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Legal Risks of Smart Contracts: Enforceability Explained

LegalGPS : Nov. 23, 2024

11:22

Smart contracts are at the heart of many blockchain innovations, promising automation, transparency, and efficiency. But as exciting as they are, smart contracts are still subject to the legal systems of the real world, and understanding their enforceability is crucial. In this blog, we'll explore the legal risks surrounding smart contracts and break down how enforceability works in practice.

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What Are Smart Contracts?

A smart contract is a self-executing piece of code that runs on a blockchain. It automatically executes terms once predefined conditions are met. For example, think of a smart contract as a vending machine—once you insert the money and make your selection, the machine automatically dispenses the item. Smart contracts aim to replace traditional contractual agreements by eliminating the need for intermediaries.

While this technology offers many benefits, such as reducing transaction costs and minimizing trust requirements, it also brings legal challenges that are crucial for users to understand.

Are Smart Contracts Legally Enforceable?

The main question around smart contracts is whether they are legally enforceable. The answer is, "it depends." Enforceability is determined by how well a smart contract aligns with the legal requirements of traditional contracts, such as offer, acceptance, consideration, and the intent to create legal relations.

Key Legal Elements to Consider

Offer and Acceptance: In the traditional sense, a contract is formed when one party makes an offer, and another party accepts it. In smart contracts, the "offer" can be the conditions encoded in the smart contract, and the "acceptance" occurs when the counterparty initiates the transaction. However, translating this into legally recognized intent can be challenging, especially across different jurisdictions.

Example: Imagine a smart contract for renting an apartment. The offer is encoded in the contract with conditions like rent amount, duration, and deposit. When the potential tenant agrees to these terms and sends the required payment, the smart contract automatically executes, indicating acceptance. However, ensuring both parties fully understand and legally accept these terms can be challenging, especially if one party is unaware of the contract's legal implications.
Consideration: Consideration refers to something of value exchanged between parties. Smart contracts often facilitate the exchange of cryptocurrencies or tokens, which can fulfill this requirement. But it's essential that both parties understand what they're agreeing to and that the value exchanged is legitimate under applicable law.

Example: In a smart contract facilitating freelance work, the consideration could be the cryptocurrency paid to a developer for their services. Both parties must ensure that the payment is legal within their jurisdictions and that they agree on the value being exchanged.
Capacity and Intent: To be enforceable, the involved parties must have the legal capacity (e.g., they are not minors, mentally incapacitated, etc.) and the intent to create a legally binding relationship. Since smart contracts are digital and often pseudonymous, proving capacity and intent can be problematic. The anonymity in blockchain networks complicates the identification of parties, which could lead to disputes if things go wrong.

Example: If a minor enters into a smart contract, their legal capacity to contract is questionable, potentially rendering the contract unenforceable. Verifying age and identity on a blockchain can be difficult, increasing the risk of disputes.
Certainty of Terms: The terms of the contract must be clear and understandable. Smart contracts are written in code, and unless both parties are proficient in reading and understanding that code, disputes may arise over misunderstandings about what the code was meant to do.

Example: If a smart contract is designed to execute a payment based on certain performance metrics, but the metrics are not clearly defined or are ambiguously coded, it could lead to disputes regarding whether the terms were properly met.

Legal Risks of Smart Contracts

1. Code Vulnerabilities and Bugs

One of the most significant legal risks associated with smart contracts is the presence of coding errors. A bug or vulnerability in the code can result in unintended consequences, such as funds being locked or lost. Since smart contracts execute automatically, there is often no recourse to correct an issue after it has occurred.

Example: In 2016, the DAO (Decentralized Autonomous Organization) experienced a significant hack due to a vulnerability in its smart contract. Millions of dollars worth of cryptocurrency were stolen, and this incident highlighted the risks of relying on immutable code without a safety net. This incident led to a controversial hard fork of the Ethereum blockchain to recover the stolen funds, demonstrating the complexity and risks involved.

2. Jurisdictional Issues

Smart contracts operate on a decentralized network, meaning they can involve parties from multiple jurisdictions. Different countries have different contract laws, making it difficult to determine which jurisdiction's rules apply if a dispute arises. This ambiguity can make enforcement challenging, as one jurisdiction may not recognize or enforce a smart contract formed in another.

Example: Suppose a smart contract is executed between a party in the United States and a party in Germany. If a dispute arises, which country’s contract laws apply? The lack of a clear jurisdictional framework can make resolving disputes cumbersome and expensive, often requiring complex legal navigation.

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3. Lack of Legal Recourse

Traditional contracts offer the possibility of judicial intervention if one party fails to fulfill their obligations. With smart contracts, the automatic execution of code means that transactions happen without manual oversight, making it difficult to seek legal recourse once the contract executes. This "code is law" philosophy can be problematic if one party believes they have been wronged but has no practical way to reverse or amend the outcome.

Example: Imagine a smart contract for the automatic delivery of digital goods once payment is received. If the digital goods are defective or not as promised, the buyer has no way to halt the transaction or get a refund once the contract executes, as there is no intermediary to manage disputes.

4. Regulatory Uncertainty

Smart contracts often fall into a regulatory gray area. Different jurisdictions have varying views on whether smart contracts constitute legal contracts at all. For instance, some countries may treat them as legally binding, while others may not recognize them in court. Regulatory frameworks around blockchain and smart contracts are still evolving, which adds another layer of risk.

Example: In the European Union, the regulatory landscape for blockchain and smart contracts is evolving, with the EU’s Digital Finance Strategy aiming to address the legal standing of smart contracts. However, until comprehensive regulations are in place, the enforceability of smart contracts across EU member states remains uncertain.

How to Mitigate Legal Risks

1. Legal Review of Code

It's crucial to have a professional legal review of the smart contract code, ideally by someone who understands both the legal and technical aspects of the agreement. This review can help ensure that the contract meets legal standards and that both parties understand the terms encoded.

Example: A legal expert can collaborate with a blockchain developer to ensure that the encoded terms comply with contractual obligations and are consistent with the parties' intent. This collaboration can help identify any potential issues in the code that could lead to disputes or legal challenges.

2. Hybrid Contracts

Consider using a hybrid approach that combines traditional written contracts with smart contracts. A traditional contract can outline the parties' intentions, while the smart contract automates specific aspects of performance. This dual approach can provide additional legal clarity and fallback options in case something goes wrong with the code.

Example: A real estate transaction could use a traditional contract to outline the terms of the sale, including contingencies and dispute resolution clauses, while a smart contract handles the automated transfer of funds once the property title is verified. This ensures that the legal relationship is clearly defined while benefiting from the automation of certain aspects.

3. Clear Dispute Resolution Terms

Including dispute resolution clauses within a traditional contract can help mitigate jurisdictional issues. These clauses can specify which laws govern the contract and how disputes will be handled, providing more certainty for both parties.

Example: A smart contract for an international trade agreement could include a clause stating that any disputes will be resolved through arbitration in a specific jurisdiction. This provides a clear path for resolving issues, even if the smart contract itself is decentralized.

4. Testing and Audits

Before deploying a smart contract, conduct extensive testing and hire third-party auditors to review the code. A thorough audit can help identify vulnerabilities or bugs that could pose legal or financial risks down the line.

Example: Blockchain security firms like CertiK and Quantstamp offer auditing services that evaluate smart contract code for potential vulnerabilities. Having a smart contract audited by such firms can provide greater confidence in its reliability and reduce the risk of costly errors.

Wrapping Up

While smart contracts offer significant benefits in terms of automation, efficiency, and trust reduction, they come with unique legal risks that cannot be ignored. Enforceability depends on aligning the code with traditional legal principles, and parties should be aware of potential vulnerabilities, jurisdictional challenges, and the lack of traditional legal recourse.

To navigate the legal complexities, consider combining smart contracts with traditional written agreements, seek legal and technical reviews, and always include dispute resolution mechanisms. Additionally, understanding the regulatory environment and proactively working with experts to mitigate risks can help ensure your smart contract doesn't become a liability.

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