There is a surface and structural similarity between a written contract and a computer program – both of which are carefully structured and typically contain definitions, descriptions of actions to be taken, and conditional logic.
But can a contract be fully computerized into code?
Most chances you have already used a fully computerized contract. Take a vending machine for example – it offers you a snack, and you can accept by putting in the correct amount of coins or swiping your card. The vending machine identifies the selection, verifies that the payment is sufficient and vends the desired product to finalize the contract.
This is of course a very basic contract, but computerized contracts are becoming more and more sophisticated.
What is a Smart Contract and How Smart Contracts Work
The term “smart contract” was first introduced in 1994 by computer scientist and cryptographer Nick Szabo, who some believe might actually be Satoshi Nakamoto, the creator of Bitcoin.
A “smart contract” can be defined as a computer program that runs on the blockchain and automatically executes all or parts of an agreement between parties, with the terms being directly written into the code.
Thanks to blockchain technology, smart contracts are tamper-resistant and self-verifying without any intermediary’s involvement. They also have the potential of changing the face of various industries, in the form of error-free processing of insurance claims, transfer of settlement funds between parties upon the performance of predefined obligations, automatically making payment upon delivery of goods or services, smooth peer-to-peer (p2p) payments, and so on.
Smart contracts can be either created and deployed without any enforceable text-based contract behind them, or used as vehicles to execute certain provisions of a traditional contract.
Currently, most smart contracts follow a conditional logic with specific and objective inputs, e.g., if X is true then execute Y. If the contracting parties have indicated that certain parameters have been met, the code will execute the step triggered by these parameters.
However, as more people begin to recognize the potential of smart contracts and as the adoption of blockchain spreads, smart contracts will become increasingly sophisticated and capable of handling a greater range of transactions.
Still, smart contracts may not be suitable for all types of transactions, and the objectivity required for smart contracts might not reflect how contracting parties interact. A smart contract cannot include ambiguous terms and has to address all potential scenarios. Contracting parties may not want to spend time and legal fees on addressing every conceivable eventuality, and may determine that if an unanticipated event occurs, they will figure out a resolution at that time. Similarly, parties may intentionally opt to leave a provision somewhat ambiguous, with flexibility to argue later on that the provision should be interpreted in their favor.
DAOs
One of the more interesting manifestations of Smart Contracts is the Decentralized Autonomous Organization (DAO) – an organization represented by rules encoded as smart contracts that is controlled by its members and not influenced by a central government.
The stake in a DAO is represented by crypto tokens, which are equivalent to shares in a traditional corporation and afford their holders with voting rights. Governance is conducted through a series of proposals that members vote on through the blockchain.
There are already quite a few DAOs, and we can expect many more to see the light of day in the near future.
One of the notable DAOs was ConstitutionDAO – a DAO formed in November 2021 to purchase an original copy of the United States Constitution. The group raised $47 million in an ICO (Initial Coin Offering) but eventually lost the bid and disbanded.
Bloomberg News wrote that the effort showed that DAOs have the potential to change the way corporate governance works and the way people buy things, build companies, share resources and run nonprofits.
While Wyoming became the first state to recognize DAOs on July 2021, the legal status of DAOs as a legal entity is still generally unclear.
As the concept of smart contracts matures, the DAO model may be adopted by more and more organizations and entrepreneurs to help govern some of their activities.
Are Smart Contracts Enforceable?
The recognition of smart contracts as legally binding and enforceable in a court of law is crucial for the potential utility and adoption of smart contracts.
Many jurisdictions take a flexible approach to formalities of contracts, but at a minimum, a legal contract must include the elements of offer, acceptance and intention of the parties to enter into a legal agreement.
Israeli law implements objective criteria that focuses on the external manifestation of the will of the parties when determining whether a contract was concluded, and takes a flexible approach to the form of contracts. It is therefore likely that Israeli law would recognize “smart contracts” as “contracts”, as long as they meet the fundamental elements of offer, acceptance and intention of the parties to enter into a legal agreement.
Thus, the uploading of the smart contract to the blockchain platform by one party can be considered an offer, while the transfer of funds on the other party’s behalf can be considered an acceptance under the Israeli Contracts Law.
While non-lawyers can read a traditional contract and generally understand the set of rights and obligations it confers, non-programmers would find it nearly impossible to understand smart contracts, which are written in computer code.
Hence, the contracting parties may need to accept natural language terms that confer binding contractual effect on the transaction performed by the code (by, for example, a clickwrap agreement) drafted by lawyers who specialize in the field, in order for the smart contract to be regarded as legally binding. By doing so, it is quite likely that a court would recognize the validity of the smart contract.
However, many aspects of the legal regime pertaining to smart contracts, such as resolution of disputes concerning the execution or interpretation of smart contracts, are still unclear. Because of the importance of legal certainty in the context of smart contracts, the adoption of smart contracts may necessitate the enactment of a special law or an amendment to the Israeli Contracts Law dedicated to the regulation of smart contracts.
Smart Contracts and Lawyers
Smart contracts represent a new frontier for lawyers, who may find themselves in a rapidly changing legal landscape as the use of smart contracts grows. Nonetheless, the implementation of this emerging field and the novel legal questions it presents will require the application of human legal minds.
As the adoption of blockchain spreads and the potential of smart contracts is realized, lawyers will need the technical knowledge and the requisite expertise to navigate the relevant legal issues that arise and to retain a competitive edge.
It is likely that we will see the emergence of a new specialty that bridges the gap between traditional and coded contracts, and lawyers with coding skills will be integral to drafting of, and performing due diligence on, smart contracts.
Smarts contracts can liberate lawyers from certain technical tasks, and allow them to focus on strategic solutions and negotiate the optimal deal for their clients. Smarts contracts won’t replace lawyers, but have the potential to change the way the legal industry operates.
The Future of Smart Contracts
The smart contracts market was valued at US$ 397.8 million in 2022 and is anticipated to reach US$ 1460.3 million by 2029, growing by a compound annual growth rate of 24.2% during 2023-2029[1].
Smart contracts are here and are getting smarter, and will soon be far more mainstream and used for more complex legal matters.
Across the globe, governmental bodies are already catching up. For instance, in the United Kingdom, the Law Commission (a statutory body that keeps the law under review and recommends reform where it is needed) published on November 2021 an extensive report and advice on smart contracts. Arizona, Illinois and Tennessee have introduced legislation which defines the term “smart contract”, and provides that a contract is not to be denied legal effect solely because it is written in computer code. The Singapore Court of Appeal ruled that both offer and acceptance can be automated by computer programs on a cryptocurrency exchange platform[2].
Before smart contracts are more widely used, developers of smart contracts would have to face some key challenges on the way, such as determining more subjective legal criteria (for example, whether a party acted in bad faith or used his commercially reasonable efforts) or whether an indemnification clause should be triggered and compensation paid.
However, it is important not to simply think how smart contracts can be used for existing concepts and structures, rather, the revolution of smart contracts may come from entirely new paradigms we have not yet envisioned.
This document is intended to provide only a general background regarding this matter. This document should not be regarded as binding legal advice, but rather a practical overview based on our understanding. APM & Co. is not licensed to practice law outside of Israel.
[1]Valuates Reports, Global Smart Contracts Market Research Report 2023.
[2] Quoine Pte Ltd v B2C2 Ltd.
