Smart contracts are changing how businesses make agreements, not only with their customers but with other businesses as well. Smart contracts are computing programs that automatically carry out what they are programmed to do. As such, they are only as good as the data they receive. You may be thinking about using blockchain and implementing smart contracts in your business. However, it is important to consider whether smart contracts are legally binding contracts. The answer depends on the type of smart contract. This article will outline the different forms of smart contracts and outline the requirements to make them legally binding.

What is a Smart Contract?

Despite having ‘contract’ in its name, a smart contract is not strictly a contract. It is actually a form of one-sided promise that is fulfilled once a computer program receives certain instructions. Smart contracts have their contractual terms encoded in computer language instead of the legal language that you would find in a standard contract. The terms are automatically enforced by a protocol that is followed in the entire network. Therefore, the essential feature of a smart contract is automated performance.

The four different types of smart contracts are the:

  1. natural language contract with some functions encoded in digital form. This is a normal contract on paper and written in a natural language such as English. However, some of the functions such as payment will be automated;
  2. natural language contract with encoded performance mechanism. This is also a contract on paper. However, the automation is not limited to simple functions like payment. Some performance of the contractual obligations may be automated on a digital platform to carry out itself;
  3. contract in code but supplemented by a document in natural language. The contractual terms might be in code but they are supplemented by a schedule that is in a natural language like English; and
  4. contract that is entirely in code and executed without human intervention. This is code that is legally recognised and enforceable on its own basis with no natural language to supplement it.

Can a Smart Contract Be a Legally Enforceable Contract?

A legally enforceable smart contract must meet all the elements of a binding paper contract. As identified above, each form will have different issues relating to whether or not they are binding. For example, it would be unlikely that a contract that is completely in code and has no human intervention would be legally binding because the identity of the parties may not be easy to determine. Therefore, the smart contract will not satisfy the elements of the formation of a contract.

However, simply because a contract is made electronically does not make it invalid. But there is a requirement that the contract is accessible in the future and that the parties consent to contract in this way. Importantly, a contract between a natural person and an ‘electronic agent’, which would be an automated system, is enforceable if all the other contractual elements are present.

What Are the Key Elements to a Contract?

Contract Element Explanation
Offer and Acceptance

Firstly, one of the parties must offer goods or services to the other. This offer must have the details set out so that both parties are fully aware of the content of the contract.

You can make and accept offers through electronic messaging. Smart contracts are commonly initiated through a Public Key Infrastructure, which is a cyber security system that helps you message securely.

Consideration There must be a valid reason for the two parties to enter into the contract and there must be an exchange of value between the parties. Generally, consideration is money but it can also be one party accepting some liability or choosing not to act.
Intention to create legal relations The two parties must also clearly intend to create legal relations. If you are using a contract in English or another natural language, this is easy to work out. However, with smart contracts, it is not always easy to work out because the code is not a language that the courts can interpret.
Certainty and Completeness The parties must also be competent to enter into a binding contract. In addition, the terms of the contract must not be too vague or uncertain as this will make the contract unenforceable.

What Are the Differences Between Smart Contracts and Normal Contracts?

Smart Contract / Computer Code Normal Contract / Contractual Obligations
Expressed in code that a machine can read Expressed in a natural language such as English
A machine will execute or carry out the contract that is coded in software The contract uses special, legal terms and language
Performance is through software Humans carry out the performance of the contract
The computer code carries out the actions literally Parties can overcome errors by disregarding them or adjusting where necessary
If the code is ambiguous, the machine may not carry out the actions or it may carry them out incorrectly Contractual provisions can be ambiguous but parties may be able to work together to achieve the overall goals

Important Considerations

Because smart contracts are self-executing and self-enforcing, they will be useful in realising the full potential of the blockchain. When thinking about adopting smart contracts in some form, it is important to consider that:

  • smart contracts are in code and therefore they will only be as good as the data that you input. They execute literally and cannot disregard ambiguity;
  • smart contracts cannot assess the broader commercial arrangement and only carry out the terms once the party meets their obligations. Often the intentions and purpose of the contract will be much broader than just automated processing and this is where human intervention is valuable; and
  • in every instance, you will need to consider the contract elements to assess whether you have satisfied all the elements.

Key Takeaways

Ultimately a smart contract is not really a contract. Currently, smart contracts only carry out what they are programmed to do and if there are any errors in the data, the smart contract will carry out the instructions anyway. As such, smart contracts will not replace broader contractual agreements but will replace those parts of the arrangement that are suited to automation. Therefore in this digital age, it is prudent that your business considers a mix of smart contracts and contractual agreements. If you need help working out whether your smart contract is legally binding or need any other help drafting a contract, you can contact LegalVision’s online lawyers on 1300 544 755 or fill out the form on this page.

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