Part of the appeal of blockchain technologies is the potential for smart contracts to reduce transaction and enforcement costs associated with contract performance. A smart contract is a set of code stored on the blockchain that implements the terms of the contract. Since computer code controls the execution of a contract, the parties do not rely on each other or on third parties to validate the terms of the contract or provide the necessary confidence that both parties will perform. As such, costs associated with contract validation or counterparty due diligence are reduced or even canceled.
Smart contracts have countless applications. For example, smart contracts can be implemented to handle insurance transactions where the smart contract automates the payment of premiums and will pay insurance proceeds in the event of a covered accident. Or, if an artist creates and sells an NFT, the NFT can include a smart contract that allows the artist to take ownership every time an NFT is bought and sold.
Although smart contracts may provide an automated means of ensuring that contracts are executed according to their terms, there are technical and other limitations on the types of contractual terms that can be automated through smart contracts.
Take, for example, the insurance transaction discussed above. To implement such a smart contract, the smart contract must have a means to communicate with the insured’s bank account to pay premiums and must receive information from an external information provider to know when a covered event will occur so that insurance proceeds are payable to the insured.
There is also a risk that the smart contract itself may be improperly encoded or contain other flaws. One need only consider the experience of those who participated in the DAO, an independent decentralized organization that allowed participants to invest in user-generated proposals powered by smart contracts. The flaws in the DAO’s smart contacts encryption allowed a bad actor to transfer about a third of the money raised by the organization to the bad actor’s account. Due to the borrowed nature of the Ethereum Blockchain – the blockchain on which the DAO smart contracts are built – it was nearly impossible to identify the bad actor and take legal action against them.
The limitations and risks associated with smart contracts and the technology behind them highlight the need to put in place adequate safeguards to allow parties to pursue contract enforcement outside the blockchain. For parties seeking to implement contractual terms through smart contracts on the blockchain, they must also take into account some important considerations for enforcing smart contracts off the blockchain. Some of these considerations are discussed below.
Recognize the limits of smart contracts. Parties must understand the capabilities and limitations of smart contracts. While smart contracts are good at implementing concepts like paying royalties, premium payments, and other financial transactions, there are currently limits to what a smart contract can do, at least on its own. Common contractual clauses such as confidentiality, liability limitations, force majeure, indemnity, governing law, and what happens if one party to a contract enters bankruptcy or goes out of business are more complex and can be difficult to implement in computer code. Furthermore, there is a risk that the smart contract may be improperly coded or otherwise contain flawed logic. In such a case, the parties will be left with the question of who bears the risks of such a defect.
The identity of the counterparty. Part of the benefit of implementing a smart contract on the blockchain is that it allows two parties to participate in a transaction without the need for either party to trust that the other party will execute: the smart contract will complete the transaction as it was encrypted and neither will. The party can interfere with the performance of the contract once it has been performed. However, such an unreliable system works, as long as conflicts or problems do not arise outside the proper implementation of the smart contract code itself. In the event that an issue arises outside the smart contract’s rote implementation, knowing the identity of the counterparty or counterparties is important for the purposes of dispute resolution and contract enforcement.
The DAO experience is one example of how a lack of counterparty identity can be problematic: DAO participants were unable to pursue lawsuits against a bad actor who stole money from the project because identity was unknown. Similarly, other contractual elements, such as confidentiality or force majeure, may be difficult or impossible to enforce if the identity of the counterparty is unknown: it is impossible to sue for breach of confidentiality if the litigant does not know the identity of the infringer.
Written agreements are critical. As mentioned above, there are limits to what a smart contract can do, and smart contracts are best implemented after both parties enter into a self-contained written contractual agreement. A written agreement has the advantage of filling in loopholes that cannot be covered by a smart contract (such as confidentiality or compensation issues) and can customize the risks associated with potential flaws in smart contract code.
Moreover, a written and executed contract usually provides indisputable evidence of the contract’s formation: the written agreement shows that there was an offer, acceptance, and consideration.
Without a written agreement, the parties can be left to dispute whether a contract has been formed and what the terms of that contract are. In this way, a smart contract should be viewed merely as a tool to easily and efficiently implement certain terms of a written contractual agreement, and not as a full legally binding and enforceable contract in and of itself.
 Investigation report under Section 21(a) of the Securities Act of 1934: DAOSEC (25 July 2017), Available here. https://www.sec.gov/litigation/investreport/34-81207.pdf.
© Copyright 2022 Stubbs Alderton & Markiles, LLPNational Law Review, Volume XII, No. 251
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