randomness can be cryptographically proven).  The user in the transaction sends his bet on the result (heads or tails) and at the same time sends the amount of money that he is betting. If the user guesses correctly, then he receives double the wagered amount (or a bit less, perhaps 1.99 times, because the smart contract wants to earn money for its activity).

 

 

Legal view – contract

Depending on who concludes the contract, two situations can arise. The first situation corresponds to the example of escrow attorney services when the contracting parties are only persons.  This situation is very similar to signing a classic contract.

It is possible to view the source code of a smart contract as a public offer to conclude a contract. One of the contracting parties is the smart contract itself. The other party is the user, who utilizes the service of the smart contract. Anyone, who agrees with this contract, can conclude it. If the user concludes the contract, then the smart contract will proceed precisely according to this contract. The user has certainty that the smart contract will try to fulfill the contract exactly according to its wording. Nevertheless, it can happen that the performance of the contract is unreal, for example, the smart contract no longer possesses a sufficient amount of funds (tokens). 

From the standpoint of the current legal code, a problem arises. Although in the world of cryptocurrencies a smart contract is considered a contracting party, the current legal system does not allow for its existence. A smart contract does not have legal subjectivity like that of legal and physical persons and thus can’t even conclude a contract or be a contracting party. We will attempt to find a person, who would be a contracting party in place of the smart contract. The smart contract has a person that puts it into operation. Nevertheless, in the world of cryptocurrencies, this person can be completely anonymous. Another problem arises since this person can partially or completely relinquish control over the smart contract. 

 

Legal view – contractual disputes

The source code of a smart contract contains the complete rules that govern the execution of the contract. The contract is executed exactly as it was concluded. Individual steps of the contract are given absolutely clearly by commands of the source code program. This contract is always totally clear and precise, so a dispute about how the contract is supposed to be executed cannot arise. Unlike contracts in the real world, where potential disputes must be handled by the courts, smart contracts do not need court settlement and do not even allow for this because it operates on a cryptocurrency platform.

A conflict exists between how a contract is understood in the world of cryptocurrencies and how it is understood in the classic world. In the world of cryptocurrencies, a contract is concluded and valid if the transaction that the contracting parties signed was performed. In the classic world, a contract is a legal concept whose content is comprised of the identical intentions of the contracting parties. Nevertheless, if by mistake conclude a smart contract, whether I misunderstand by my own fault, or even because its creator intentionally misleads me with regards to the terms of the contractual agreement, no contract is created from a legal standpoint since there was no meeting of the minds of the contracting parties.

Nevertheless, a smart contract can behave differently than a contracting party anticipated. In extreme cases, a smart contract can be considered fraudulent from the legal standpoint and the result of the implemented smart contract will thus be in conflict with the law. With the anonymity of the originator of the smart contract, it will however understandably be practically impossible to sue for redress through the courts. With respect to the above mentioned and to the technical complexity of smart contract, in the future one can expect an increase in the importance of services auditing and assessing individual smart contracts. 

 

Error in the contract

If there is a programming error in the source code, then the fulfillment of the contract can significantly differ from what the user expected. Nevertheless, the user knew this contract beforehand and thus could have known the consequence of the programming error.  

This problem arose in the past with the DAO smart contract run on Ethereum. This smart contract was focused on collective investing. Anyone could entrust funds to the contract, subsequently participate in the activities of the contract and withdraw funds. Because of an error, it was possible to withdraw not only your own funds but the funds of other depositors as well. This error was exploited by a person known by the nickname of DOA Hacker, who in this way withdrew the majority of funds from the entire contract. Nevertheless, from the standpoint of a smart contract, this programming error was part of the contract with which the participants should have familiarized themselves before concluding it, so therefore nothing bad happened. The DAO Hacker was in the right and obtained the funds fully in accordance with the concluded contract.

This situation had a very unusual solution in the world of cryptocurrencies. Even though DAO Hacker was the legal owner of the funds according to the rules of the crypto world, the authors of the cryptocurrency Ethereum decided to help the original investors. Through a change in the source code of the Ethereum cryptocurrency, they took the funds away from DAO Hacker and returned them to the original investors. Some of the users of Ethereum cryptocurrency did not agree with this measure. Ethereum then split into two cryptocurrencies. The original cryptocurrency, which functions in accordance with the rules of the crypto world, is called Ethereum Classic, while the new cryptocurrency in which the funds were taken from DAO Hacker bears the original name, Ethereum. 

 

Legal view – what is a smart contract?

Is a smart contract a thing, physical person, legal person, or something totally different? A smart contract is a program, which somebody created. Source codes are intangible things to which one can have copyrights. 

Nevertheless, when the smart contract is put into operation on the blockchain, it begins to have the characteristics of a legal person, which is owned by its author, but here there is a major difference compared to legal persons in the real world, which have their partners under more or less complete control. In the case of a smart contract, its creator can only do with it what he enabled within the framework of the source code.

From the standpoint of a smart contract, its creator is only one of the users of the services of the smart contract, even though his rights can be extensive. The creator can usually withdraw profits from the smart contract, which this program earns. The creator may (but also may not) have the right to modify the source code of the smart contract to a predefined extent. 

Anytime the creator relinquishes any right, he can never get it back again. The creator can even relinquish all rights to the smart contract and thereafter the smart contract lives a life of its own. Even though it seems absolutely unimaginable from today’s standpoint, a smart contract can be considered an independent entity of its own kind (sui generis). It can for example exclusively control property in the form of tokens, conclude preprogrammed contracts and thus further expand its property, and further dispose of it. In this respect, a smart contract is closer to a physical person than a legal person. At the beginning, a smart contract is the slave of its creator and he can grant it freedom, which he then cannot take back, and a smart contract is thus emancipated.

From a legal standpoint, a smart contract will certainly never be a physical person, which are only people and for this reason enjoy a range of rights that it would not make sense to grant to a computer program. Likewise, another form of legal subjectivity is also not imaginable in the foreseeable future. Currently, in particular, the rights connected with robots endowed with higher forms of artificial intelligence are under discussion, but even in this area, the legal discussion is about determining liability, i.e. especially the fair division of liability between the manufacturer of an intelligent autonomous robot and its operator.

What we need a lawyer for

I believe that in the future law schools will regularly teach programming so that lawyers will be able to create contracts in the form of smart contracts. Currently, every creator of a smart contract is a kind of lawyer that writes a highly effective self-executing contract. Thus, it is now very desirable that lawyers also participate in the creation of smart contracts. In our opinion, the development of a smart contract should proceed in the following manner. A lawyer defines the requirements, a programmer creates the smart contract according to these requirements (this will not always go 100% precisely). The programmer subsequently describes exactly what he has created to the lawyer, and together they review all possible model situations. Subsequently, the lawyer adjusts his requirements and the programmer adjusts his program until they agree on a compromise solution.

 

Possibility of automating law offices

From the standpoint of automation, the smart contract is analogous to a form contract to which only details such as the contracting parties, amounts, date, etc. are added. 

Similar form contracts are also used in practice by service providers and sellers of goods, who conclude them with all customers. Compared to this, a smart contract is more specialized because its subject should not be a thing from the real world. The aforementioned becomes relative in the case of the effective tokenization of material things. While it is possible to wage a court dispute about the ownership of things, it is not possible to wage a court dispute about an amount sent to a smart contract. It is not possible to take away ownership of cryptocurrencies.

A typical contract could be a loan agreement. This type of contract requires that it be possible to transfer the ownership of the subject of the loan purely cryptographically. It is thus necessary to digitalize things from the real world before this in the following manner. Someone issues a token, for example digifiat, digigold, digibutter, etc., which authorizes its holder so that upon request the emitter of the token issues the given amount of the asset that covers the token. Here, it is necessary to use the services of a rating provider, which will evaluate the credibility of the token issuer, how well he is capable of meeting his obligations in the real world.

An interesting situation arises at the moment when he who receives the loan fails to repay it. Here, there are two possible solutions. Sanctions in only in the crypto world or sanctions in the real world.

Sanctions in the crypto world mean a loss of reputation. Rating agencies will evaluate this contracting party negatively and others will then not conclude with it contracts in which they would expect some kind of performance from this contracting party (for example, they will not continue to lend to it).

I would not recommend sanctions in the real world because the crypto world has found a better solution in the form of reputation, nevertheless, it is possible. For a smart contract, it is possible to create a template contract in Word into which the entry data that the smart contract received can be added. This contract can be cryptographically signed when performing the transaction. Subsequently, it would be possible to go to court with a contract signed in such a manner. The question is how the courts would react to such an innovative approach to contract signing and how would the enforcement of the performance be, when the other party has assets in a purely digital form.

Court resolution of disputes is however not excluded in the future. Just as it is possible to conclude a contract with a simple e-mail, it would be possible to conclude a contract via a blockchain transaction. The main problem will be in proving to the court who the other contracting party is and that the digital (cryptographic) signature actually belongs to this person. The platform would ideally be capable of generating the transaction details in legible form itself without the need to manually enter the details into a Word document.

 

author: Jan Lánský