Smart Contracts: The Much Awaited Law Commission Verdict

March 15, 2022

It’s here! The much-anticipated advice from the Law Commission on the application of smart contracts in the legal industry has formally arrived, leaving many to wonder, what does this mean for the future of smart contracts?

With a panel including the likes of Professor Sarah Green, this 227-page gold mine deserves the spotlight for everything it is bestowing upon technology and blockchain lawyers. Despite this, the project is vast in both depth and breadth, leaving much to consider. That’s why we’ve read it all and summarised the key things you need to know below, (you’re welcome).

The conclusion overall was that,

“…the existing law of England and Wales is able to accommodate and apply to smart legal contracts, without the need for statutory law reform.”

This is big news. Our common law is being recognised and commended for its flexibility in supporting innovative technologies and businesses without the requirement to adapt any statutory laws, (which, in a nutshell, would be very difficult and time consuming). Common law application to smart legal contracts use cases can be developed and tweaked on a case by case basis, and the Commission’s paper justifies this by including express guidance on how to increase certainty and autonomy in smart legal contracts.

What are smart contracts? And why are they important?

Time out. What are smart contracts and why are they important right now?

Put simply, a smart contract is a computer program that is stored on a decentralised network, such as a blockchain (for example, Ethereum). It is a self-executing contract, designed in code to automatically trigger, document or control certain events when required conditions are met by the parties to the contract.

A typical analogy used to explain this concept is a vending machine.

Imagine you’re in need of a sugar rush as you dash between meetings. You spot a vending machine and a Mars Bar with your name on it (figuratively speaking, of course). When you type in the right numbers/letters, a message is sent through the machine that tells it to release your Mars Bar into the collection box. Then you put in your money. If, for example, a pound is enough, you get your Mars Bar. If it’s too much money, then you get your bar and a bit of change. If it’s not enough, it will ask for more money.

This, in simple terms, is a smart contract. Once certain conditions (the number/letter and money insertion) are met, the contract executes the result, (your delicious Mars Bar and a significant improvement in your productivity and mood).

Smart legal contracts

Smart legal contracts adopt this methodology in (yep, you guessed it) legal circumstances for legally binding contracts (has the word ‘legal’ started to seem a bit weird yet?) These contracts determine the rights and obligations of the parties, and the smartness behind them is that, once one party completes their obligations, (e.g. providing a service or delivering goods) they receive their rights or rewards under the contract (e.g. most commonly, payment) from the receiving party. This process is automated by the contract itself through code. Provided that all the requirements of a legally enforceable contract are met with the smart legal contract, it will be legally enforceable in a court. As the Law Commission sets out, “Performance of [the rights and obligations] in a smart legal contract is “guaranteed” in the sense that human intervention is not required to facilitate performance.”

The Project

The Law Commission was tasked by the Lord Chancellor to include work on smart legal contracts as part of their Thirteenth Programme of Law Reform. In November 2019, the UK Jurisdiction Taskforce (“UKJT”) published its legal statement on cryptoassets and smart contracts. The UKJT Legal Statement concluded that, in principle, smart contracts are capable of giving rise to binding legal obligations, enforceable in accordance with their terms.

Following this, the Ministry of Justice asked the Law Commission to undertake a more detailed analysis of the current law as it applies to smart legal contracts. The report would need to highlight any uncertainties or gaps, and identify any present or future further work that may be required.

The Law Commission’s advice

As stated above, the Commission concluded that no changes were needed to existing primary legislation. In their words,

“Current legal principles can apply to smart legal contracts in much the same way as they do to traditional contracts, albeit with an incremental and principled development of the common law in specific contexts.”

Their report discusses the actual technology behind smart contracts in extensive detail, highlighting the different types of smart legal contracts that can be formed, (such as “Natural language contract with automatic performance by code”) and a comparison of those types, as well as examples of use cases.

In practice, smart legal contracts are currently being considered and used in the context of:

  • Facilitating “DeFi” or decentralised finance, which aims to disrupt conventional banking and securitisation arrangements
  • Service level agreement monitoring
  • Real estate transactions
  • Parametric insurance
  • Aviation refuelling
  • Managing supply chains

In terms of process, the Law Commission expect that parties to the contract will, in many cases, “engage in natural language negotiations with a view to reaching an agreement on the terms of their bargain.” Following this, they will engage a developer (if required) to “procure a piece of code which defines or performs some or all of those contractual obligations.” But prior to actually commencing drafting of the contract (whether in natural language or code) it is also crucial that the parties “conduct a rigorous planning phase”. It was emphasised that “collaboration between lawyers and coders is key” and that the parties should be clear as to what the goals and business requirements are before relying on that code to enforce performance towards those goals.

When considering which elements of the contract can be coded, versus those that should remain in natural language, the Law Commission’s consultees said that it would depend upon the obligation. The nature of a limited liability clause, for example, would render it difficult to be translated into code, as this is considered a high-risk area for clients that often leads to negotiation. Conversely, a standard boilerplate clause, such as a severance or variation clause, would be far easier to code as they are usually drafted with the same or very similar wording and have less of an impact on the performance of the contract overall.

Although these contracts will undoubtedly raise more questions along the way as they are deployed in practice, the Commission are confident that common law can evolve to accommodate them in a way that is reliable and understandable for businesses and their legal teams. At Stephenson Law are certainly willing to embrace new ways of working and would champion clients that wish to trial these coded contracts. It’s a learning curve for everyone, but with an increasing number of consultations being conducted by the likes of the Law Commission (and other regulatory and legal bodies) we are starting to form a framework of guidance to follow in this brave new (coded) world.

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