Law Commission’s Work on Smart Legal Contracts

On 25 November 2021, the Law Commission published an Advice to Government on smart legal contracts. In this post, we provide a brief overview of our project and our conclusions. We also discuss, as an illustration, an area where the law can be incrementally adapted to support the use of smart legal contracts.

Background to our project

Our work is set against the background of emerging technologies that are increasingly used to create smart contracts—computer programs which run automatically, in whole or in part, without human intervention. These programs may, for example, be used to perform transactions on a decentralised cryptocurrency exchange, facilitate games and run online gambling programs.

In addition, smart contracts can be used to define and perform some or all the obligations of a legally binding contract. Such contracts are increasingly being considered as a means of automating specific processes of conventional contracts. Examples include facilitating ‘DeFi’ or decentralised finance, monitoring service level agreements, and managing supply chains. It is this specific type of smart contract—a ‘smart legal contract’—that is the object of our analysis.

The two main features of a smart legal contract are ‘automaticity’ and ‘legal enforceability’. Automation, however, should be considered on a spectrum. Smart legal contracts can take a variety of forms depending on varying degrees of automation. We identify three main forms of smart legal contracts. First, a smart legal contract may take the form of a natural language agreement with performance automated by code. Second, a smart legal contract may be written solely in (and performed by) code. Third, and in between these two extremes, a smart legal contract may take the form of a hybrid contract, where some contractual obligations are contained in natural language terms and others are recorded in code.

Different forms of smart legal contracts give rise to different legal considerations. Where the degree of automation takes a smart legal contract out of the realm of legal familiarity, novel issues may arise for consideration. Solely coded smart legal contracts, for example, present the most challenges from a contract law perspective, both in terms of whether and when a contract is formed, and how it is to be interpreted.

Our Advice to Government

In our paper, we undertake a detailed analysis of contract law, as it applies to smart legal contracts. We provide an analysis of the ‘lifecycle’ of a contract formed under the law of England and Wales (from formation, to interpretation, through to remedies for breach) and explain how the law might apply to smart legal contracts. We also explore additional questions that may arise where smart legal contracts are offered by traders to consumers, and where courts in England and Wales have to determine whether they have jurisdiction to adjudicate disputes involving smart legal contracts.

Our paper concludes that the current law of England and Wales is clearly able to accommodate and facilitate the use of smart legal contracts. Current legal principles can apply to smart legal contracts in much the same way as they do to traditional contracts, albeit with an incremental and principled development of the common law in specific contexts. In general, difficulties associated with applying the existing law to smart legal contracts are not unique to those types of contracts and could equally arise in the context of traditional agreements.

Our findings extend and elaborate on the conclusions of the Legal statement on cryptoassets and smart contracts issued by the UK Jurisdiction Taskforce (‘UKJT’), which establishes that the current legal framework is sufficiently robust and adaptable to facilitate and support the use of smart legal contracts. The flexibility of our common law means that the jurisdiction of England and Wales provides an ideal platform for business and innovation, without the need for statutory law reform.

Interpreting smart legal contracts—‘the reasonable coder’ test

Contractual interpretation is one of the areas where we think the law needs incrementally to develop in order to provide an appropriate forensic basis for dealing with smart legal contracts.

Contractual interpretation is the process by which a court determines the meaning of the language used by parties in the express terms of a written agreement. In that regard, the courts of England and Wales take an objective approach and do not ask what the parties themselves meant by the language they used. Rather, they ask what the language used would have meant to a reasonable person, equipped with all the background knowledge available to the parties at the time the contract was made (Chartbrook Ltd v Persimmon Homes Ltd [2009] at [14]).

When terms of a smart legal contract are recorded solely or partly in code, potential difficulties may arise. This is because existing principles of contractual interpretation have been developed in response to natural language terms. Computers do not ‘interpret’ but merely execute instructions. As such, it is tempting to conclude that the ‘meaning’ of a coded term is the same as its ‘performance’ or ‘output’. It may therefore be argued that coded terms in a smart legal contract cannot be interpreted or that principles of contractual interpretation are redundant when interpreting such terms.

However, we suggest that coded terms can (and should) be susceptible to contractual interpretation, as there can be a discrepancy between what the code means to the parties, and what its effect is upon execution. It can therefore be important to ascertain the ‘meaning’ of a coded term in a meaningful legal sense.

In our paper, we identify two alternative avenues for ascertaining the meaning of a coded term. The first would be to ask how the term would be understood by a functioning computer. This, however, would entail necessarily conflating the meaning of a coded term with its performance or output. This is unhelpful in situations where a code behaves in ways unintended by parties.

We therefore think a more appropriate test would be to ask what a person with knowledge and understanding of code would understand that coded term to mean. We refer to this second option as the ‘reasonable coder’ test.

Courts are of course already used to receiving expert evidence in relation to, for instance, the meaning of contractual terms drafted in foreign languages. Such expert evidence, however, does not determine the meaning or effect of the foreign language terms: it merely puts those terms in a language the court can understand (see, K Lewison, The Interpretation of Contracts (7th ed 2020), para 5.53). Were an expert coder to do a similar thing with computer code, however, and merely translate it into human language words, the result would be a lot less helpful because the court is likely to remain unfamiliar with the way instructions in code are interpreted by a computer, or with the way a coder might arrange instructions in order to elicit a particular outcome from the running of a code. There is more to understanding computer code, in other words, than just being able to know what all the terms mean.

We propose, therefore, that courts adopt for this purpose the ‘reasonable coder test’, under which the expert coder will explain the effect of certain combinations of words (and coding logic) and give their reasoned opinion as to what the code appeared to them to instruct the computer to do.

We acknowledge that adopting this test entails a nuanced development of the existing principles of interpretation. However, we think that such a development is necessary and justified to take account of the unique nature of contracts written in coded terms. The ‘reasonable coder’ test has the benefit of providing an insight into what the parties intended the code to do, regardless of the computer’s ultimate performance. This is also consistent with the existing approach to contractual interpretation, which imbues the reasonable person with all the background knowledge (including the circumstances and context of the agreement) available to the parties at the time the contract was made (Arnold v Britton [2015] at [17] by Lord Neuberger).

Future work

We also highlight the law of deeds and the private international law rules on jurisdiction as being areas in which we think future work is required in order to ensure that the legal treatment of smart contract technology remains optimal. Both of these are the subject of future Law Commission projects.

In the context of private international law, potential issues arise in determining the location of digital assets, and the location of particular actions that take place on a distributed ledger. We will consider these issues as part of our project on conflict of laws and emerging technology. To learn more about this project, visit the project page here.

Aparajita Arya is a Research Assistant at the Law Commission of England and Wales.