Demystifying Smart Legal Contracts

5 minute read  02.11.2020 Paul Kallenbach, Jonathon Blackford, Jason Watling

We demystify smart legal contracts, set out the difference between smart legal contracts, 'smart contracts' and electronic data interchange systems, and explain how blockchain fits in.

What's a smart legal contract?

A smart legal contract is a legally-enforceable contract that is completely available in natural language, and partially available in computer code.

The natural language portion documents the parties' agreement and the computer code serves to automate aspects of the contract. The natural language and code can interact through 'markdown' language (eg words {{enclosed in double braces}} are variables accessible by code) or by embedding code into the contract in a similar way to how formulae are sometimes included in contracts.

Clauses involving inherently discretionary concepts such as 'reasonable' remain in the realm of humans to determine – whilst concepts that can be represented by formulae (like turnover-based rent) are candidates for automation.

With the rise of internet connected sensors and application programming interfaces (APIs) that facilitate efficient communication between different systems, the scope of automation has significantly increased. For example, a smart legal contract could detect the delivery of goods based on an embedded RFID tag, and automatically trigger payment to the vendor by communicating with accounting software and the purchaser’s bank via their respective APIs.

Another key feature of smart legal contracts is that in the case of inconsistency with the code, the natural language contract will prevail. As a legally binding contract, all the usual dispute resolution mechanisms (eg courts and arbitration) will be available should an issue arise.

This doesn't sound like a recent idea?

The first smart legal contract emerged in 1996 when Ian Grigg released the Ricardian contract, which links a natural language contract securely with other systems.

Smart legal contracts are also similar to existing electronic data interchange (EDI) systems, which have been used in supply chains for many decades. If you're not familiar, an EDI system lets businesses exchange information electronically using a standard format. For example, a purchaser makes the decision to buy 100 widgets. They create a purchase order in their software, which then automatically transmits the relevant information to the supplier. The supplier's software then receives the order and updates their internal systems, before transmitting back an acknowledgement of receipt.

Electronic data interchange systems provide some of the benefits of smart legal contracts outlined below. However, the separation of implementation in code away from the contract can result in uncertainty and error, given that contractual obligations (and their implementation) may be fragmented across multiple internal systems and processes.

EDI-related contracts also aren't written with code in mind – meaning coders may be unable to automate many clauses. For example, consider a contract that specifies a delivery within a 'reasonable period'. Both parties would be happy with a delivery window of 10 days, but the lawyer's intentionally left this vague to provide parties with greater flexibility. However, given potential efficiency savings from automation, both parties may be happy to specify this timeframe if it was considered during contract negotiations.

So what's new with Smart Legal Contracts? How are they different from EDI systems?

EDI can be thought of as digitising traditional business information like invoices and purchases orders, to enable automation and integration with existing business processes. Smart legal contracts apply this same thinking to the entire contractual process.

By taking these existing ideas around automating parts of the contract and applying them to the pre-contractual phase, smart legal contracts aim to ensure that:

  • contracts are negotiated with code and potential automation in mind, so greater business value can be unlocked by clearly negotiating for code-friendly terms (see Part 2 for more details);
  • the legal position and the code are developed simultaneously, so risks around flawed external data sources, incorrect coding and the like can be adequately considered (see Part 3 for more details); and
  • there is a single source of truth about the state of the contract, with the smart legal contract talking to your other internal systems (and with other smart legal contracts as well).

Just as there are existing EDI standards that enable businesses to effectively communicate with each other, so too do we expect that there will be smart legal contracting standards that enable all parties to talk to each other effectively.

How does blockchain fit in?

Firstly, let's define what we mean by 'blockchain'. At a high level, blockchain is a technical solution to data exchange and storage where there is no trusted party for a chain of transactions. It works by distributing a copy of all transactions to all participants, which updates in real time when all parties agree that a transaction is legitimate. This is achieved through consensus where certain network participants validate transactions. When a certain number of validators agree (normally 51%), that transaction then becomes the next 'block' in the 'chain'.

Blockchains can provide a platform on which smart legal contracts can run code. They're the appropriate solution where parties do not want to rely on a trusted intermediary to facilitate their smart legal contract, but come with additional costs as all parties need to co-ordinate their technology stack and this may also reduce contractual privacy.

Blockchains can also be used to store data while the transactions are handled by a trusted intermediary. Running smart legal contracts off-chain can increase privacy and flexibility. For example, this approach can be adopted where it is necessary to keep contractual details confidential while sharing data about the resulting transactions with the blockchain.

And of course, smart legal contracts can be completely separated from blockchains, where a distributed data store is not necessary. For example, a bank dealing with small customers may keep a centralised database and execute code itself, as the bank – which is subject to strict regulatory oversight – already acts as a trusted party.

How about plain 'smart contracts'? What are those?

In the blockchain space, 'smart contracts' refer to computer code that runs on distributed ledgers (eg blockchains). Unfortunately, as various commentators have quipped, they are neither smart nor a contract – a program that prints 'Hello World' is a 'smart contract' in common usage. This misnomer has been the source of much confusion, as lawyers try and impose contract law principles on computer programs, while technologists try and replace contracts with code.

By contrast, a smart legal contract aims to ensure that traditional jurisprudence is applied and dispute resolution mechanisms (eg arbitration, courts) are available, to provide for cases where the code does not reflect the intention of the parties – while still affording the benefits of automated contract execution.

Find out how smart legal contracts can help your business?


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