Smart contract enforcement on the blockchain

Part of the appeal of blockchain technologies is the potential that smart contracts have to reduce the transaction and enforcement costs associated with contract performance. A smart contract is a set of code stored on a blockchain that executes the terms of a contract. Because computer code controls contract execution, the parties are not dependent on each other or third parties to validate the terms of the contract or provide the necessary confidence that both parties will perform. As such, the costs associated with contract validation or counterparty work are reduced or even eliminated.

Smart contracts have countless applications. For example, smart contracts can be implemented to handle insurance transactions where the smart contract automates the payment of premiums and will pay out insurance proceeds in the event of a covered event occurring. Or, if an artist creates and sells an NFT, the NFT can include a smart contract that allows the artist to receive a royalty every time the NFT is bought and sold.

Although smart contracts can provide an automated means of ensuring that contracts are executed according to their terms, there are technological and other limitations to the types of contractual relationships that can be automated through smart contracts.

Take, for example, the insurance transaction discussed above. To implement such a smart contract, the smart contract must have a way to communicate with the insured’s bank account to pay premiums and must receive information from an external information provider to know when a covered event occurs so that the insurance proceeds will be paid to the insured .

There is also a risk that the smart contract itself may be incorrectly coded or contain other errors. One need only consider the experience of those who participated in The DAO, a decentralized autonomous organization that allowed participants to invest in user-submitted proposals powered by smart contracts.[1] Errors in the coding of the DAO’s smart contacts allowed a bad actor to transfer about a third of the funds collected by the organization to the bad actor’s account. Given the pseudonymous nature of the Ethereum Blockchain – the blockchain on which the DAO’s smart contracts were built – it was nearly impossible to identify the bad actor and take legal action against them.

The limitations and risks associated with smart contracts and the technology that underpins them highlight the need to put in place adequate safeguards to allow parties to pursue contract enforcement outside of the blockchain. For parties looking to implement contract terms through smart contracts on the blockchain, they should also keep in mind some important considerations for enforcing smart contracts off the blockchain. Some of these considerations are discussed below.

Recognize the limits of smart contracts. Parties should understand the capabilities of smart contracts and their limitations. While smart contracts are good at implementing concepts such as payment of royalties, payment of insurance premiums, and other financial transactions, there are currently limits to what a smart contract can do, at least by itself. Common contract terms such as confidentiality, limitations of liability, force majeure, indemnification, applicable law, and what happens if a party to the contract goes bankrupt or goes bankrupt are more complex and can be difficult to implement in computer code. In addition, there is a risk that a smart contract may be coded incorrectly or otherwise contain incorrect logic. In such a case, the parties will be left with the question of who bears the risk of such a deficiency.

Counterparty identity. Part of the advantage of implementing a smart contract on the blockchain is that it allows two parties to engage in a transaction without either party needing to trust the other to perform: the smart contract will complete a transaction as it was coded, and neither party can interfere with the performance of the contract once it has been performed. However, such a trustless system works to the extent that no disputes or problems arise outside of the correct execution of the smart contract code itself. In the event that a problem arises outside of the execution of the smart contract, it is important to know the identity of the counterparty or counterparties for dispute resolution and contract enforcement.

The DAO experience is one such example of how the lack of counterparty identity can be problematic: participants in the DAO were unable to pursue claims against the bad actor who stole funds from the venture because the identity was unknown. Similarly, other contractual elements, such as confidentiality or force majeure, may be difficult or impossible to enforce if the identity of the counterparty is unknown: suing for breach of confidentiality is impossible if a legal party does not know the identity of the breach.

Written agreements are essential. As mentioned above, there are limits to what a smart contract is capable of, and smart contracts are best implemented after the parties have entered into a separate written contract agreement. A written agreement has the advantage of filling in the gaps that cannot be covered by a smart contract (such as confidentiality or indemnification) and can spread the risk associated with potential errors in the smart contract code.

Moreover, a written and executed contract usually provides undisputed evidence of contract formation: the written agreement makes it clear that there was an offer, acceptance and consideration.

Without a written agreement, the parties may be left to dispute whether a contract was formed and what the terms of this contract are. In this way, a smart contract should only be seen as a tool to implement certain terms in a written contractual agreement easily and efficiently, not as a fully formed legally binding and enforceable contract in itself.

FOOTNOTES

[1] Report of Examination Pursuant to Section 21(a) of the Securities Exchange Act of 1934: DAOSEC (July 25, 2017),