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Smart legal contracts: a new game or the same?

bitcoin btc keyboard
The good, the bad and the ugly of digital trends

 By Christina Anastasiou

The European Commission has long recognised the impact of the Fourth Industrial Revolution or 4IR (also known as Industry 4.0) globally. Consequently, in embracing the new digital trends and technology markets, it has set an objective of securing a future for members’ markets which is fit for the digital age.

This will involve moving from 27 members’ individual digital markets to a Digital Single Market (DSM). The DSM has been one of the EU’s priorities since 2015. It is directed at resolving the complexities of key differences between online and offline markets and facilitating cross-border online activity between the 27 members. The introduction of the DSM is aimed at maximising the growth potential of the European Digital Economy.

As these digital trends emerge in different member state economies, they impose a necessity for legislative bodies and government agencies to regulate and legislate for them. Furthermore, this must take place at the same high speed at which the 4IR innovates. Simultaneously, the legal profession is also kept busy reshaping and adapting its services to the Fintech players and accommodating their business objectives. This spirit of evolving as legal professionals raises the novel concept of introducing smart contracts within the European zone; a move which would create extremely fluid commerce.

However, the EC fears that smart contracts may risk fragmenting the DMS, unless a well suited ‘law & technology approach’ is adopted and adapted in each member state’s infrastructure. The EC proposes that a ‘law & technology approach’ will develop the knowledge and understanding which will result in the replacement of prohibitions with opportunities, and problems with possibilities, in the application of smart contracts.

nick szabo
Nick Szabo

 

When did these contracts become smart?

Smart contracts were first introduced by computer scientist Nick Szabo who defined them as a “computerised protocol that executes the terms of a contract”. He explained them by illustrating them as a vending-machine whose manufacturer sets the terms of the machine creating specific functionality when the consumer inserts its coins and automatically goods are released. However, certainty is limited to the trust the customer has in the manufacturer, since the latter party could always change the terms of the vending machine and deceive the customer.

To eliminate any notions of trust dependency by one party to the other, digital ledgers known as blockchain, were adopted. Blockchain’s immutability serves as its greatest functionality, meaning that entries on these types of digital ledgers cannot be modified after they are created. Currently, the most famous blockchains on which smart contracts are being coded, are the Ethereum, Tezos and Stellar. In non-professional terms, smart contracts operate through a network of computers which execute the actions when predetermined conditions have been met and verified. Such actions could include releasing funds to the appropriate parties, registering a vehicle, sending notifications and so forth. Only the parties who have been granted permission can see the results within the blockchain of smart contracts.

Smart contracts meet the ‘common law’ of contracts

Moreover, the digitalisation of smart contracts, and by extension the transactions, have in their initial stages evolved using a combination of Smart Legal Contracts (SLCs), Smart Contract Code, Internal and External Models which theoretically, permits any legal written agreement to be codified, and by extension allowing the whole or part of the transaction to also be digitalised.

Undoubtedly, these processes have inherent drawbacks as well as benefits which are derived as a direct result of automating elements of English contract law, and by extension all common law jurisdictions whose contract law principles originate from English common law, such as Cap.149 Cyprus Law of Contracts. It is worth noting that Cypriot contract law is identical to the Indian Contract Act 1872 (as amended), on the basis that Cyprus was a British colony and has adopted the English and Indian legal systems after its independence from the British. Thus, legal practitioners in Cyprus rely on the fundamental principles of English contract law when the codified contract legislations do not address specific matters, such as the notion of smart legal contracts. Recent reports by the Law Society of England, have studied and affirmed that the principles of contract law will complement and support the emerging technologies of smart contracts almost with no disruption.

For example, the doctrine of certainty, which traditionally assesses that the parties should ensure that the contract’s terms are certain, is naturally guarded through the functionality of immutability by the existence of smart contracts on the blockchain. SLCs are, as traditionally established, written legally binding contracts, where certain clauses are represented by or written in code. Additionally, Smart Contract Code is written to execute certain obligations once the SLC conditions are met, or even to operate as a language between existing smart contracts.

The good, the bad and the ugly

As mentioned above, the presence of blockchain does not allow much scope for misinterpretation or competing interpretations in SLCs. For a transaction which partially occurs off-chain (not on the blockchain), appropriate dispute resolution mechanisms will be able to resolve issues arising from competing interpretations more efficiently than traditional methods. One example would be when, the SLCs will depend exclusively on the computer’s programming which will be final as to whether a condition has been met rather than assessing the parties’ interpretation of a certain contractual term or clause in dispute. Nonetheless, where contractual disputes arise, using novel dispute resolution mechanisms, elements of a dispute may be isolated to be resolved without affecting the overall performance of the agreements.

There is some good to come out of these emerging technologies. First and foremost, SLCs increase accuracy and transparency of contractual terms in the blockchain, with automatic executions facilitating an environment of trust. The standardised SLCs have increased efficiency through their automating performance limiting the need for negotiation of commercial and legal terms.  Even if the SLC is programmed to allow negotiation in transactions, it should be conducted quickly and finalised by making the transactional agreement dependent on variables or computable logic provided by the contracting party. As for concepts, such as the consideration (value of the agreement) of SLCs, these are matters for further research and complex analysis by the competent authorities. It appears that the consideration may be recognised in tokenised form or via objects that can be quickly transferred possibly through a blockchain.

Furthermore, a computer code is definitive, precise and immediate, contrary to traditional written agreements. The automation of the documents, through various inputs and outputs accompanied by an automated generation of an audit trail of transfers of tokens, will enable the fulfilment of contractual terms, passing of ownership of title, and eliminating contractual claim disputes. The digitalised audit trail may also assist in the occurrence of a dispute presenting evidential value.  SLCs may also facilitate escrow mechanisms, or parties can pre-authorise the transfer of funds as part of the Smart Contract Code. SLCs establish the notion of interoperability, whereby contractual data can be imported and exported into an SLC, allowing the users to monitor their contracts and manage risk.

And then we have some bad that comes along in every revolution and every evolution. Many of the above advantages would apply in cases where the SLCs are in standardised form, but such over-automation may restrict the flexibility on provisions the parties may wish to amend, waive, or negotiate from time to time. This may result in unintended risks and frustration of the agreement.  Additionally, full automation is not always possible given that some terms are implied under the Cyprus Law of Contacts, Cap.149 (or English common law of contracts), and by extension the Cyprus Sale of Goods Law 1994 (L.10(I)/1994 as amended from time to time).

Any attempts for these legal parameters to be resolved by automation may result in agreements being unenforceable or failing to reflect the parties’ intention. Digitisation must seek to identify and address contracts or transactions which are highly complex, or one-off transactions contingent on many external parties and factors, that would be best facilitated off-platform. Moreover, the immutability of the blockchain may support certainty of contract, but the inflexibility to amend contracts or waive provisions, may act to the parties’ detriment since they would be unable to prevent or reverse performance of the SLC.

The fact that the SLCs through a Smart Contract Code may simultaneously assess performance, discharge obligations, and authorise the transfer of assets, renders the pre-funding of accounts a necessity. This is due to the automation of movements of value, through specific accounts/smart wallets which are linked to the Smart Contract Code.  But such payment facilities are not applicable in all markets. All the above are considerations the SLCs must soon expand on, by providing application to all these theoretical assessments. Thus, the demand for legislation, regulation, guidance, and code-literacy are key factors which must be satisfied to ensure a smooth transition of  legal services in the 4IR.

 

cysec
Cysec

Lastly, one must address the ugly, the regulatory concerns. In Cyprus, as in every other jurisdiction, there are regulatory authorities that develop policies to combat money laundering; the main Cypriot authorities are the Central Bank of Cyprus, the Cyprus Securities Exchange Commission (Cysec) and the Cyprus Bar Association (CyBar). There is also a special police unit and the Unit for Combating Money Laundering (Mokas) dealing with the investigation and processing of suspicious reports. The Law on Preventing and Combating Money Laundering Act 2007 (188 (I) / 2007) has yet to address the issue of SLCs and any regulations their platform may require. Nonetheless, one of Cysec’s main objectives in 2022 is to establish a “dialogue with businesses providing emerging financial technologies to determine and accelerate their business models in line with CySEC’s commitment to ensuring regulated entities’ investor protection”.

In conclusion, the principles of contract law as we know them will probably continue to operate as they always have, since its principles and doctrines will continue to be examined and assessed in the case of any dispute. However, the changes which we all need to adopt are understanding the platforms in which the contract law principles will come to exist and adapting to the new digital era of law. The legal profession must aim to grasp a “technology + law” approach, which will expand eventually not only to the Digital Single Market but all markets in general. To paraphrase Darwin evolution equals survival.

Christina Anastasiou is a lawyer at Elias Neocleous & Co LLC

 

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