On 25 November 2021, the English Law Commission published a report on Smart Legal Contracts. The Report concludes that the current English legal framework is “clearly able to facilitate and support the use of smart contracts”. For Virtual Asset Service Providers (VASPs), this is positive news: the use and acceptance of smart contracts are likely to increase.
However, VASPs should note that with greater legal certainty comes greater responsibility. Now that smart contracts have been accommodated into English common law, there are notable consequences for using them. This blog post briefly summarises the Report and addresses some of the consequences for VASPs.
The Report states that smart contracts will apply current legal principles in the same way they do to natural language (traditional) contracts. This confirmation means that the industry can now use smart contracts in England with the assurance that the smart contract itself does not need to be accompanied by another contract. This is likely to increase the use and acceptance of smart contracts in English common law systems, including Gibraltar, which VASPs should see as a positive.
There is judicial support for this approach. At para 1.27, the Report quotes Sir Geoffrey Vos, a leading British judge who is currently head of civil justice in the English court system. He states:
“We should … remove any fundamental legal impediment to the use of smart contracts. We should try to avoid the creation of a new legal and regulatory regime that will discourage the use of new technologies rather than provide the foundation for them to flourish”.
The level of acceptance from a senior judicial figure suggests that the use of smart contracts will be encouraged under English law.
Application of smart legal contracts to Decentralised Finance (DeFi)
Between paras 2.88 – 2.90, the Report makes specific reference to DeFi. The Report quotes Herbert Smith Freehills (HSF). HSF has identified Aave’s smart contract, which allows users to lend and borrow digital assets, as an example of a peer-to-peer smart legal contract valid under English law, which the Report acknowledges. The Report’s recognition of the validity of smart contracts for DeFi purposes is another strong result for the industry.
According to the Report, as a VASP, using a smart legal contract alone “may actually increase instances of defective performance”. This is because there is scope for the code to perform in ways the parties did not intend. There are two main issues VASPs will have to contend with to ensure their smart contracts comply with English law: (1) rectification (2) misrepresentation.
Firstly, there are practical difficulties in rectifying code should there be an issue that requires changing in the smart contract. At para 5.10, the Report claims that ‘Rectification based on common intention’, which is currently rare, may be a relevant remedy in the context of smart legal contracts. VASPs should be aware of instances where they bargain in natural language negotiations, and then translate that bargain into code by enlisting the services of a coder. This process of translating a bargain from natural language into code creates a risk that the code will fail to reflect the parties’ intentions correctly.
A practical difficulty of remedying this is that it may not be possible to amend code if recorded on DLT technology. VASPs must ensure that they are precise in coding smart contracts when using immutable technology. As translation errors from natural language to code frequently arise, VASPs should be aware that this could become actionable at law. Having suitable code audits would be advisable to solve this issue.
Secondly, at para 5.30, the Law Commission recognises the traditional contractual vitiating factors of mistake, misrepresentation, duress, and undue influence will now be applied to smart contracts. These may make a contract “void” or “voidable”. If a contract is void, it is treated as though it never existed. If a contract is “voidable”, then it remains valid unless and until it is “rescinded” by the party who has the power to do so.
VASPs should be particularly concerned with misrepresentation. As stated at para 5.77, a misrepresentation can be fraudulent, negligent, or innocent – all these could lead to a voidable contract.
For example, VASPs offering ICOs or NFTs must ensure that the quality of their offering is as reasonably expected and that no false representations are made about a matter of fact or a matter of law. If the VASP fails to do so, they could be liable at law for damages if the claimant entering the contract suffers a loss.
There are benefits to VASPs in solely utilising smart legal contracts as they will increase the efficiency of contractual negotiations. There are fewer chances of human error which could lead to breach of contract. However, it is important for VASPs to be aware of English law rules on rectification and misrepresentation. It is also crucial that a smart contractual offering is in accordance with general T&Cs on a VASP’s website. If your product contains smart contractual elements which do not accord with your general T&Cs, as a VASP, you could be in breach of English contract law.
Disclaimer: This article is not a substitute for professional legal advice and does not intend to offer legal advice.
Subscribe to XReg Consulting's newsletter and stay informed about global developments in crypto-asset regulation