The Law Applicable to Smart Contracts, or Much Ado About Nothing?

The question of how people can trade with each other independently of national laws is a question that has kept philosophers, economists and lawyers busy for centuries. In recent years, the discussion has been fuelled by the phenomenon of digitalisation and, in particular, by the emergence of smart contracts. Those contracts enable automated execution of agreements without the need for a central authority or an external enforcement mechanism. And many authors claim that smart contracts, especially when stored on and enforced via a blockchain, will make traditional contract law obsolete.

However, as things stand at the moment the initial hopes that smart contracts will free the exchange of goods and services from national laws do not seem to come true. Indeed, the classic questions of contract law arise also when parties enter into a smart contract. And just like all other contracts, smart contracts demand that the law answers them. The decisive question, therefore, is not whether smart contracts are subject to the law, but rather to which law they are subject. Which law regulates the effective formation of a smart contract? Which law determines whether a particular contractual term is fair? Which law governs the consequences of a breach of contract?

Traditionally, the question  of which law applies to a contract is determined by the provisions of private international law. As an area of law that looks back on almost 1000 years of history and that is, today, firmly anchored in the legal systems of almost all states, it assigns cases that have a connection to different states to a specific legal system with the help of choice of law rules. So, how does private international law deal with smart contracts? Are the traditional rules of private international law able to assign smart contracts to a particular legal system? And do they do so in a predictable manner? In this post I argue that the answer is yes.

Rome I Regulation

The most important instrument that determines the law applicable to international contracts in the European Union is the Rome I Regulation. By virtue of its Article 1 it covers almost all contractual obligations in civil and commercial matters. As a consequence, there can be little doubt that it also covers smart contracts. However, there is one important qualification: the Rome I Regulation applies only to contractual obligations in a legal sense. A smart contract is—at least in most cases—merely a piece of software or programme code that controls, monitors, or documents the execution of a contract that has been concluded elsewhere. The Rome I Regulation will, therefore, usually not apply to the smart contract as such, but ‘only’ to the contract which it helps to execute. Direct application of the Rome I Regulation to the smart contract, however, will be possible if the smart contract itself is legally binding. This, in turn, may be the case if software and code is used for the conclusion of the contract and if the contract is comprehensively and exclusively embodied in a software code.

Party autonomy

If and to the extent that the Rome I Regulation applies, the applicable law is first and foremost determined through the principle of party autonomy. Embodied in Article 3 Rome I Regulation, it allows parties to submit their contract to the law they want—and without requiring a territorial connection to that law. As regards smart contracts—which operate in a virtual and, as the case may be, decentralised environment—the principle of party autonomy is, therefore, able to provide much needed legal certainty.

It is hard to see, however, how a choice of law can be represented in algorithmic fashion (‘if-this-then-that’). As a consequence, it seems that it cannot be directly incorporated into a smart contract, but must be declared otherwise. The most straightforward way to do so is an express choice of law. It can be part of the contract which is executed with the help of the smart contract, or it can be enshrined in a separate declaration. In addition, a choice of law can also be implied. A smart contract or the contract that it serves to execute may, for example, be so obviously tailored to a particular legal system that it can be assumed that the parties wanted the contract to be governed by this law. However, Article 3(1) Rome I Regulation places high demands on an implied choice of law: it must be ‘clearly demonstrated’ by the terms of the contracts or the circumstances of the case and there must be evidence that the parties actually had the will to choose the applicable law. In many cases, a choice of law will, therefore, be missing. Yet this is nothing special—and nothing that can only occur when parties conclude a smart contract.

Closest connection and characteristic performance

If the parties have not chosen the applicable law, Article 4 Rome I Regulation comes into play. It subjects contracts to the law of the closest connection and determines the applicable law with the help of a complex combination of specific choice of law rules, residual choice of law rules, and escape clauses. In most cases this combination will lead to application of the law of the habitual residence of the party required to effect the characteristic performance. Smart contracts that execute, for example, sales and service contracts will, therefore, usually be governed by the law of the country where the seller or the service provider is habitually resident. And since parties only have one habitual residence, this seems a good way to assign smart contracts to a particular legal system if the parties have not done so through a choice of law.

Of course, this is not to say that application of Article 4 Rome I Regulation and especially the characteristic performance principle will never cause any difficulties. For example, it may happen that the habitual residence of the relevant party cannot be determined because the smart contract is processed anonymously via a blockchain. The law of the closest connection will then have to be determined in accordance with Article 4(4) Rome I Regulation by taking into account all circumstances of the case. It goes without saying that this will not always be an easy task.

Protection of weaker parties

A review of the Rome I Regulation would be incomplete without a brief look at Articles 5 to 8 Rome I Regulation. These provisions contain specific choice of law rules for carriage contracts, consumer contracts, insurance contracts, and employment contracts. They modify both Article 3 and Article 4 Rome I Regulation to protect weaker parties. However, as a matter of principle they also call for application of the law chosen by the parties or, in the absence of a choice, the law of the habitual residence of one of the parties. Where the parties have not chosen the applicable law, carriage contracts are, therefore, usually governed by the law of the passenger’s habitual residence, consumer contracts by the law of the consumer’s habitual residence and insurance contracts by the law of the policyholder’s habitual residence. Just like Articles 3 and 4 Rome I Regulation, the special choice of law rules of Articles 5 to 8 Rome I Regulation, thus, rely on connecting factors which allow for fairly straightforward determination of the applicable law even if the contract in question, is fully or partly executed with the help of a smart contract.

Conclusion

Smart contracts are said to change the way we trade goods and services. And they are said to pose numerous challenges for the law. As this post has demonstrated, determination of the applicable contract law is not one of them. To be sure, smart contracts, especially if they are processed via a blockchain, may have connections to a large number of jurisdictions. However, it will usually be possible to assign a smart contract to a particular legal system because the Rome I Regulation does not rely on the place of formation or the place of performance to determine the applicable law, but resorts to connecting factors, namely party choice and habitual residence, which work reasonably well in a globalised and digitalised society.

A completely different question is, of course, whether the law applicable by virtue of the Rome I Regulation offers a suitable legal framework for smart contracts. However, we can expect that parties will increasingly make use of their right to choose the applicable law in accordance with Article 3 Rome I Regulation and, hence, make a judgment about the quality of the applicable law by voting ‘with their feet’. In the long run, private international law will, therefore, not only determine the law applicable to smart contracts and thereby foster legal certainty. It will also reveal which law is best equipped to meet the challenges of digitalization in the eyes of the parties. And this, in turn, may inform domestic law reform processes and eventually lead to better laws for smart contracts.

Giesela Rühl is a Professor of Private International Law and (Co-)Director of the Centre for European Studies at the Friedrich Schiller University in Jena.

The above post is based on the author’s contribution ‘Smart contracts – Welches Recht gilt?’ in T Braegelmann and M Kaulartz (eds), Smart Contracts (C.H. Beck 2019).