Negotiation and drafting considerations
Smart Contracts and the blockchain technology they use are hot topics in almost every industry sector. In this article, we explain what Smart Contracts are, the types of dispute that may arise when code and contract law intersect, and the role arbitration can play in resolving them.
What are Smart Contracts?
Despite the hype, there is a lack of understanding about what Smart Contracts are and how they work. The best description of a Smart Contract is: “a set of promises, specified in digital form, including protocols within which the parties perform on these promises” (Nick Szabo, Smart Contracts: Building Blocks for Digital Markets, 1996).
A drinks vending machine is a straightforward, early example embodying the characteristics of a Smart Contract. When money is paid, an irrevocable action is put in motion. Money is retained and a drink is vended. The transaction cannot be stopped in the middle of the process. The terms are, in a sense, embedded in the hardware and software that runs the machine.
A more recent example is a Smart Contract for a flood insurance policy, linked to a feed of precipitation data from the Met Office. When the data feed shows the threshold is met, the policy automatically pays out claims.
The key characteristics of the modern conception of a Smart Contract are
- Digital: it is in computer form – code, data and running programs.
- Embedded: contractual clauses (or equivalent functional outcomes) are embedded as computer code in software.
- Performance mediated by technological means: the release of payments and other actions are enabled by technology and rulesbased operations.
- Irrevocable: once initiated, the outcomes for which a Smart Contract is encoded to perform cannot typically be stopped (unless an outcome depends on an unmet condition).
Corporates and financial institutions are developing a vast range of uses, from issuing and transferring securities, clearing derivatives, tracking the ownership of commodities for trade finance transactions, arbitraging energy consumption to passenger identity verification and ticketing.
Smart Contracts lie on a spectrum
- A contract may be written entirely in code.
- A contract in code with a separate natural language version.
- A hybrid or split model e.g. a contract in code incorporating by reference the terms of a natural language master agreement.
- A natural language contract with some encoded performance e.g. the payment mechanism.
Today’s Smart Contracts are implemented in platforms that rely on what is referred to as distributed ledger technology (DLT) or often blockchain. DLT and blockchain enable parties (e.g. counterparties, banks, regulators and/or auditors) to come to a consensus over a shared set of facts.
In very simple terms, a blockchain operates as follows
- Identical copies of a ledger database are shared amongst a community of participating computers, called nodes.
- When a party wants to execute or record a new transaction, a request is sent to the network, where it is received for processing by the nodes.
- A consensus algorithm, administrator or sub-group of participants determines whether the request received is authentic.
- If so, the ledger is automatically updated with new “blocks” of data.
Some DLT platforms can also run programmes on each of the network nodes that use or add to the data on the ledger. Smart Contracts are implemented using these programmes. For example a blockchain may record ownership of a digital currency and a Smart Contract could include code that automatically transfers an amount of that digital currency to another account on the blockchain on the occurrence of a specific event.
Smart Contract disputes risks
Many technologists believe that Smart Contracts replace contract law and courts and tribunals with code. There is a misconception that, because they perform automatically and performance cannot be stopped, they remove the potential for disputes. At least for the moment, this is wishful thinking. Although Smart Contracts provide huge potential benefits in terms of reducing transaction costs and increasing security, disputes can and will arise. In fact, the intersection of contract law and code creates new areas of potential dispute.
- Is the Smart Contract legally binding? In many common law jurisdictions, a contract can only be valid if it is entered into by a person (i.e. a human or legal person, such as a corporation) with legal capacity to do so. There is also common law authority (for example, in English law) that a contract cannot arise unless there is sufficient certainty over who the contracting parties are. Some civil law jurisdictions lay down other legal requirements for the formation of a legally binding contract.
- Coding errors may cause unexpected performance issues.
- There may be discrepancies between coding and natural language versions of a Smart Contract.
- Parties may want to terminate a Smart Contract for repudiatory breach or unwind it on the grounds of misrepresentation, mistake or duress.
- Subsequent changes of law or regulation (e.g. sanctions) may make performance of the Smart Contract illegal.
- Smart Contracts may perform on the basis of an inaccurate data feed.
Why include an arbitration clause?
Smart Contracts give rise to a number of dispute resolution challenges that make including a robust dispute resolution system key.
Difficulty identifying someone to sue
Smart Contracts can be executed pseudonymously. In those cases, it may be difficult to identify someone to bring a claim against. There may also be evidential difficulties in pinpointing who is responsible for loss that is caused by bugs in the operating system, corrupted messages or defective code.
Uncertainty over jurisdiction and governing law
As Smart Contracts operate via distributed nodes (computers) which may be based all over the world, it may be difficult to determine the applicable governing law and jurisdiction; it also increases the risk of satellite disputes over such issues.
Novel enforcement issues
One of the key characteristics of a Smart Contract, and what many see as an advantage, is that they are irrevocable and the transaction is indelibly recorded on the blockchain. However, this creates problems when a party is entitled to terminate or unwind a transaction and the record no long reflects the legal position.
Arbitration is likely to emerge as the preferred means of resolving Smart Contract disputes for a number of reasons, and Smart Contract disputes will, in turn, drive innovation within arbitration, as arbitral bodies and arbitration law and procedure adapt to meet the needs of new types of dispute.
Protecting proprietary information
Some Smart Contract disputes are likely to involve evidence about proprietary software and/or hardware. Where that is a risk and the source code and other proprietary information becoming public may have material commercial ramifications for one or both of the parties, it is preferable to agree that disputes will be resolved by confidential arbitration and to limit disclosure.
Tribunal with specialist technical knowledge
Some Smart Contract disputes will be fairly vanilla contract law disputes, but others will be of a highly technical nature, for example, where the code does not operate as expected. The courts in many jurisdictions are adept at getting up to speed with technical issues quickly, but the parties to a Smart Contract can agree an arbitration clause which enables them to appoint someone with, for example, an understanding of coding. The arbitral institutions are likely to develop specialist pools of arbitrators with relevant experience or published blockchain-tailored procedures over time.
Bespoke procedures and automated enforcement
Arbitration offers parties the potential to agree bespoke procedures that may help overcome the challenges presented by pseudonymity and the irrevocable nature of Smart Contracts. For example, the parties may agree to refer disputes below a certain threshold to a central blockchain administrator with the power to determine disputes and insert remedial transactions into the blockchain as necessary. Technologists are going a step further and looking at the idea of decentralised arbitration, whereby disputes in relation to Smart Contracts are referred to arbitrators selected at random, and their decision is then recorded on the blockchain.
A variation on this is where parties to a Smart Contract incorporate into the Smart Contract an agreement to refer disputes to arbitration and a mechanism to allow the arbitrator automatically to enforce any award without the intervention of a third party. For example, the “multisig” mechanism enables the parties collectively to nominate an arbitrator, which then triggers the power of that arbitrator to transfer assets or money on the blockchain.
Drafting arbitration clauses
Smart Contracts raise some interesting drafting considerations in respect of arbitration clauses.
Consent to arbitrate
Parties should ensure that they can establish consent to the arbitration agreement. This may be an issue in circumstances where the Smart Contract is entered into by a computer, is in code and/or and does not create legally binding contractual obligations under the applicable law.
Given the distributed nature of blockchain and the operation of Smart Contracts, it is important to agree a seat for the arbitration to avoid satellite disputes about the applicable seat and/or procedural law. Parties should check that the law of the chosen seat does not render a Smart Contract illegal or unenforceable, that the disputes likely to arise are arbitrable (in some jurisdictions for example, intellectual property disputes are not arbitrable), and that the codified arbitration agreement in question will be upheld and enforced by the supervisory courts.
Appointment of arbitrator(s)
Parties should weigh the importance of having a tribunal familiar with the technology against the importance of having the dispute decided by experienced contract lawyers. There is likely to be relatively little overlap between the two, so requiring both skill sets risks restricting the pool of potential arbitrators to such an extent that the arbitration agreement becomes unworkable in practice.
Formality requirements and enforceability of awards
Parties should ensure the arbitration agreement meets any formality requirements under the governing law of the arbitration agreement and Smart Contract, the law of the seat and wherever the award is likely to be enforced. For example, an arbitration agreement in code, or incorporated by code, may not meet the requirements for writing under the New York Convention 1958.
A common mistake by parties is to assume that arbitration is by default confidential. That is not the case in all jurisdictions. If a desire for confidentiality is important, the parties should expressly agree in the arbitration agreement that they will keep the arbitration, together with all materials created and all documents produced in the proceedings confidential, except to the extent required for enforcement.
For an in depth analysis of Smart Contracts and blockchain technology, see our publications: