Are Smart Contracts Real Contracts?

A number of cryptocurrencies (Ethereum, NEO, Byteball) offer the ability to create smart contracts. The smart contract is a new flavor of legal instrument, but nothing puts it outside of the law. While smart contracts have all the formal elements of a legally enforceable contract, there is no guarantee they will be enforced by US courts, or that the party on the other side of the contract can be found and brought within the jurisdiction of the court.

This article proposes a definition of a smart contract: a “non-centrally enforced agreement memorialized in computer code and settled with cryptocurrency.” This article emphasizes the primacy of blockchain platform governance vis-a-vis courts of law in resolving smart contract disputes.

Handkerchiefs and Handshakes: Contract Law is Flexible

Contracts don’t have to be formal written documents. A handshake or scrawl on a handkerchief can create a contract. The only necessary element is bargained for exchange of value.

Contract law requires a bargained-for exchange of something valuable, nothing more. The canonical contract is a written document; however contract law doesn’t require formal writing. An agreement penned on a napkin or a handkerchief can be an enforceable contract. If you agree orally to buy a particular car at a particular price, and you shake hands with the seller on the deal, you are bound to an oral contract. It is not the form or the signature that matters to the courts, it is the fact that there has been a ‘meeting of the minds.’

As further example of the flexibility of contract law doctrine, whenever you buy something, the seller agrees to an implied contract, between you and the merchant, that the thing will do what it is intended to (legally called the ‘implied warranty of merchantability’). If you return the item you purchased because it doesn’t work, you are claiming that the seller broke this implied contract because the item is not merchantable. So, without getting into the weeds, we enter into contracts all the time, often without knowing it; contracts take many forms, and a signed document is just one of them. If a contract is formed with computer code, assuming both parties can understand the nature of the code, there is no reason in law that it cannot be a legitimate “full-fledged,” legally enforceable, contract.

Smart Contracts

Ethereum forked in order to “fix” a single smart contract.

A commentator in Forbes defined the purpose of smart contracts as follows:

“The principal aim of the smart contract is a tamper-proof, unambiguous, computable contractual relationship whose payout (or other outcome) automatically occurs after some pre-specified event and that once started cannot be stopped, even by injunction.” — Mark Obald (https://www.forbes.com/sites/maryjuetten/2017/09/06/legal-technology-and-smart-contracts-blockchain-smart-contracts-part-iv/#3fe288326a5f)

(I’ll pause for a moment to quarrel with Mr. Obald’s characterization of smart contracts as either tamper-proof or something that “cannot be stopped” in light of history. After the DAO ‘hack,’ Ethereum founder Vitalik Buterin et al made the governance decision to modify the entire cryptocurrency protocol to correct a single malfunctioning contract that affected the DAO ICO, resulting in a hard-fork that split the Ethereum blockchain into Ethereum from Ethereum Classic.)

Regarding form and enforceability, Mr. Obald commented that smart contracts are something more than just self-executing agreements, they involve integration with a blockchain or similar decentralized enforcement-mechanism:

“The concept of an automated contract is not new. An option to purchase IBM stock at $100 on December 1 will result in an automatic payout on the contract calculated on the actual trading price of the stock on that date, is automated, but not novel. What is new and interesting with smart contracts is the attempt to generalize the concept for a wider class of contracts and to use a newer set of technologies, such as decentralized blockchains and oracles, to strictly enforce the contracts.” — Mark Obald (Id.)

Following these general principles, I define a smart contract as a non-centrally enforced agreement memorialized in computer code and settled with cryptocurrency. The question then becomes, if it is enforced in a decentralized manner, and deals in “digital dollars,” does the terrestrial court system play any role?

ICOs

A number of ICOs have arisen claiming to either create smart contracts without coding (e.g. Etherparty) or produce legally enforceable contracts on the blockchain (e.g. SmartOne). This author believes that the former will be more useful than the latter. This is because most smart contracts are legally enforceable on their own. In the case of contracts created by SmartOne and similar entitites, the court is unlikely to see their smart contract as legitimate simply because they claims it is.

Terrestrial Courts

Although smart contracts contain all the formal elements of a traditional contract, courts may be biased against enforcing them.

Whether the participant in a smart contract will have access to land-based courts to solve disputes is an entirely different matter. Simply put, many judges will view the blockchain realm as a fairly land and smart contracts as fairly land contracts. Think for a moment about the absurdity of trying to enforce a contract generated between Second Life participants, or Grand Theft Auto players in a US court room. The fact that cryptocurrency is the asset typically being exchanged in a Smart contract makes matters even more etherial from a judges’ point-of-view; the venerable judge will see a fairly land contract over funny money, nothing worth his or (much less typically) her time. A judge reticent to hear a smart contracts case may be persuaded by (otherwise weak) arguments from the party looking to avoid the contract — e.g. no meeting of minds, parties were mutually mistaken — to find that a particular smart contract is not legally enforceable.

However, it is certain that as blockchain protocols intersect with the traditional world of commerce — real estate sales in bitcoin for example — it will weaken arguments against legally recognizing smart contracts. Disputes will inevitably arise that have financial dimensions sufficient to justify the cost of lawyers, and that means litigation is not far behind.

Identity of the Parties; Decentralized Platforms; Avoiding Subpoena

It’s hard to sue someone you can’t find. It’s hard to be sued if you can’t be found.

A final wrinkle is that in smart contracts, you may not know the identity of the party on the other side of the contract. Where a litigant can’t identify, much less find and serve process to, a defendant, his or her lawsuit may result in a judgement but is much less likely to result in actual compensation. Because of this, parties may prefer to contract using decentralized platforms and protocols such as decentralized marketplaces and decentralized cryptocurrency. By going decentralized-only, contracting parties who wish to avoid the purview of the court (and the attendant risk of a subpoena) can substantially mitigate that risk.

• Collin Dyer, J.D. Ph.D. (twitter: @collinscustomIP)