Smart contracts have a wide range of possible applications, particularly in the field of the Internet of Things. Imagine a “smart” fridge that could detect when you run out of milk. Upon such detection, your fridge would order a new carton of milk online. Is this order, placed by a fridge, a legally binding contract? Charles Duro, Lawyer at Allen & Overy Luxembourg SCS* is going deeper into details.
(Featured Image: Charles Duro, Lawyer at Allen & Overy Luxembourg SCS / Image Credit © Olivier Minaire)
What are “smart” contracts?
While there is no universally agreed definition of what constitutes a “smart” contract, digital currency and smart contracts pioneer Nick Szabo defined it as “a set of promises, specified in digital form, including protocols within which the parties perform on these promises”(1). Roughly summarised, a smart contract is an “IF-THEN” statement in a piece of code that is executed by each node on the network to automate (potentially) a particular state resulting from a contractual deliverable without further human interaction.
Smart contracts take different forms and can be divided into three main categories: (i) smart contracts which consist purely of a computer code, (ii) contracts in natural language (i.e. regular language as opposed to a computer code), but which rely on a computer code in order to be executed, and (iii) “split contracts”, which contain both coded and natural language.
When is a contract legally binding?
In order for a contract to be legally binding under Luxembourg law, four conditions need to be cumulatively met pursuant to article 1108 of the Luxembourg Civil Code (the LCC): (i) consent, (ii) legal capacity (2), (iii) a determined or determinable object of the obligation (3), and (iv) an existing and lawful cause (4). A contract is, in principle, not subject to formal requirements (i.e. it does not need to have written support to be legally valid).
“Whether a smart contract is legally binding or not depends on the circumstances.”
Are you legally bound to pay for the milk?
It is not sufficient for your fridge to detect that you ran out of milk for it to order a new box. You need to “allow” your fridge to place an order first: you connect it to the internet, enter your payment details and select the item that you require your fridge to order (in this case, milk). Assuming that you are a fully capable adult (5), your consent is given (6). A contract is then formed in order to buy milk (which is the determinable object of the contract as well as its lawful cause). In this example, the legal contract is established before the fridge orders the milk – the ordering of milk is just an automated execution of a pre-established contract which was waiting for one coding condition to be fulfilled: there was no longer any milk in your fridge.
The order placed by the fridge is therefore not a legally binding contract on its own, but solely an instrument evidencing the pre-established contract executed through a smart contract.
Whether a smart contract is legally binding or not depends on the circumstances: is the smart contract just a code enabling the automatic execution of a previously agreed deal (i.e. the fridge simply executing the already-formed contract), or does it meet the four conditions provided by the law? Generally, smart contracts are only an automated execution of pre-established contracts rather than legally binding contracts. It is precisely this automated execution which represents the usefulness of the smart contract. As soon as the conditions are met, the obligations of the parties will be automatically executed through a computer code. (e.g. in the context of a loan or a bond one could put in place a smart contract at the time of issue that automates the payment of interest to each investor on the given due dates. Accordingly, the bond or loan would service itself when triggered by the borrower sending funds to the smart contract. It is therefore a very useful tool to automate operative parts of normal legal contracts, but the parties to the contract will still need all the regular contractual protections such as representations, warranties and indemnities drafted in natural language. These cannot currently be replaced with code.)
It’s fair to say there is some confusion and concern about smart contracts among lawyers with many concerned that regular natural language contracts will be replaced by code. Smart contracts are not (yet) a replacement for normal legal contracts but rather sit behind and augment a legal contract whereby snippets of code replicate and automatically perform certain terms of the contract.
If you were to sign a contract directly with your fridge, the analysis would probably be different, as an entirely new spectrum of questions (and, moreover, answers) would arise.