The latest analysis of “smarter contracts” provides helpful guidance on the opportunities and potential legal and practical risks in adopting these technologies.
By Christian F. McDermott, Andrew C. Moyle, and Nara Yoo
LawtechUK’s latest analysis of so-called smarter contracts in the UK, set out in its Smarter Contracts Report (the Report), seeks to identify how technology is transforming contract practices, and to explore future opportunities and innovation. The Report defines a “smarter contract” as a legally binding digital contract, including legally enforceable contracts in which some or all of the terms are represented in code, and identifies a range of smart contract applications, from simple electronic signatures to sophisticated self-executing contracts.
The Report builds on the premise that the current UK legal framework facilitates companies’ use of these smarter contracts, a position that the UK Law Commission broadly adopted. LawtechUK predicts that, on the basis of this robust legal foundation, companies will be eager to benefit from potential improvements in efficiency, value, data, and relationship and risk management, leading to a rapid proliferation of smart contract tools.
Notably, the “smarter contracts” that the UK Law Commission discussed in the Report are different in scope than the “smart contracts” as understood in the crypto industry. There, a smart contract is generally understood as a self-executing program that lays out the terms of agreement and utilises blockchain so that it is immutable and irreversible. As such, a smart contract (as understood in the crypto industry) is not necessarily an enforceable “contract” in the legal sense. By the same token, the “smarter contracts” discussed in the Report are not necessarily blockchain-based, as illustrated by the following diagram:This post focusses on legally binding contracts that use various technologies (which may or may not include blockchain) to define and/or perform the terms of such contracts.
Current UK Legal Framework
The conclusion that the current legal framework supports smarter contracts is explored in detail in LawtechUK’s Legal Statement on Cryptoassets and Smart Contracts by its UK Jurisdiction Taskforce. The UK Law Commission builds on that legal statement in its Smart legal contracts: Advice to Government (the Advice), similarly concluding that current UK laws facilitate and support the use of smarter contracts. Whilst confirming that the law does not, in principle, prevent the use of smarter contracts, the Advice notes a number of practical issues that companies may wish to address in express terms in their smarter contracts to mitigate potential uncertainty, including:
- The role of the code in the smarter contract (i.e., will the code simply perform the contractual obligations, or both define and perform those obligations? What is the role of non-executable comments?)
- Order of precedence of natural language terms and coded terms
- Risk allocation in relation to code errors, inaccurate/malfunctioning data inputs, and misunderstandings as to how the code will perform
- The parties’ choice of law and jurisdiction
- Natural language explanations of the workings of coded terms, to form part of the contract itself
The Report and Case Studies
Against this backdrop, the Report collates 13 case studies of smarter contract applications that are already in mainstream use across business and consumer life (three of which are discussed below). These examples demonstrate that smarter contracts can respond to the real world events as they happen, capture valuable data, link data between systems, minimize manual steps and human error, and enable automatic monitoring and reporting.
However, the Report notes that a lack of harmonised international approach and a need for uptake across the entire chain are seen as major hurdles for any transformative change with smarter contracts. The Report also highlights common risks and barriers to adopting smarter contracts, which include reluctance to change, the requirement of continued data collection, data ownership and privacy, fragmented systems, and integration/operationalisation challenges in the absence of a common/shared infrastructure.
Case Study 1: Contract Automation and Management
Software platforms built in this space help to create contracts as structured data, making them searchable and easy to query individually or at scale and to track important contract metrics, like renewal dates and contract value, and query them in real time. These platforms allow legal teams to automate steps in the contracting process, speeding up time to contract for business and other teams. However, due to various barriers, the Report notes that these platforms are currently applied primarily to simple agreements like employment contracts, rather than complex multiparty legal agreements.
The Report highlights three main barriers/risks. First, digitising conventional, Word/PDF contracts into structured, searchable data requires time, resources, and domain expertise and an understanding of legal terminology. Second, even when documents are digitised, incomplete or missing documents and data can undermine the accuracy of commercial insights. Third, when historic data has been digitised, every new contract should be digitised at the point of creation. Therefore, creating a clear ongoing data digitisation process throughout the contract lifecycle is important.
Case Study 2: Digital Representation and Ownership of Physical Assets
The Report finds that, unlike digital assets that have enjoyed explosive growth, physical assets are often undervalued due to a lack of full, transparent, and reliable information about the asset. The Report highlights two critical issues that limit e-commerce platforms and the digital trade of physical assets: the ability to establish precise identity, provenance, ownership, condition data, and characterization; and processes for creating legally binding and enforceable rights and obligations.
The Report takes as an example Mattereum, a technology enterprise that created an end-to-end smart legal contract ecosystem for the sale, lease, and transfer of rights relating to physical assets. The Report explores Mattereum’s ecosystem with a particular focus on asset passport, protocol, and digital dispute resolution rules (DDRRs).
- Mattereum Asset Passport records a complete data set of descriptors (i.e., provenance or the history of ownership of an item) along with digital copies of the relevant physical documentation. This data is placed on the blockchain, and the appropriate smart contracts are created to support each point of information (also known as certification). Each certification is backed up by a smart contract stating the nature of the indemnity the certifier is willing to place behind their statement, and its accuracy is legally enforceable if demonstrated to be incorrect.
- Mattereum Protocol enables non-fungible tokens (NFTs) to be securely linked to the ownership of physical assets by combining digital smart contracts and asset passports for real-world, physical assets with custody, authentication, dispute resolution, and transaction warranties.
- If there is a dispute, Mattereum is able to arrange for any claims to be dealt with through arbitration, in accordance with and subject to the DDRRs. The DDRRs were published by the LawtechUK UK Jurisdiction Taskforce to facilitate the rapid and cost-effective resolution of commercial disputes, particularly those involving novel technologies, and provide for enforceable arbitral decisions.
Case Study 3: Digital Company
The Digital Company is a project that seeks to create a digital ecosystem in which companies can operate and interact with stakeholders and regulators on a digital and automated basis. The Report uses the Digital Company project as an example to explore various efforts undertaken to digitise the existing corporate form, in order to improve corporate and contracting processes without undermining the protections afforded by UK company law.
One such effort discussed in the Report is Smart Registers, a digital share register composed of registers of shareholders, directors, and people with significant control. Unlike a paper share register, Smart Registers are implemented as a blockchain-based smart legal contract, in which each share is represented by a fungible token and recorded on the digital register. The Report notes that Smart Registers and tokenised shareholding functionality could enable a range of smart contracting use cases.
Another technological solution explored in the Report is a digital infrastructure for private limited companies, currently developed as part of the Digital Company project, that uses documents created in a digital format and smart legal contracts. The Report suggests that this infrastructure would produce a digital framework that progresses a company from being an amalgamation of static paper contracts to a digital form using digital contracts and documents that enables businesses to leverage their data and introduce automated business processes.
In this context, the Report notes that existing corporate law may require further review by the Law Commission and, in some cases, legislative change to accommodate the developments introduced by the Digital Company project.
The Report and the Advice demonstrate a robust foundation in UK law for the use of smarter contracts, and a willingness to proactively address potential legal impediments to the commercial use of the new contracting and legal technologies. LawtechUK predicts rapid growth in smart contracts and other digital contracting tools. Companies exploring smarter contracts in their businesses can expect to see an expanding range of innovative and accessible smarter contract tools, and increasingly established market practices around their use.