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New Year - new boilerplates needed for your contracts?

Posted on 13 January 2022

Following the UK Law Commission's (Commission) call for evidence on smart legal contracts, the Commission has concluded in its advice to the Government (Advice) that legislative reform to the current legal framework is unnecessary: English law is able "to facilitate and support the use of smart legal contracts".

The Advice echoes the statement issued by the UK Jurisdiction Task Force (UKJT) in 2019 which we wrote about here and concluded that, in principle, smart contracts are capable of giving rise to binding legal obligations, enforceable in accordance with their terms.

What is a smart legal contract?

The Commission's Advice focuses on smart legal contracts. Smart legal contracts are legally binding agreements where the contractual terms (either wholly or in part) are self-executed by a computer program. This autonomous character, which precludes the need for human intervention, is known as "automacity". The contracts may also be deployed on a distributed ledger technology (DLT) such as Ethereum.

Smart legal contracts are increasingly being considered as a means of automating specific processes within conventional contracts. In addition to facilitating decentralised finance (DeFi) or managing service level agreements that monitor Real Estate transactions, parametric insurance, aviation refuelling and other sectors have also benefitted from the use of the burgeoning legal technology.

Notably, the Commission highlights the flexibility of English common law as an advantage when it comes to technological development, providing an "ideal platform for business and innovation, without the need for statutory reform".

What forms can a smart legal contract take?

The Advice identifies three types of smart legal contract (thought the form may vary from obligation to obligation):

  1. a natural language contract with automatic performance by code;
  2. a hybrid code and natural language contract;
  3. a contract recorded solely in code.

The key differences between these broad types of smart legal contracts is the role played by the code – which parties are advised by the Commission to make clear from the outset. For example, the use of code may be intended to both define contractual obligations and perform them (such is the case in a contract recorded solely in code) or simply perform them (as is the case for natural language contracts). A natural language contract with automatic performance by code may also be referred to as an "external" contract as the code falls outside the scope of the parties' legally binding agreement.

Interpretation of smart legal contracts

Whilst the Advice concludes that English law is flexible enough to allow current legal principles for traditional analogue contracts to apply to smart legal contracts, it recognises that the use of computer code in smart legal contracts recorded partly or solely in code may give rise to novel legal issues, particularly in the context of interpretation.

The Commission concludes that the appropriate test for interpreting coded terms is to use the "reasonable coder" test. Essentially, the "interpretation of a code should be determined by asking what the term would mean to a reasonable person with knowledge and understanding of the code".

In order to assist with interpretation, the parties may want to consider using natural language aids to interpret coded terms. This may include the use of the following which could be incorporated into coded agreements:

  • documents or term sheets prepared in advance of the parties engaging a coder to draft the code, detailing the terms of the transaction. Such a document may also contain an explanation as to how the code works;
  • a natural language explanation of the code. For example, the natural language component in a hybrid smart legal contract could include express terms detailing how the code is intended to operate (e.g. as a legally binding agreement). A separate document in the context of a smart legal contract written solely in code could detail the same. Alternatively, it could simply be a broad statement of intent;
  • natural language comments in source code. Here, the coder could include within the code itself comments to describe in natural language "the purpose of the code and any algorithms used to accomplish the purpose".

Whilst the Commission provides a logical approach for courts on the issue of interpreting code, it states as part of its conclusion that further study is required in the area of conflict resolution arising from smart legal contracts and emerging technology in general. Parties are encouraged to make clear which terms take precedence where terms are expressed in both code and natural language.

Smart deeds

The Advice notes that deeds "which are wholly or partly defined by code" are unsupported by the current law. In particular, there is "uncertainty as to whether smart contract technology can facilitate compliance with the various formalities that apply to deeds" – that is, witnessing and attestation. Law reform would be required to allow for safeguards other than physical witnessing (the same is true for electronic signatures as it is for smart deeds per the Commission's report in 2019 on the electronic execution of documents).

In R (Mercury Tax Group Ltd) v Her Majesty’s Commissioners of Revenue and Customs [2009] EWHC 2721 (Admin), [2009] STC 743 Mr Justice Underhill (as he then was) said that, under section 1 of the Law of Property (Miscellaneous Provisions) Act 1989, “signature and attestation must form part of the same physical document”. He also referred to a document as needing to be “a discrete physical entity (whether in a single version or in a series of counterparts) at the moment of signing” (at paragraphs 40 and 39). These statements raise the question of how a witness can attest to the signing of a piece of code. We await further guidance in this respect.

Remedies and smart legal contracts

What happens if a party only discovers an error in the code after the code has executed? Or, if errors in translation result in obsolete code at the time of contracting?

According to the Commission, such instances of defective performance could be resolved by rectification. However, rectification of coded terms may not be a silver bullet where transactions are deployed on an immutable block chain ledger.Other remedies available to contracting parties include vitiation on the ground of common mistake (where the code executes in a way contrary to those beliefs or assumptions), restitutionary remedies (where a void contract provides a foundation for an unjust enrichment claim, or where there is no mechanism for the parties to stop the execution of the code) as well as smart legal contracts becoming voidable (where parties are reinstated to their position pre-agreement, to achieve "practical justice").

Parties could also structure their smart contract to include "kill" switches or "self-destruct" mechanisms, which prevents computer programmes from automatically executing in certain circumstances, for example, where one of the parties terminated the contract following a breach.

To assist in resolving such disputes, the Jurisdiction Taskforce of LawtechUK (UKJT) published its Digital Dispute Resolution Rules. The Rules, which can be incorporated into both off chain and on-chain digital relationships and smart legal contracts, are designed to enable rapid, innovative and cost-effective resolution of legal disputes concerning novel digital technology, such as cryptoassets and distributed ledger technology.

B2C smart legal contracts

Under section 68 of the Consumer Rights Act 2015 (the "CRA") a trader must ensure that the written terms of a consumer contract are "legible, plain and intelligible". Many consumers are not familiar with programming languages used in coded smart legal contracts (e.g. Solidity (in the case of Ethereum)).

As best practice, users of B2C smart legal contracts are advised to provide a natural language explanation of coded terms to consumers to explain any coded terms to them and ensure that such agreements are not constituted as "unfair".

Whilst the Commission does not consider it necessary at the present time to introduce a separate legal requirement that traders provide a natural language explanation of coded terms to consumers, this is being kept under review.

Jurisdiction, applicable law and smart legal contracts

Jurisdiction and application of law are noted as areas of concern where the smart legal contracts are unilateral and drafted solely in code, or formed without the need for human intervention. In such circumstances, smart legal contract users are advised to "anticipate and cater for potential uncertainties" surrounding the legal technology by "encouraging parties to include express legal terms" such as choice of court and choice of law clauses in natural language terms.

Separately, private international law will need to tackle the issue of digital location (i.e. the difficulty of ascribing real world locations to digital actions and objects) which the Commission hopes to address as part of a new conflict of law project concerning smart contracts and digital assets in mid-2022. In the meantime, regulators, courts, legal advisors and marketplace actors are already having to grapple with questions such as where a cryptoasset is located for jurisdiction and applicable law purposes. This issue has been considered recently in two first instance decisions of the High Court, in which the courts adopted Professor Andrew Dickinson's view in his book Cryptocurrencies in Public and Private Law that a cryptoasset is located in the place where an owner is domiciled. We wrote about these cases here.

What kind of contractual pitfalls should parties consider to avoid disputes?

Appendix 3 of the Advice sets out a non-exhaustive list of issues, in an attempt to reduce the scope for disputes and provide parties with certainty and autonomy. As noted above, some of these include setting out choice of court and choice of law clauses in their smart legal contract, either in a separate natural language agreement, or by way of comments in the code.

The importance of this Advice cannot be overstated, especially as smart legal contracts become more mainstream. This Advice is useful for all organisations considering the adoption of smart legal contracts as part of their business.

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