Blockchain – determining the role of contract law in automated transactions

Blockchain has proven to be a game-changing technology with worldwide effects. In addition to use cases such as cryptocurrencies and non-fungible tokens (NFTs), Blockchain has introduced a world where contracts can be embedded in digital code and stored in transparent shared databases, where the terms of the contract are protected from deletion, tampering and revision and their performance is fully automated without the need for human intervention. These contracts are called “smart contracts.”

First proposed in 1994 by Nick Szabo, Smart Contract is a term used to describe computer code that automatically executes all or part of an agreement and is stored on a Blockchain-based platform. Smart contracts represent the latest instance of contract law on digital technology and are meant to bypass – or at least be independent of – the machinery of contract law.

As such, it is not surprising that there have been various claims about how the law (especially contract law) has no role to play in smart contracts. In addition, the lawyer’s role has been reduced to, at best, drafting the standard terms of the contract to be reproduced in the Smart contract.
In this essay, we will examine the correctness or otherwise of this claim and assess the impact that the law plays in Blockchain-based transactions that run on smart contracts.

The nature of smart contracts
Smart contracts solve a years-long challenge that most contracting parties have faced. In most cases, parties cannot act at the same time, so one party risks that the performance will not be reciprocated. Thus, the person who has performed must trust/hope that the other party will fulfill its obligations under the agreement. In case of default or other forms of default, the defaulter is forced to rely on the relief available from the state institutions such as the court, or other alternative dispute resolution mechanisms.

This framework has three challenges, namely: The state does not enforce all agreements; the parties often have to deal with extraneous but unavoidable problems/risks when they turn to the state/court for enforcement; and parties cannot, despite the best efforts of the state/court, get the same result as they would have got if the other party had fulfilled their obligation.

Smart contracts solve the above problems by automating and guaranteeing performance immediately the specified parameters are met. This is done by putting the terms of the contract in code replicated across multiple nodes in a blockchain. Putting the code on the Blockchain ensures that the code/terms benefit from the security, permanence and immutability that a Blockchain offers. This replication also means that as each new block is added to the blockchain, the code is actually executed. If the parties have indicated, by initiating a transaction, that certain parameters are met, the code will execute the step triggered by those parameters. If no such transaction is initiated, the code will not take any steps.

To that extent, questions about whether smart contracts are valid contracts are irrelevant. The very nature of smart contracts ensures that they are always executed when the parameters are met, and therefore questions of whether such contracts are legally enforceable are irrelevant.
To be clear, smart contracts, by their very nature, do not need the government or the court system to enforce their terms. However, this is not to suggest that the consideration of a valid contract is completely irrelevant to a smart contract.

Smart contracts are meant to bypass – or at least be independent of – the machinery of contract law.

Types of smart contracts
Smart contracts can be code-only smart contracts or additional smart contracts. Code-only smart contracts are smart contracts that are created and deployed without any enforceable text-based contract behind them. For example, two parties obtain a verbal understanding of the business relationship they wish to capture and then reduce this understanding directly to executable code.
Conversely, supplemental smart contracts involve the use of smart contracts as a vehicle to implement certain provisions of a traditional text-based contract, where the text itself refers to the use of the smart contract to effectuate certain provisions.
Although legal enforceability may not be a consideration for code-only smart contracts, such enforceability may be critical to the execution of additional smart contracts.

Use cases of smart contracts
The fact that smart contracts offer guaranteed enforcement independent of the whims of states/court systems; effective formation and interpretation of terms; immunity to external interference; and complete respect for the wishes of the parties has led them to adopt various commercial transactions and explains the potential Smart Contracts have for even further adoption as time goes on.
Currently, smart contracts are best suited to perform two types of “transactions” found in many contracts: (1) ensuring the disbursement of funds upon certain triggering events and (2) imposing financial penalties if certain objective conditions are not met.

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Nevertheless, Smart Contracts are also used and can be used for Dynamic NFTS; Betting/gambling transactions; and royalties from the sale of NFTs.
However, the three main limitations to the adoption of smart contracts are the contingent nature of smart contracts, the slowness of processing transactions, and the gas fees required.
The conditional nature of Smart Contracts prevents Smart Contracts from being used/adopted for complex commercial transactions, especially regarding transactions that require subjective judgments. Although a major problem with Blockchain adoption has been the slowness of transactions, newer Blockchain solutions are scaling for speed. With regard to gas fees, before a compiled smart contract can be executed on certain blockchains, an additional step is required, namely the payment of a transaction fee for the contract to be added to the chain and executed. This fee is known as “gas”, and the more complex a transaction is, the more gas must be paid to execute the smart contract.
Despite these limitations, Smart Contracts are expected to see an increasingly high adoption rate.

The role of the law
Perhaps it will be useful to delve into a scenario to illustrate the role of law in a smart contract. A smart contract can be compared to an automated vending machine (“AVM”) that also automates the execution of the terms of the contract. Specifically, AVM automatically releases the selected items when the payment is made (parameters are met).
However, this does not mean that the law has no role to play in the transaction between the buyer and the seller interacting through AVM. The buyer can, for example, still sue for repayment of amounts paid where the released items have expired. In the same way, the buyer/seller can use the law’s means to recover compensation where excess or insufficient items were released to the buyer due to an error by AVM. In addition, the law can order the seller to refrain from delivering certain items in AVM with the risk of prosecution. In essence, although the law does not play a role in the execution of the terms, the law does play a supervisory role in the overall transaction.
The same logic can be applied to Smart Contracts. Specifically, the law may order the reversal of Smart Contract transactions under certain circumstances or order the performance of certain obligations despite the absence of the agreed objective parameters. Some of these conditions are examined below.

1) Presence of harmful elements
The court can order reversal of a Smart Contract transaction where there is a harmful element in the agreement. For example, the Contracts Act requires that a valid contract must not have a harmful element. Aggravating elements include absence of capacity, absence of illiteracy, illegality, etc. For example, a contract for loans, contracts for goods (except contracts for necessities, i.e. goods appropriate to the infant’s state of life at the time of sale and delivery of such goods) and account provided is invalid for an infant. Thus, where an infant contracts for a loan using a smart contract, the court can order a reversal of the transaction.

2) Error in the transaction
The court can order reversal if an error has occurred during the transaction. This could be due to an error in the code of the smart contract, a hack of the blockchain on which the smart contract is written, or even an error from the oracle from which the off-chain information is obtained. The smart contract, due to its automated nature, will enforce the terms of the contract as entered, but the law may later reverse the transaction.

3) The doctrine of quantum meruit
The law can order fulfillment of the terms encoded in a smart contract, even if the objective terms of the contract are not fulfilled in their entirety. A case where this will play out is where a party has substantially performed its obligations under the Smart Contract, but still does not meet the agreed parameters that will trigger enforcement under the Smart Contract due to the actions/inactions of the counterparty; such a party may have an opportunity to go to court and receive some level of compensation under the doctrine of quantum meruit.

Conclusion
Smart contracts are a fascinating development in the commercial transaction sphere. However, an examination of the realities of smart contracts reveals that they are merely an enhancement of already existing structures and, like their predecessors, will require a level of oversight from the law.
The idea that smart contracts are independent of the legal system may seem accurate at first glance; however, a deeper analysis shows that contracts do not end at the point of performance. The performance performed according to a smart contract can be easily undone with the help of the law.
As such, the law in general, and lawyers in particular, still have a central role to play in the enforcement of smart contracts.

Davidson Oturu is a partner and head of the intellectual property and innovation practice group at AELEX, and Agboola Dosunmu is an associate at the firm.