Smart contracts feature a unique blend of legal agreement and technical code. This innovation has the potential to reshape how business is conducted. At the same time, smart contract legal issues around enforceability, jurisdiction, identity, and compliance are common. The legal framework for these self-executing agreements is still evolving.
What Are Smart Contracts?
Smart contracts, also known as self-executing contracts, blockchain contracts, or digital contracts, are digital contracts stored on a blockchain. They are automatically executed when predetermined terms and conditions are met. While a standard contract outlines the terms of the parties’ relationship in a written document, a smart contract enforces the relationship using cryptographic code. Smart contracts exist across a decentralized, distributed blockchain network. Because of this, they allow transactions to take place among unrelated, anonymous parties in the absence of any central authority, legal system, or external enforcement mechanism.
Even though they are high-tech, smart contracts share some basic elements with traditional contracts. They reflect an agreement between two or more parties, which are usually referred to as signatories. Smart contracts also spell out the terms that the signatories have agreed upon. Although they use math rather than words, they include the requirements and obligations of each party. They also outline the rewards for meeting the requirements and the penalties for non-compliance.
Understanding the Risks and Benefits of Smart Contracts
Smart contracts have the potential to reshape the way business is conducted. Below are several key advantages:
Key Advantages of Smart Contracts
Autonomy: Blockchain contracts eliminate the need for a third-party intermediary, such as notaries, brokers, advisors, and other agents. This allows the parties to have greater control over the transaction and tailor it to their exact needs.
Transparency: Smart contracts are encrypted and stored on a secured, shared ledger. Because of this, the parties must only trust the system rather than each other.
Cost-effectiveness: The elimination of intermediaries makes smart contacts less expensive than their non-digital counterparts. This is especially true given the high fees intermediaries often charge.
Security: If coded properly, smart contracts are extremely secure. In addition, because they are stored in a decentralized registry, they can’t be lost or physically stolen.
Efficiency: By eliminating human participation, smart contracts are more efficient. They eliminate the time and expense of sending documents back and forth during the execution phase. In addition, smart contracts can be automatically enforced.
Common Risks and Legal Challenges
Smart contracts are designed to be more transparent and reliable than standard contracts. However, they are also built using software. Like any technology, they are susceptible to problems, like software bugs and hacking. As blockchain contract law continues to develop, several legal uncertainties remain. Below are several common smart contract legal issues:
Legal Recognition
In many jurisdictions, contracts require offer, acceptance, intention, and consideration. While smart contracts can technically satisfy these requirements, courts may not always recognize or enforce them. This is especially true if there’s ambiguity or a lack of traditional legal form.
Smart contracts operate on decentralized platforms, which create ambiguity regarding which jurisdiction’s laws apply when contract disputes arise.
To avoid conflict, parties should agree on applicable law and forum for resolution, particularly in cross-border contexts.
Lack of Flexibility
While traditional contracts allow for nuance and interpretation, smart contracts are rigid. In many cases, modifying a deployed smart contract is difficult without built-in upgrade paths. As a result, the terms of the contract take on greater importance.
Fraud
Smart contracts are still susceptible to fraud and manipulation. For instance, they may be manipulated by insiders who have “backdoors” or “kill switches” to the code. They may also be exploited by those who possess a deeper understanding of how the smart contract will react to particular events or inputs. If funds are stolen or misused due to an exploit, it’s often unclear who is responsible. The developer, platform, or user could each be at fault.
Third Parties
Smart contracts may depend on other systems to fulfill contract terms. These other systems may have vulnerabilities that could prevent the smart contract from functioning as intended.
Forked Blockchain
If the blockchain forks or otherwise diverges, it can result in multiple smart contracts where only one existed. It may also disrupt the functioning of a smart contract.
Lack of Governance
Smart contracts may be subject to a variety of existing legal frameworks. For instance, smart contracts involving token exchanges or financial services potentially trigger complex crypto compliance obligations including securities laws, tax reporting, and AML/KYC requirements.
However, blockchain contract law is still catching up, and there is not yet formal governance standards.
Navigating Blockchain Contract Law and Smart Contract Legal Issues
At Scarinci Hollenbeck, our team of smart contract attorneys advise clients on the wide range of smart contract legal issues. We have a deep understanding of the legal and technical aspects of these contracts. Armed with this knowledge, we provide comprehensive counsel through every step, including formation, regulatory compliance, enforcement, and litigation.
Contact us today to find out how you can leverage smart contracts to automate and streamline your operations. We’ll help you mitigate legal risks every step of the way.
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