Like many high-tech innovations, the concept of a smart contract is often misunderstood. The term itself is largely to blame for this confusion. First and foremost, a smart contract is not a contract in the legal sense, although it may assist in the performance and enforcement of a legal contract. Furthermore, a smart contract is not "smart" either. While a smart contract may result in a range of different outcomes, it merely follows pre-programmed instructions and does not think independently.

A smart contract is computer code that may allow a legal contract to self-perform in one way or another upon the fulfillment of certain conditions. Smart contract code may also verify and enforce performance of the legal contract in question. In theory, this offers two main advantages over purely text-based legal contracts:

  1. it limits debate with respect to the meaning of the agreement, since code is precise and free from fallible human interpretation; and
  2. it reduces transaction costs, as the contract is performed automatically once the requisite conditions materialize.

However, code often has its own flaws and deficiencies, and the realized efficiencies will depend on whether the transaction in question benefits from being hosted on a distributed platform.

Reliance on Blockchain

Blockchain, initially famous for being the technology behind Bitcoin, offers the potential to overcome data integrity challenges and to further reduce the transaction costs for smart contract transactions.

Blockchain enables this by creating a secure distributed ledger, which is essentially a decentralized record of all transactions entered into on the network. In the case of smart contracts, this record also includes the associated smart contracts, programmed to self-execute, verify and/or self-enforce upon certain conditions. This record is stored on all the computers connected to the network, rendering it tamper-proof. Indeed, to interfere with smart contracts, one would need to harness processing power exceeding the combined processing power of every other computer on the network to change the ledger's consensus on the existence, order and outcomes of the recorded transactions.

Blockchain technology makes smart contracts possible on a wide scale. In the near future, it may be accepted that, for example, a consumer's access to their car could be granted or withheld instantly, depending on whether the requisite payments have been made pursuant to a smart financing contract. The potential applications for smart contracts extend into banking and payment systems, even among parties who do not necessarily know or trust each other. Many banks, insurers, and accounting firms are already testing blockchain-based distributed ledgers and various smart contract applications.

Applications and Implications

Once adopted more widely, millions of contractual clauses could be performed every minute without human involvement. Ensuring that a legal smart contract achieves the intended purpose may require understanding not only the text of agreements between contracting parties, but also the smart contract code to ensure that the combination will produce the intended results.

As with many electronic agreements that are already commonplace, a legal smart contract arises upon certain formalities being satisfied, such as the exchange of consent and consideration, depending on the jurisdiction. At some point, parties choose to participate in the smart contract ecosystem, they engage with the smart contract and submit their transactions to its code.

This raises the question as to whether parties can be expected to give informed consent, and what that means in terms of executable code expressed only in a programming language. Parties to a legal smart contract may need to accept a certain amount of ignorance about the terms thereof and appreciate the loss of control over the contract's performance and enforcement.

Contracts, whether augmented with smart contract code or not, remain subject to a given jurisdiction's limits on enforceability. Courts have the authority to set aside a contract if the code renders the contract unconscionable or if the contract is found to be in breach of the public interest, such as under consumer protection legislation. The potential illegality of a smart contract, however, provides little comfort to a party looking for a remedy. By their nature, legal smart contracts make the transaction outcomes unassailable. The existence of smart contracts, as distributed multi-jurisdictional applications, will present challenges to the enforcement of traditional court remedies.

To deal with the hybrid of contract text and code, smart contracts may end up regulated by statute. Some jurisdictions, such as the states of Vermont, Nevada and Arizona, have already enacted legislation recognizing the legal validity of contracts entered into on a distributed ledger. As the application and complexity of such contracts expand, lawmakers may find that the unique situations they present require further legislation to clarify their legal effect.

Automation Ecosystem

Automating a transaction is not a novel idea. For instance, code already handles performance on many online shopping platforms and consumer digital rights management systems. An early iteration of this concept is the vending machine, which is designed to automatically output an item once it receives a determined input. Smart contracts promise value and convenience for even more transactions, especially as other forms of automation and the Internet of Things become mainstream.

The potential exists in the near future for an ecosystem of smart contracts and connected devices where micro-transactions execute automatically in response to real world triggers without further input from the contracting parties. However, like other Internet of Things technologies, the promise of smart contracts has yet to be fulfilled. As these systems evolve, they will influence each other, and contract law will have to keep up.