London Calling: The Clash of Smart Legal Contracts?

Key Points:

  • UK advised Smart Legal Contracts can work within the current legal framework
  • Smart legal contracts may pose risks with identity, remedies, and term certainty
  • Smart legal contracts must cater for disputes and recourse actions
What are smart legal contracts (SLCs)?

SLCs come in various forms: ranging from contracts written in natural language supported by automatic performance of terms through code; through to contracts with terms wholly defined in code that automatically execute without human intervention. 

Why the fuss?

Automatic execution of contracts is not new e.g automated banking and card payments, electronic property settlement and electronic highway tolls. However, the game changer is the ability to execute SLC using the blockchain or other distributed ledger technology.

What is blockchain or distributed ledger technology (DLT)?

Blockchain or DLTs may be public (permissionless) such as Bitcoin as the widely-known example, or private (permissioned) where participants require authorisation to participate. Blockchain networks permit highly secure and peer to peer data transmission between parties unknown to each other, without using intermediaries. Unlike traditional platforms, records are not stored in a central database or location but are instead distributed across the network. Clever consensus algorithms agree when valid records should be added to the network using timestamped blocks with advanced encryption; resulting in an immutable chain of records that cannot be altered or deleted, and allegedly impossible to hack.

The execution of SLC can leverage blockchain benefits using the peer-to-peer architecture (without any intermediaries). Transactions are highly secure against hackers, stored as a permanent, immutable record that cannot be modified or deleted.

UK findings

The UK report assessed SLCs against the traditional legal elements of a contract. Some concerns were highlighted, especially SLCs existing wholly as code:

First, the inability to identify counterparties, for contract offer and acceptance, is problematic for dispute resolution or recourse actions. Blockchain’s strength is the ability to scale trust through unknown, unidentified transacting parties.

Secondly, contract terms may be subject to uncertainty. Misunderstandings over contract terms occur within traditional, natural language contracts. Deciphering terms coded in software written by a developer may prove harder. Computers tend to execute exactly as they are instructed which may lead to unexpected results and incorrect outcomes – commonly known as defects. Also, when considering consumer SLC, software terms may not be transparent for consumers, giving rise to potential unfair terms.

Thirdly, some natural language terms are difficult to translate into machine code. For example, “reasonable”, “good faith” are imprecise terms. The report suggests that judicial assessment may require introducing the ‘reasonable coder” test in addition to the “reasonable person” if a court were to make a judgment on software terms.

Fourthly, contracts remedies are problematic. Voiding or unwinding contracts are not possible if they exist as an unchangeable blockchain record. Further, stopping their execution may be impossible once launched on the blockchain. The report suggests courts adhere to ‘practical justice” between the parties regarding recission. For example, executing an equal but reverse transaction to nullify the effects of the initial transaction, even though the transaction cannot not be strictly voided from the beginning.

Finally, identifying a legal jurisdiction may be difficult where parties’ identities and locations are not known. Typical investigations to deduce the applicable location such as place of formation, relevance of parties to determine jurisdiction, may not be feasible.

UK Guidance

The report provides some guidance in mitigating risk for parties entering a SLCs, including:

  1. Consider the form of contract; the use of natural language, code or a hybrid
  2. Consider whether code defines and performs contractual obligations; or only performs them.
  3. Consider the precedence for definition of terms between natural language and code
  4. Consider an accompanying document written in natural language to define terms or context of contract
  5. Cater for external events and failures affecting SLC execution, such as reliance on oracle inputs, system upgrades or defect fixing
  6. Confirm the role of non-executable comments in code (similar to use of headings in natural language contracts).
  7. Consider incorporating software ‘kill switches’ to terminate contract execution if required.
  8. Parties to incorporate choice of law either in code or separate legal agreement written in natural language

The lure of SLCs may prove hard to resist with promises of efficiency for digital transactions. However, as with any disruptive technology, opportunities abound but not without risk. Insights into current gaps and shortfalls may help position to better manage disputes and losses arising in an increasingly online world leaning toward SLCs.

Quincy is an experienced commercial lawyer with a particular focus and expertise in information and communication technology and intellectual property matters.

Please contact Hicksons Partner, Quincy Wong, at [email protected]u if you need any assistance or guidance.

Post by Hicksons' Partner, Quincy Wong, and Solicitor, Stephen Penzo.

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