Whilst the UK may not be renowned as a “crypto-friendly” jurisdiction, recent legal developments have highlighted the potential role of the law of England and Wales in the development of financial services utilising blockchain technology.
From a legal perspective, it is essential for English law to recognise and accommodate smart contracts to provide users a level of comfort.
The UK Law Commission’s Advice
In November 2021, the Law Commission published its advice to the Government on the legal status of smart contracts, including a detailed analysis of the application of the existing law. In particular, the report addresses “smart legal contracts”: a legally binding contract in which some or all of the contractual obligations are defined in and/or performed by the execution of code in a computer programme.
The Law Commission considered three categories of smart contracts:
- a natural language contract with automatic performance by code;
- a hybrid contract, under which the contractual terms are split between natural language terms and terms in code; and
- a contract which is recorded solely in code.
Key contractual aspects
- Formation
Under English law, there are a number of requirements for a legally binding contract to be formed: (i) an agreement (ie. an offer to be bound on specified terms and acceptance of that offer); (ii) consideration (what is given to the counterparty in return for the party’s obligations under the contract, eg. payment) (iii) certainty and completeness (iv) an intention to create legal relations and (v) compliance with legal formalities. The Law Commission concluded that all those requirements could be met by a smart legal contract. As with “standard” contracts, each contract is assessed on its facts – in particular:
- Negotiations do not have to be in natural language: the parties can indicate offer and acceptance through their deployment of and interaction with code on a blockchain.
- An agreement can also be reached automatically if the computer code is “held out” for (anonymity or pseudonymity is not a problem for smart legal contracts): it is not essential for counterparties to an English law contract to know who the other is, although this might cause issues on enforcement down the line, especially if a conflict arises between the parties.
- Where a smart legal contract is a solely code agreement, one would usually expect executable code to indicate certainty and completeness. But there may be some instances where although the code is executable and provides a certain result, the nature of the legal arrangement is not clear from the code. In such case, as with the other categories of smart contracts, in deciding whether the contract is certain and complete, the English courts can apply normal principles of contractual interpretation.
There are certain types of contracts which must be in writing and signed. Under English law, “writing” includes “representing and reproducing words in a visible form”: smart legal contracts meet this requirement where the terms are set out in a natural language document.
Interpretation of smart legal contracts
Where there is a contractual dispute between the parties, the courts will consider what the language would mean to a reasonable person, with all the background knowledge available to the parties at the time the contract was made. Even smart legal contracts consisting solely of code should be subject to interpretation, as there may be a divergence between what the code means and what it does when it is executed: ie. a distinction between meaning and effect. However, the addition of code into the interpretive mix is likely to give rise to interpretation difficulties. The Law Commission has proposed that the test used should be a version of the ‘traditional’ one: what would a person with knowledge and understanding of code understand the coded term to mean? This is consistent with the English courts’ existing approach to contractual interpretation.
Remedies
Parties to a traditional contract can seek various remedies, but how might these apply to smart legal contracts? Many practical, rather than legal, issues could arise in this area: for example, it is not possible to amend a smart contract which has been deployed on an immutable distributed ledger or distributed ledger technology (“DLT”). So, to achieve rectification, a court may order a party to enter into an amended contract onto the ledger.
From a legal perspective, if a smart contract is solely in code, it could be particularly difficult to establish a breach of contract, due to the interpretive constraints outlined above. However, once interpreted, the courts should be able to apply existing principles to determine whether a breach of contract has occurred.
Given these considerations, ultimately a key issue is jurisdiction.
Jurisdiction
When jurisdictional issues arise with cross-border contracts (ie. in the absence of governing law and/or choice of court clauses) standard rules under private international law apply for determining which courts have jurisdiction to hear disputes and which governing law shall apply.
The jurisdiction of a traditional contract can be the law of the place where the contract was entered into, namely the lex loci contractus.
On the other hand, smart legal contracts may be agreed without any natural language communication between the parties and different elements of these may have been dispersed or validated across multiple computers located in multiple physical jurisdictions. Consequently, the use of smart contracts can pose unique jurisdictional issues: whereas usually, the place of formation of a contract, or the physical location of the defendant, can be used as factors to establish which court has jurisdiction to hear disputes arising from a particular contract, treating smart contracts in this way can be challenging.
Lack of clarity as to which court has jurisdiction is a fundamental issue for smart legal contracts. Under private international law, there are various factors which may be relevant to determining the applicable jurisdiction of a smart contract with no jurisdiction clause; however, factors involving physical location of the parties are naturally more complicated in the context of smart contracts than under traditional ones.
As DLT based systems rely on information processing performed by multiple components (nodes) located in physical locations that can be spread across different jurisdictions, it is hard to identify a specific physical place of contract formation. Further, participants in DeFi (decentralised finance) protocols usually interact with each other on a pseudonymised basis, which makes it difficult (though not entirely impossible) to determine the identity and physical location of a contracting party. However, where a smart legal contract is made by or through an agent located in England or Wales, this can be a factor on which it can be more easily determined that the English courts have jurisdiction.
The most widely cited example of multiple jurisdictional acts is those carried out on a distributed ledger by a cross-border network of computers: but ascribing a physical location to a distributed act appears inherently implausible and new legal fictions are needed for locating such acts.
The Law Commission therefore recommended that smart legal contracts should include appropriate jurisdictional and governing law clauses to mitigate these legal uncertainties.
Governing law
Again, lack of clarity as to the governing law of a smart legal contract may require the application of private international law, which may in turn impact on the appropriate jurisdiction. While many of the existing aspects relevant to governing law are unlikely to require modification to address smart contracts, the English courts may consider new factors, such as the location of any private key or the domicile of any central administrator, if the relevant ledger is permissioned.
As regards digital location, the issue comes down to two key questions:
- where is a digital asset located?
- where is an act which takes place on a distributed ledger located?
Jurisdiction and governing law of digital assets and digital acts is therefore a crucial area where the development of English law is likely to be required.
Conclusion
The flexibility of the remedies available under the law of England and Wales is such, they will adapt to new concepts, technologies and business practices in rapidly changing times; so it is unlikely that smart contracts will present significant challenges to the application of practical justice. This means English law could be a popular choice of governing law for international businesses wanting to use smart contracts to regulate their contractual relationship.
If you require support or advice on this matter, please do not hesitate to contact a member of the team.
