Smart Legal Contracts Advice To Government

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Smart legal contractsAdvice to GovernmentCP 563Law Com No 401

Smart legal contractsAdvice to GovernmentPresented to Parliamentby the Lord Chancellor and Secretary of State for Justiceby Command of Her MajestyNovember 2021CP 563

Crown copyright 2021This publication is licensed under the terms of the Open Government Licence v3.0 exceptwhere otherwise stated. To view this licence, visit /version/3.Where we have identified any third party copyright information you will need to obtainpermission from the copyright holders concerned.This publication is available at enquiries regarding this publication should be sent to usat 978-1-5286-3007-8E0269405911/21Printed on paper containing 75% recycled fibre content minimumPrinted in the UK by HH Associates Ltd. on behalf of the Controller of Her Majesty’sStationery Office

The Law CommissionThe Law Commission was set up by the Law Commissions Act 1965 for the purpose ofpromoting the reform of the law.The Law Commissioners are:The Right Honourable Lord Justice Green, ChairmanProfessor Sarah GreenProfessor Nicholas HopkinsProfessor Penney LewisNicholas Paines QCThe Chief Executive of the Law Commission is Phil Golding.The Law Commission is located at 1st Floor, Tower, 52 Queen Anne's Gate, LondonSW1H 9AG.The terms of this paper were agreed on 13 October 2021.The text of this paper is available on the Law Commission's website s/.i


ContentsGLOSSARYVABBREVIATIONSIXCHAPTER 1: INTRODUCTION1Smart legal contracts1This project2Structure of the paper4Conclusions and future work5Acknowledgements and thanks7The team working on the project7CHAPTER 2: WHAT IS A SMART LEGAL CONTRACT?An introduction to code88Features of a smart legal contract11Oracles21The forms a smart legal contract can take22Use cases for smart legal contracts30Costs and benefits of smart legal contracts35CHAPTER 3: FORMATION OF SMART LEGAL CONTRACTS39The law on contract formation39Agreement39Consideration49Certainty and completeness50Intention to create legal relations54Formality requirements57Legislating to confirm the validity of smart legal contracts?71CHAPTER 4: INTERPRETATION OF SMART LEGAL CONTRACTS74The principles of contractual interpretation74Identifying the terms of a smart legal contract76Applying the principles of interpretation to smart legal contracts78Natural language aids to interpreting coded terms88iii

Implied terms94Is the courts’ current approach to interpretation problematic?97CHAPTER 5: REMEDIES102Rectification103Vitiating Factors111Remedies where the contract has been vitiated128Breach of contract132Power of the court to suspend performance of the code pending a dispute143UKJT Dispute Resolution Rules146Frustration148Illegality153CHAPTER 6: CONSUMERS AND SMART LEGAL CONTRACTS156B2C smart legal contracts156Consumer protection and smart legal contracts157Use cases for B2C smart legal contracts163CHAPTER 7: JURISDICTION AND SMART LEGAL CONTRACTS166Introduction166The applicable private international law rules166Contracting parties and the circumstances of contract formation170Applicable law178Performance, breach, acts, and enrichment190Jurisdiction rules for special types of contracts195Comparative appropriateness196The most problematic jurisdictional rules and issues, including digitallocation198APPENDIX 1: TERMS OF REFERENCE202APPENDIX 2: ACKNOWLEDGEMENTS205APPENDIX 3: A NON-EXHAUSTIVE LIST OF ISSUES PARTIES MAYWISH TO PROVIDE FOR IN THEIR SMART LEGAL CONTRACT211iv

GlossaryTermDefinitionAlgorithmA set of mathematical instructions that must be followed in a fixedorder and, if given to a computer, will calculate an answer to amathematical problem.BitcoinA type of cryptocurrency which is supported by blockchain.Bitcoin blockchainor networkA blockchain which records transactions in the bitcoin cryptocurrency.BlockchainA method of recording data in a structured way. Data (which may berecorded on a database or ledger) is usually grouped intotimestamped “blocks” which are mathematically linked or “chained” tothe preceding block, back to the original or “genesis” block.CodeA language used to give instructions to computers.ComputerprogramA collection of instructions written in code that are executed by acomputer.ConsensusmechanismThe process by which participants on a DLT system reach consensusthat a new data entry should be recorded on the ledger. Theconsensus mechanism is set by the software underlying the DLTsystem.CryptoassetA digital asset created or implemented using cryptographictechniques.CryptocurrencyA form of cryptoasset which is used as a medium of exchange on aDLT system. Bitcoin and Ether are examples of cryptocurrencies.Distributed ledgerA digital store of information or data. A distributed ledger is shared(that is, “distributed”) amongst a network of computers (known as“nodes”) and may be available to other participants. Participantsapprove and eventually synchronise additions to the ledger throughan agreed consensus mechanism.v

Distributed ledgertechnology(“DLT”)Technology that enables the operation and use of a distributedledger.EtherThe native cryptocurrency of the Ethereum network.EthereumA blockchain based, permissionless, public DLT system.Fiat currencyCurrency that is issued by a government and is accepted to havevalue independently of the material from which it is made.Hybrid contractA smart legal contract, some terms of which are defined in naturallanguage and other terms of which are defined in the code of acomputer program. Some or all of the contractual obligations areperformed automatically by the code. In addition, the samecontractual term(s) can be written in both natural language and incode.MiningThe process by which participants on a DLT system solve acomputationally intensive mathematical problem so that data can beadded to the distributed ledger. Mining is typically a feature ofpermissionless DLT systems, which require participants to solvemathematical problems as part of the consensus mechanism.Permissioned DLT systems may use different consensusmechanisms, and so may not necessarily involve mining.Natural languageLanguage that has developed in the usual way as a method ofcommunicating between people, rather than language that has beencreated for a specific purpose or application.Natural languageA contract in which all of the terms are recorded in natural language,contract/traditional either orally or in writing.contractNodeA participant in a DLT system.Off-chain / onchain“Off-chain” refers to actions or transactions that are external to thedistributed ledger or blockchain. “On-chain” refers to actions ortransactions that are recorded on the distributed ledger or blockchain.OracleAn external data source which transmits information to a computerprogram.PermissionedRequiring authorisation to perform a particular

PermissionlessNot requiring authorisation to perform a particular activity.PermissionedDLT systemA DLT system in which authorisation to perform a particular activityon the system is required.PermissionlessDLT systemA DLT system in which authorisation to perform a particular activityon the system is not required.Private DLTsystemA DLT system which is accessible for use by a limited group ofparticipants.Private keyA string of data that is unique to a participant on a distributed ledgerand is known only to the participant. A participant can digitally sign atransaction by combining the transaction data with their private key.PseudonymityThe practice of using a false or fictitious identifier which conceals aperson’s real identity.Public DLTsystemA DLT system which is accessible for use by the public.Public keyA string of data that is unique to a participant on a distributed ledgerand is shared with other participants. A participant’s public key can beused by the recipient of a transaction to confirm the authenticity of thetransaction.Smart contractComputer code that, upon the occurrence of a specified condition orconditions, is capable of running automatically according to prespecified functions.Smart contractplatformA DLT or other network upon which a smart contract may bedeployed.Smart legalcontractA legally binding contract in which some or all of the contractualterms are defined in and/or performed automatically by a computerprogram.There are essentially three forms a smart legal contract can take,depending on the role played by the code. These are: natural language contract with automated performance; hybrid contract; or solely code contract.vii

Solely codecontractA smart legal contract in which all of the contractual terms are definedin, and performed automatically by, the code of a computer program.TokenA type of digital asset. A token typically represents something elsethat exists either digitally or physically.UKJT LegalStatementUK Jurisdiction Taskforce, Legal statement on cryptoassets andsmart contracts (2019).Unilateral contractA contract where one party (the offeror) makes a promise in return forperformance by the other party (the offeree), but the offeree does notpromise to perform so that only the offeror is bound under thecontract. The contract forms when the offeree fulfils the specifiedcondition.viii

AbbreviationsAbbreviationMeaning1967 ActMisrepresentation Act 19672019 reportElectronic Execution of Documents (2019) Law Com No xecution-ofdocuments/AESAdvanced electronic signatureCCRsThe Consumer Contracts (Information, Cancellation and AdditionalCharges) Regulations 2013, SI 2013 No 3134CJEUCourt of Justice of the European UnionCPRsThe Consumer Protection from Unfair Trading Regulations 2008, SI2008 No 1277CRA 2015Consumer Rights Act 2015DLTDistributed ledger technologyEDIElectronic Data InterchangeeIDASRegulation on electronic identification and trust services for electronictransactions in the internal market and repealing Directive1999/93/EC (EU) No 910/2014 Official Journal L 257/73 of28.08.2014EUEuropean UnionQESQualified electronic signatureUKJTUK Jurisdiction Taskforce of the Lawtech Delivery PanelONLINE CONTENTAll websites referenced in this document were last accessed on 18 November 2021.ix


Smart legal contractsTo the Right Honourable Dominic Raab MP, Lord Chancellor and Secretary of Statefor JusticeChapter 1: IntroductionSMART LEGAL CONTRACTS1.1Emerging technologies, such as distributed ledgers, are increasingly used to create“smart contracts”: computer programs which run automatically, in whole or in part,without the need for human intervention. Smart contracts can perform transactions ondecentralised cryptocurrency exchanges, facilitate games and the exchange ofcollectibles between participants on a distributed ledger, and run online gamblingprograms.1.2Smart contracts can also be used to define and perform the obligations of a legallybinding contract. It is this specific type of smart contract – a “smart legal contract” –that is the object of our analysis. For the purposes of this paper, we define a smartlegal contract as a legally binding contract in which some or all of the contractualobligations are defined in and/or performed automatically by a computer program. 1Smart contracts, including smart legal contracts, tend to follow a conditional logic withspecific and objective inputs: if “X” occurs, then execute step “Y”.1.3Smart legal contracts are expected to revolutionise the way we do business,particularly by increasing efficiency and transparency in transactions. They areincreasingly being considered by contracting parties as a means of automatingspecific processes within conventional contracts, from payment of insurance claims tomanaging supply chains. Currently, smart legal contracts are likely to be useful inrespect of only fairly rudimentary agreements, such as to transfer an amount ofcryptocurrency to a person’s wallet when certain conditions are met. However, as thetechnology underpinning smart legal contracts becomes increasingly sophisticated, agreater range of obligations may be suitable for coding, resulting in these contractsbecoming increasingly more complex and able to perform a greater range of tasks.1.4Smart legal contracts can take a variety of forms with varying degrees of automation. 2In the first instance, a smart legal contract may take the form of a natural languageagreement with performance automated by code. Alternatively, a smart legal contractmay be written solely in (and performed by) code. In between these two extremes, asmart legal contract may take the form of a hybrid contract, consisting of both natural1We discuss the three forms of smart legal contract in more detail from para 2.51.2We discuss the three forms of smart legal contract in more detail from para 2.51. We discuss automaticity inmore detail from para 2.14.1

language and coded terms. Different forms of smart legal contract give rise to differentlegal considerations.1.5Automation should be considered on a spectrum. Smart legal contracts which involveelements of standard automation, such as payment by way of direct debit, have beenin use for many years and are therefore unlikely to give rise to novel legal issues.However, a smart legal contract drafted primarily or solely in code and recorded on adistributed ledger, is likely to give rise to novel legal questions; the automation inquestion takes the contract out of the realm of legal familiarity.THIS PROJECTBackground1.6The Law Commission was asked by the Lord Chancellor to include work on smartlegal contracts as part of our 13th programme, agreed in December 2017. Afterdiscussions with stakeholders, our initial intention was to publish a call for evidence inJanuary 2019.1.7In the same period, the Lawtech Delivery Panel was created with the support ofGovernment. 3 There was clearly some common ground between the proposed LawCommission work and that of the Delivery Panel, and in particular its UK JurisdictionTaskforce (“UKJT”). In those circumstances, we agreed to pause our work until suchtime as the conclusions of the UKJT were known. 41.8In November 2019, the UKJT published its legal statement on cryptoassets and smartcontracts. 5 The UKJT Legal Statement concluded that, in principle, smart contractsare capable of giving rise to binding legal obligations, enforceable in accordance withtheir terms. Following this, the Ministry of Justice asked the Law Commission toundertake a scoping study on smart legal contracts.1.9The purpose of the scoping exercise is to provide an analysis of the current law as itapplies to smart legal contracts, highlighting any uncertainties or gaps, and identifyingsuch further work as may be required now or in the future. The project is intended tobuild on the foundations laid by the UKJT Legal Statement, and consider additionalquestions raised by stakeholders regarding smart legal contracts. Our terms ofreference do not include other areas of law in so far as they relate to smart legalcontracts, such as tax and data protection. Our full terms of reference are set out atAppendix 1.Call for evidence1.10 In December 2020, we published a call for evidence, which closed on 31 March 2021.The primary function of the call for evidence was to seek views about, and evidenceof, the ways in which smart legal contracts were being used, and the extent to which3More information is available at Chair of the Law Commission and the Commissioner for Commercial and Common Law both hadobserver status on the UKJT.5UK Jurisdiction Taskforce, Legal statement on cryptoassets and smart contracts (2019) (“UKJT LegalStatement”), JO Cryptocurrencies Statement FINAL WEB 111119-1.pdf.2

the existing law could accommodate them. In each chapter of the call for evidence, weset out our understanding of law and practice, and asked consultees for their views.We did not make any proposals for law reform.1.11 We received 47 responses to the call for evidence. The responses were from a mix ofstakeholders, including individuals who responded in their personal capacity,individuals who responded on behalf of organisations, and academics. We summariseour findings and conclusions to the consultation exercise in this paper. A list of allconsultees who responded to the call for evidence is set out in Appendix 2.Extent1.12 This project focuses on the law of England and Wales. International conventions,including the United Nations Convention on Contracts for the International Sale ofGoods, are not considered. 61.13 In relation to Wales, we consider that the subject matter of the project is reserved,being primarily a matter of private law. 71.14 The project does not consider the law of Scotland or of Northern Ireland.Activity in other jurisdictions1.15 Some other countries have already taken steps to put smart legal contracts andassociated concepts on a statutory footing. In addition, courts in other jurisdictionshave had the opportunity to consider some of the issues that we discuss in this paper.Given the cross-border nature of many of the transactions which take place usingsmart legal contracts, it is and will continue to be important to be aware ofdevelopments elsewhere, with the hope that legal approaches will be broadlycompatible. In the call for evidence, we asked consultees which other jurisdictions weshould look to for their approach to smart legal contracts. 81.16 Consultees noted that various states in the United States of America includingArizona, Illinois and Tennessee have introduced legislation which defines the term“smart contract”, and provides that a contract is not to be denied legal effect solelybecause it is a smart contract.1.17 Some consultees mentioned other jurisdictions which are perceived as beingparticularly proactive in the development and use of smart legal contracts anddistributed ledger technology, including Australia, China, Dubai, Estonia, India, NewZealand, Sweden and Switzerland. Several consultees commented that Singapore is6The United Nations Convention on Contracts for the International Sale of Goods is a multilateral treaty thatestablishes a uniform framework for international commerce. It applies to contracts for the sale of goodsbetween parties whose places of business are in different contracting states, or when the rules of privateinternational law lead to the application of the law of a contracting state. It may also apply by virtue of theparties' choice. The United Kingdom has not ratified the convention, and is therefore not a contracting state.For more information see UNCITRAL, "United Nations Convention on Contracts for the International Sale ofGoods (Vienna, 1980) (CISG)", ions/sale of goods/cisg.7Wales Act 2006, sch 7B, para 3(1). Private law is defined for this purpose as “the law of contract, agency,bailment, tort, unjust enrichment and restitution, property, trusts and succession”: sch 7B, para 3(2).8Call for evidence, question 57, para 8.4.3

particularly important because of its advanced use of smart legal contracts, and for itsdeveloping jurisprudence on smart legal contracts following High Court and Court ofAppeal decisions in Quoine Pte Ltd v B2C2 Ltd. 91.18 We refer to specific developments in other jurisdictions throughout this paper, wherethey are relevant to the particular issues being discussed.Related work within the Law Commission1.19 The UKJT Legal Statement also considered the legal status of cryptoassets. The LawCommission is currently working on a separate digital assets project drawing on thisaspect of the UKJT Legal Statement. We published a call for evidence on digitalassets in April 2021. We are analysing the responses received, and intend to publisha consultation paper next year. 10STRUCTURE OF THE PAPER1.20 This paper analyses the current law as it applies to smart legal contracts, particularlyin relation to:(1)formation and enforceability, including in relation to deeds;(2)interpretation;(3)remedies;(4)vitiating factors (mistake, misrepresentation, duress and undue influence);(5)consumer protection; and(6)jurisdiction.1.21 It comprises six further chapters. In each chapter, we provide a summary of theresponses we received to the various questions raised in the call for evidence. Webuild on additional insights provided by consultees, and provide more complex anddetailed examples. We also explain where, and why, our thinking has changed anddeveloped since the call for evidence, and draw on consultee views to inform ourthinking and to formulate our conclusions.1.22 In Chapter 2, we set out the background to smart legal contracts, our workingdefinition of what a smart legal contract is, current use cases and a discussion ofdistributed ledger technology in the context of smart legal contracts. We include adiscussion on the prevalence of the various forms of smart legal contracts, how theyare used in practice, and the costs and benefits associated with smart legal contracts.1.23 The next three chapters provide an analysis of the “lifecycle” of a contract formedunder the law of England and Wales (from negotiation through to remedies for breach)and explain how the law might apply to smart legal contracts. Chapter 3 considers the9[2020] SGCA(I) 02.10More information and the latest updates are available on the Law Commission’s digital assets project ets/.4

formation of a smart legal contract, including whether the parties intended to enter intolegal relations, with all the associated legal rules and remedies. In Chapter 4, weconsider how the courts might interpret a smart legal contract, looking at existingprinciples of interpretation. In Chapter 5, we consider the remedies which might berelevant if things “go wrong”, such as where the code does not execute as one ormore of the parties intended.1.24 In Chapter 6, we specifically consider potential issues for consumers who enter intosmart legal contracts, and consider how existing consumer protections might apply inthe context of smart legal contracts.1.25 In Chapter 7, we consider the factors which may determine whether the courts ofEngland and Wales have jurisdiction in relation to a smart legal contract, in theabsence of a jurisdiction or choice of court agreement between the parties.CONCLUSIONS AND FUTURE WORKExisting legal principles can accommodate smart legal contracts1.26 In this paper, we undertake a detailed analysis of the application of existing contractlaw to smart legal contracts. Our findings conclude that the current legal framework isclearly able to facilitate and support the use of smart legal contracts. Current legalprinciples can apply to smart legal contracts in much the same way as they do totraditional contracts, albeit with an incremental and principled development of thecommon law in specific contexts. 11 In general, difficulties associated with applying theexisting law to smart legal contracts are not unique to them, and could equally arise inthe context of traditional contracts. In addition, even though some types of smart legalcontract may give rise to novel legal issues and factual scenarios, existing legalprinciples can accommodate them.1.27 This paper therefore builds on the conclusions reached by the UKJT Legal Statement,which established that the current legal framework is sufficiently robust and adaptableso as to facilitate and support the use of smart legal contracts. The conclusionsreached in this paper echo the view expressed by Sir Geoffrey Vos below.English law is in a good position to provide the necessary legal infrastructure tofacilitate smart legal contracts if, but only if, we try to keep any necessary reformssimple. We should, I think, keep sharply in focus the advantages of the common law.It is dependable and predictable and able to build on clear principles so as to applythem to new commercial situations. We should, therefore, be looking to identify and,if necessary, remove any fundamental legal impediment to the use of smartcontracts. We should try to avoid the creation of a new legal and regulatory regimethat will discourage the use of new technologies rather than provide the foundationfor them to flourish. 1211For example, we discuss the merits of a limited common law development to the existing test forinterpretation in the context of coded terms; see from para 4.32.12Sir Geoffrey Vos, “Cryptoassets as property: how can English law boost the confidence of would-be partiesto smart legal contracts?” (2 May 2019) Joint Northern Chancery Bar Association and University of LiverpoolLecture, ech-on-cryptoassets-2.pdf.5

1.28 The flexibility of our common law means that the jurisdiction of England and Walesprovides an ideal platform for business and innovation, without the need for statutorylaw reform.1.29 The market also has an opportunity to anticipate and cater for potential uncertaintiesin the legal treatment of smart legal contracts by encouraging parties to includeexpress terms aimed at addressing them. Throughout the paper, we identify particularissues that parties may wish to address in their smart legal contract in order topromote certainty and party autonomy. A non-exhaustive list of these issues is set outin Appendix 3 to this paper. In addition, as smart legal contracts become increasinglyprevalent, we anticipate that the market will develop established practices and modelclauses that parties can make use of when negotiating and drafting their smart legalcontracts. We hope that work in this area could be led by the UKJT or LawtechUK. 131.30 We also consider separate, related areas of law, such as the law of deeds and therules on jurisdiction. Deeds and private international law are the two areas where wethink future work is required to support the use of smart contract technology inappropriate circumstances. In relation to both of these areas, future law reformprojects are in train.Related technological advancements1.31 Smart legal contracts should not be considered in isolation. Related technologicaldevelopments, such as the evolution of sophisticated smart contract platforms and thedigitisation of contracts, have a direct bearing on smart legal contracts and theiruptake. Digital contract initiatives and associated technologies are aimed at digitisingcommercial and legal documentation. 14 Rather than being written in natural languageand stored as such, such technologies enable a contract to be produced in structuredformats, with supporting code that acts as a map or set of instructions, enabling acomputer to read it. 15 Legal documents produced in such a format can have theircontents more easily read for reporting, analysis, automated processing, and lifecyclemanagement. 16 Even though a digital contract does not need to be a smart legalcontract, digital contracts will likely trend towards the inclusion of coded elements.Although these developments are outside the scope of this paper, it is worth notingtheir advancements.1.32 The development of smart legal contracts may introduce new issues and harms whichthe law needs to respond to. For example, oracles (external data sources whichtransmit information to a computer program) may require further consideration orindeed regulation. As technology and use cases develop, it will be important to keep13LawtechUK is a work programme that is helping transform the UK legal sector through tech, and is deliveredthrough a collaboration between Tech Nation, the LawtechUK Delivery Panel and the Ministry of Justice. Formore information see, for example, the Legal Schema, which is an “open source initiative that provides a common languagefor creating and managing legal documents as data”: Hilborne, “Structured data format a ‘great step forward’ for digital contracts” (23 June ital-contracts.16N Hilborne, “Structured data format a ‘great step forward’ for digital contracts” (23 June ital-contracts.6

the law under review, and consider whether reform or regulatory intervention isnecessary to address novel issues which arise.ACKNOWLEDGEMENTS AND THANKS1.33 We are grateful to all those individuals and organisations who responded to our callfor evidence, as well as to those who have taken time to discuss the paper with us.Appendix 2 contains a list of consultees who responded to the call for evidence, and aseparate list of those who we have spoken to directly during the course of this project.THE TEAM WORKING ON THE PROJECT1.34 The following members of the Commercial and Common Law Team have contributedto this paper: Laura Burgoyne (team manager); Daniella Lupini (team lawyer);Matthew Barry (research assistant); William Vaudry (research assistant) and AparajitaArya (research assistant).7

Chapter 2: What is a smart legal contract?2.1In this chapter, we begin by providing an introduction to code, and explaining what wemean by a smart legal contract in the context of this paper. We then outline thefeatures of a smart legal contract, and the various forms that a smart legal contractcan take, including the significance or otherwise of distributed ledger technology(“DLT”) in the context of smart legal contracts. 17 We also identity, and provideexamples of, the type of contractual terms that are most suitable for automation.Finally, we provide some context for the discussion on smart legal contracts bysummarising use

The forms a smart legal contract can take 22 Use cases for smart legal contracts 30 Costs and benefits of smart legal contracts 35. CHAPTER 3: FORMATION OF SMART LEGAL CONTRACTS 39. The law on contract formation 39 Agreement 39 Consideration 49 Certainty and completeness 50 Intention to create legal relations 54 Formality requirements 57

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