Thoughts on smart contracts regulation

29 June 2020 | blog

This article is an expanded version of the text originally published in Pravna praksa, a Slovenian legal weekly. You can read it in Slovene language here (paid subscription required). In this article I discuss the issue from a general perspective, but occasionally refer to the Slovenian legal context.

The COVID-19 pandemic has accelerated the migration of human activities into the digital environment. It has also given added impetus to legislative changes in the wider area of electronic transacting. This trend coincided with the existing interest in blockchain or, more generally, distributed ledger technologies (DLT). In this space, so-called smart contracts receive a lot of attention as well. Smart contracts are a technical innovation, which, as the name would suggest, is also of interest to legal practice. Legal theory has discussed the legal nature of smart contracts at length, while legislators the world over – including in Slovenia – are looking into appropriate regulatory responses to the technology. While certain USA states seem to be most advanced in these endeavours, a recent thematic report by European Union Blockchain Observatory & Forum called for a harmonised approach to the regulation of these technologies within the EU.

This article summarises some of my thoughts on the aspects of smart contracts regulation which I believe would be useful to consider during the legislative process. I also touch upon the issue of whether smart contracts require additional regulation within the Slovenian legal system at all (section 3.1).

Use of terms

The term smart contract does not have a single definition. Recently, smart contracts have acquired instinctive association with blockchain technology, in particular due to their mention in the 2013 Ethereum blockchain platform whitepaper. Within the technical or developer community smart contracts typically mean code (in Ethereum's case expressed in Solidity programming language) executed by a particular blockchain platform and mostly deployed to manipulate digital assets (such as cryptocurrencies). Such code is typically not accompanied by a contractual text written in natural legal language.

However, the term smart contract long predates blockchain technology, and is often used in a legal technology context to broadly denote the concept of a legal contract expressed in machine readable form, often frequently combined with corresponding contractual matter in regular natural language (legal Slovene, legal English). In this article the term hybrid approaches will be used for the combinations of the natural language and machine readable renderings of a contract of this kind (this idea first appeared as so-called Ricardian contracts). In this sense a distinction is frequently made between (i) smart contract code (smart contracts in the narrow sense) and (ii) smart legal contracts, which roughly correspond to the hybrid approaches. The differences in perception of smart contracts is illustrated by the graphic below. "Contract-as-Software" in the graphic refers to the hybrid approaches mentioned above. 

 

How does the above discussion impact smart contracts regulation? Where a piece of legislation refers to smart contracts, it should define them appropriately and be clear to which "smart contracts" it applies: is it only the narrow blockchain implementation (smart contracts in the narrow sense) or is it the broader concept of legal content expressed in machine-readable form. Terminology is not an end in itself but rather reflects the variety of technical implementations falling under the umbrella of smart contracts, of which more in the following section.

As regards the systemic placement of the smart contracts definition, the latter should ideally appear only once within the legislative corpus, e.g. in one chosen legal act. Any other legislation operating with the term should then refer to this systemic act and should not contain native smart contract definitions unless this is necessary due to the specificity of the area. This approach should make it easier to keep the use of the concept consistent across the legal system. 

The principle of technology neutrality in light of the various smart contracts implementations

The principle of technology neutrality

As mentioned in the preceding section, smart contracts encompass several technical implementations, which are fast developing. We may soon also see new – currently unfathomable – forms. The legislator is usually not willing to take on the role of an arbiter of which minuscule sub-form of the new technology is the "most appropriate" for the public and business and thus entitled to the regulated status and accompanying legal certainty. This is why the comparative international law developed the principle of technology neutrality, which means that the regulation describes the specific technology only at a very abstract level. At the same time, regulation sets out the characteristics of such technology (regardless of which technical process is used to achieve them) required for such technology to be granted specific legal qualities. An example of this approach is the 2017 UNCITRAL Model Law on Electronic Transferable Records, which equalises an electronic transferable record of a transferable document or instrument with its counterpart in regular written form, if, inter alia, reliable methods are used to identify that electronic record as the electronic transferable record and to retain the integrity of that electronic record (Article 10). The Explanatory Note to the Model Law describes the principle of technology neutrality thus (p. 23): "The principle of technological neutrality entails adopting a system-neutral approach, enabling the use of various models whether based on registry, token, distributed ledger or other technology." Technology neutrality simply means that it is preferable to set a goal rather than prescribe the means to achieve it.

Blockchain / DLT as one of the smart contracts platforms

It may be possible in a specific situation that a broad expert consensus exists as to the single technical implementation which is the only one having the characteristics to which the legislator intends to ascribe certain legal qualities or legal status. Before we apply the principle of technology neutrality to smart contracts regulation, it should be analysed within the legislative process whether blockchain and DLT might be just such unique technologies (the differences between the two are intentionally not discussed here). Below is a summary of some convincing views appearing in literature on this topic (partly based on the paper Eliza Mik, Smart Contracts: A Requiem (2019) which discusses the issue comprehensively):    

  • The distributed ledger technology (at least in certain implementations) ensures a high level of traceability and data integrity, which are without doubt desirable features. On the other hand, its revolutionary potential is sometimes overestimated in the legal context. DLT does not in itself check the quality or even legal compliance of data recorded thereon, but rather ensures that an entry to the distributed database is made only if it satisfies pre-determined technical parameters and that this fact is established through a mathematical consensus by a certain proportion of nodes (validators) hosting the distributed ledger (validation). It is of course possible to integrate a DLT smart contract with "real world" data, for example using so-called oracles. Interesting solutions already exist to that effect (e.g. Chainlink). However, such integration is technically possible with a non-DLT system as well. DLT is also frequently lauded as a technology which "removes the human out of the equation." This may be accurate only in a limited sense. Humans are of course involved with the development of the DLT implementation, as well as with coding of the smart contract. DLT in itself cannot prevent all too frequent human errors in platform design as well as in the assembly of a specific smart contract. From this point of view DLT does not operate in an entirely trustless manner – this may be the case for the parties to a transaction, but even they need to first trust the initial developer of a DLT.  
  • Many DLT and blockchain implementations exist – Bitcoin and Ethereum (Virtual Machine) may only be the most famous of them. The question then arises as to which technical characteristics a particular implementation must possess in order to be granted particular legal qualities through regulation. If, for example, one wishes to optimise for the level of decentralisation (the number of validator nodes serving as a rough proxy for that) as an indicator of security (or rather the ability to guarantee integrity), how many validators should the blockchain have to qualify as good enough? Will the government set up a special body that will maintain a "register of qualified implementation of the distributed ledger technology" and perform technical audits? Should there be a difference in the treatment of permissionless and permissioned DLTs? Will the government develop an "official" DLT (in Slovenia perhaps based on the SI-Chain test infrastructure), which will be the only legally recognised DLT for the purposes of regulation, and how would the decentralisation be ensured in such case? Which DLT will thus be the real "DLT" for the purposes of regulation? These often technically complex issues should be carefully assessed by a legislator attempting such (technology specific) regulation.
  • DLT is only one among the possible execution environments, i.e. "operating systems" which can run smart contracts code. We can just as easily imagine a smart contract being executed on a centrally run cloud-based system (and among hybrid approaches such solutions are already appearing, e.g. DocuSign Agreement Cloud). Many internet services already depend on cloud services offered by the likes of Amazon (AWS) or Microsoft (Azure). These products are often centralised by their nature and numerous companies (perhaps not always justifiably) entrust them with their sensitive data. In Slovenia, both the land register and business register are structured as centrally managed databases, and it does not seem that this is their most glaring weakness or that the integrity of their data would regularly be called into question.

Smart contracts as a legal technology innovation

Using DLT as an execution environment is therefore not a necessary element of smart contracts. From the perspective of legal users (and not technology enthusiasts), the key innovation of smart contracts lies in their combined record of legal (contractual) matter in (i) machine-readable form, which offers broad possibilities of automating contract performance, contract interpretation and contract portfolio analysis (see also the second frame of linked article) and (ii) natural legal language understood by regular courts – already mentioned hybrid approaches

The above does not mean that smart contracts in the narrow sense (i.e. DLT-run code) are entirely uninteresting or useless from a legal and business perspective. It also does not follow that a smart contract in the narrow sense can in itself never be a contract in the legal sense (but the discussion on this issue exceeds the scope of this article). Rather, the message is this: pure computer code is not always the most convenient medium for expressing legal rights and obligations in the manner customary in legal practice and familiar to courts. Code, however, can be effectively used to automate contract performance in a legal transaction. Views appearing in the blockchain community that smart contracts make regular courts obsolete are likely premature; in this context it should also be mentioned that technical literature often conflates the legal terms "performance" and "enforcement". It is unlikely that businesses will be willing to give up the option of court-enabled (and state-force-backed) enforcement just yet.

In the context of smart contracts regulation this means that any legislative process should encompass a critical analysis of different smart contracts implementations, including DLT and its strengths and weaknesses. It seems, however, that it would make sense to adhere to the principle of technology neutrality in defining and further regulating smart contracts, which means that the target technology will be defined on the most abstract level possible. Such a regulatory approach would focus on the innovative potential of machine-readable records of legal (including contractual) matters, and less on the specific implementations or platforms (such as DLT). 

Legislative approaches

Preliminary issue – do we need to regulate smart contracts at all?

The emergence of new technologies often presents the legislator with the dilemma whether the technology should be regulated anew or should it rather be left to business and court practice to place it among the existing legal concepts. In deciding on this issue, the societal objectives targeted by such regulation (consumer or weaker party protection, fostering innovation, allocation of liability, etc.) are usually identified and it is ascertained whether these objectives may be effectively achieved by a legislative intervention at all.

As already mentioned, the most interesting innovation behind smart contracts from the legal perspective is the concept of reliable machine readability of legal matter, which enables multiple further applications. Judging from numerous academic papers dealing with topics such as "are smart contracts really contracts" (all this with the still prevailing confusion as to the meaning of the term) it is clear that legal uncertainty surrounds the concept of smart contracts. Slovenian legal theory, among others, already expressed the view that – leaving aside special form requirements – there is no legal impediment to recording legal obligations in the form of code (that this may not be the most convenient way to do so has already been stated herein). There is a danger, however, that the caution of business and legal practice regarding smart contracts in the narrow sense ensnares all implementations, including hybrid approaches. In addition, the views of legal academia, in particular regarding new technologies and concepts, may not always suffice to fundamentally shift commercial practice – theory may serve as persuasive authority, but it is not binding law. Uncertain legal status may thus hinder innovation and practical testing of various smart contract implementations, even though some of them could be very promising technologies.

Should smart contracts therefore be regulated? The shortest answer is: not necessarily, but there may still be a benefit in doing it. If we limit ourselves only to the technology per se (more ambitious legislative interventions are discussed in the next section), even explanatory provisions on the legally binding nature of obligations expressed in machine-readable form or as code (which will benefit DLT implementations) may have a useful impact. Explanatory provisions may increase legal certainty, even though the legal result they re-affirm may be, in the opinion of theory, already allowed or present under the existing body of law. In terms of regulatory objectives, such an approach mostly targets the fostering of innovation. Some examples on how such explanatory provisions could be formulated are set out in section 3.3 below.

Placing smart contracts regulation within the legal system

If we accept that it is useful to regulate smart contracts, the question arises of where and how. Multiple approaches are possible, equally with respect to where to place the explanatory provisions referred to in the previous section (with relatively limited legal effect), as well as regarding more ambitious solutions seeking to integrate governmental systems with private electronic documents and reassessing the role of the so-called "gatekeepers" in the Slovenian legal system.

Following are a few thoughts on placing smart contracts within individual (classic and specialised) legal disciplines:

  • general contract law: on the account of smart contracts there seems to be no need for a legislative intervention within the core subject matter of contract law, such as the prerequisites for contract formation. Placing the explanatory provisions referred to in the previous section (which otherwise do not interfere with general civil law) in the Slovenian Code of Obligations may attract the most attention but may also face opposition on theoretical grounds. It is also not consistent with past legislative practice: provisions on the equivalence of electronic form where the law calls for written form ("if the information in electronic form is accessible so as to be usable for subsequent reference") were placed in a separate (and much less visible) Electronic Business and Electronic Signature Act (ZEPEP);
  • property law: the most promising line of legislative inquiry within this area is in respect of additional legally recognised modalities of legal acts required to establish, transfer and terminate property (in rem) rights. An initial trial step in this direction could be the legislative and technical development of the digital (smart) land register permit or at least of a "permit" for the re-registration of a nonpossessory pledge over movables in the relevant register. This may in turn pave the way towards smart in rem legal acts (which would, for example, enable the tokenisation of in rem rights and not only of contractually established rights) and their integration with smart contracts. Any legislative changes in this area are inextricably connected with the form requirements and the role of notaries and other gatekeepers in the Slovenian legal system (see next bullet point);        
  • form requirements for specific legal transaction and the roles of the notaries, land register court and commercial register court: these areas present the key issue for the wider usability of smart contracts (and smart in rem acts) between private actors. This does not mean that the above-mentioned bodies and professions do not play an important and useful role. It is entirely legitimate for a legislator to attach additional formalities to a specific transaction due to the significance of their legal consequences for the parties concerned. This is all the more true in cases where the individuals involved are not knowledgeable about the law. However, it will nevertheless be necessary in the future to rethink the roles of these bodies and professions (perhaps by designating them as official oracles) and to adapt form requirements to the digital environment if we are to systemically enable wide-ranging electronic transacting. The gradual roll-out of such a regime could start off by making a distinction between consumers and non-consumers or, taking a leaf from financial regulation, between professional clients / eligible counterparties and retail clients;  
  • corporate law: there has been a lot of interest, including in Slovenia, in integrating smart contracts with corporate law, in particular in the context of decentralised autonomous organisations – DAOs. In large part, rethinking form requirements and the role of the notaries and commercial register court in the incorporation process will be the key in this area as well. As regards the DAO structures, the main policy issue is whether to recognise them as legal persons and endow them with limited liability. The other side of the same coin is of course whether to subject the DAOs – to prevent the exploitation of the aforementioned qualities – to mandatory rules on corporate governance, shareholder rights, creditor protection, etc. I note that participation in DAO structures is not prohibited under the existing law, while they likewise do not possess legal personhood under Slovenian law; 
  • ZEPEP amendment or special act on smart contracts: the enactment of explanatory provisions, discussed in the previous section, could also be achieved through a relatively limited amendment to the ZEPEP or – in particular if the legislator chose to extensively regulate the technical aspects – within a special legislative act on smart contracts. A ZEPEP amendment or such a special act would also be natural places for the definition of smart contracts, which would then be referenceable across the entire Slovenian legal system.

Examples of explanatory provisions on smart contracts

The below examples of explanatory provisions on smart contracts follow established formulas used by the ZEPEP and comparative international law (such as the UNCITRAL Model Law on Electronic Commerce and UNCITRAL MLETR). The examples are of course rough conceptual drafts requiring careful redaction, placement and technical review.

  • "Where the law requires [a certain legal act or [official filing]] to be in writing, that requirement is met by an electronic record of computer code or a different machine-readable text, if (i) such record contains the information that would be required to be contained in such [legal act or [official filing]], (ii)  the information in electronic form contained therein is accessible so as to be usable for subsequent reference, (iii) […]."
  • "The formation of a contract may also be recorded in the form of computer code or a different machine-readable electronic record, if the [general] contract formation requirements can be ascertained from such computer code or different machine-readable electronic record. This provision shall be without prejudice to the [general] contract formation and termination requirements."
  • "[A legal act] shall not be denied validity or enforceability on the sole ground that such [legal act] is expressed in the form of computer code or a different machine-readable electronic record, if the [general] requirements for the performance of such [legal act] can be ascertained from such computer code or different machine-readable electronic record. This provision shall be without prejudice to the [general] requirements for the performance of any [legal act]."

Jurij Lampič

Attorney at Law in cooperation with Schoenherr

T: +386 1 200 09 74
j.lampic@schoenherr.eu

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