Can a Smart Legal Contract Be Considered a Contract According to the U.S. Contract Law?
In the previous articles, I explained why it is essential for smart legal contracts to be legal contracts. This article provides an analysis of the applicability of contract law to the technology. But firstly, I need to explain the difference between external and internal smart contracts.
Models of Smart Legal Contracts
It is important to mention that smart contracts can take various forms. It can be a contract entirely in code; a contract in code with a separate natural language version; a “split” natural language contract with encoded performance; a natural language contract with encoded payment mechanism. Other permutations are, of course, possible and are likely to emerge when the amount of smart contract applications increases. In any case, the smart legal contract is an electronic agreement as it is formed digitally.
When the code is not a part of a legal contract, it can be called an external model. A legal contract is a document written in humanly comprehensible language that is external to the smart contract code; certain conditional logic elements of the legal contract would be coded, so the required actions happen automatically when the relevant conditions are satisfied. The so-called internal model is more innovative than the external one. With the internal model, the code of the smart contract becomes an inextricable part of the legal contract. The code and the relevant part of the written contract become an integral whole.
Definition of Contract According to the U.S. Contract Law
There are different definitions of a contract in different statutes. Moreover, contract law is mostly an area of states’ jurisdiction. However, the aim of this article is not to find a precise definition, but to briefly go through various theories related to the elements of a contract using the Restatement (Second) of Contracts, a non-binding, but authoritative source of contract law, articles, and books of scholars and the U.S. case law.
The Restatement defines a contract as a promise or a set of promises for the breach of which the law gives a remedy or the performance of which the law in some way recognizes as a duty. A promise is a manifestation of an intention to act or to refrain from acting in a specified way. The general rule is that a promise is a valid contract when there is an offer, an acceptance of the offer, a consideration, mutual assent, and an intent to be bound. This section takes a look at whether a smart legal contract falls within this definition.
The Benefit-Detriment theory establishes consideration when there is the legal benefit to the promisor or detriment to the promisee. Hence unless one of the elements present, promises to make gifts are not binding since the promisor receives nothing given in exchange as part of a swap, as a promise is not supported by consideration. According to the bargain, theory consideration is established when performance or a return promise must be bargained for. A performance or return promise is bargained for if it is sought by the promisor in exchange for his promise and is given by the promisee in exchange for that promise. Both theories are used by the courts to establish whether there is a consideration present. Additionally, consideration should be adequate.
A typical smart legal contract will involve some consideration that induces the reciprocal promise. If exchange element is present, the smart legal contract can pass the bargain theory test. Benefit-Detriment theory test can also be satisfied. We can imagine an agreement that a person receives money if he studies well. Such requirement can be incorporated into the software and intranet of the university can easily become an oracle
Smart legal contracts that imply only providing a gift will not be considered as a formed contract. Theoretically, defenses to consideration such as promissory estoppel, exceptions as a promise to pay indebtedness, promise to perform a duty despite a non-occurrence of a condition, option contract, and promise under seal can be applied. For moral obligation defense, it is hard to imagine, how it can relate to the smart legal contract.
The exciting thing is that regardless whether it is a contract in a legal sense, promise without consideration will be performed by a computer. For more than 200 years, there is much criticism regarding the consideration. There are even ideas to remove it, while slowly expanding the promissory estoppel principle. According to the principle of promissory estoppel, there is no need for consideration when a promisee reasonably expected the performance of the promise, and a non-enforcement results in injustice. If we think about the smart legal contract, it is hard not to expect performance when the promise is performed automatically.
Consideration as a formal requirement has the evidentiary function as it provides evidence that a contract exists, the cautionary or deterrent function as it discourages parties to act in haste and assume legal obligations without deliberation; and the channeling function, as it is a signal that agreement can be enforced. It seems like a smart legal contract can perform some functions of consideration.
Firstly, it cannot be erased from the blockchain, so there is a constant proof that contract exists. Secondly, automatic enforcement by a computer is a deterrence for a person to create a ‘smart gift.’ As long as execution of promises happens in any case, why not to consider the smart legal contract as an exception to consideration and provide contract law protection to gifts made using this technology?
Mutual Assent and Intent to Be Bound
The formation of a contract requires a bargain in which there is a manifestation of mutual assent to the exchange and a consideration. Some time ago, the subjective theory of mutual assent was dominant, and it assimilates mutual assent to a meeting of minds. Nowadays, the objective theory is more relevant for the determination of mutual assent. It provides that mutual assent to a contract is determined by a reference to external acts and manifestations, not by evidence of a subjective internal intention. It is closely linked to the reasonable man concept. If earlier mutual assent was more like a factual meeting of minds, now it is a meeting of minds that reasonable men would achieve.
Additionally, for a promise to become a contract, there should be an intent to be bound (intent to create legal relations). There is a rebuttable presumption that commercial or business relations imply intent to create legal relations, while social friends’ relations and family or domestic relations do not have such presumption. According to the objective theory, promise that a reasonable person would not take seriously cannot become legally binding.
As the intention test is objective, the fact that the parties submit their cryptographic private keys to commit resources to a smart contract can be served such a commitment. The parties’ mutual intent to be bound does not, however, prove a meeting of minds about some specific contractual provisions. The intent in contracts is about manifestation to be legally bound to something. There is an intention to be bound but to be bound to what exactly? Meetings of minds can be formulated in code, as, in general, mutual assent can take many forms, including a wide range of conduct as long as it clearly implies agreement.
It is not even required to be aware of all the terms of a contract in an electronic agreement. However, to establish mutual assent it is necessary to ensure that the smart contract self-enforces as intended or as promised. The problem is whether the parties understand the functionality of the smart contract in question, and if they are not programmers themselves, they cannot verify whether the code accurately reflects their intentions or whether it will do what it was promised to do. Hence, there can be a discrepancy between what parties were thinking about and what the contract actually does. The problem may become even more dramatic when neither of the parties ordered the creation of code, and they use a smart contract available on the market.
Electronic Agency as a Specific Intent Issue
Intent is what differentiates smart legal contract from just some software based on a smart contract code. Problems may arise when a smart contract concludes another smart contract or when a smart contact is “too smart,” so it is hard to differentiate between the intent of the parties and the ‘own’ will of the computer. If parties intended to give “independence” to a computer, can it be considered as a continuation of parties’ will? In the example of insurance contract we have a computer system based on smart contract code that regulates an amount of premium and provides payment on behalf of the parties to the contract in question. The question is to what extent can it legally bind the parties?
This computer system is called an electronic agent, as defined by the UETA. “Electronic agent” means a computer program or other automated means used independently to initiate an action or respond to electronic records or performances in whole or in part, without review or action by an individual. This program may act automatically, but not autonomously. In 1973, a U.S. insurance company was held liable for its computerized reinstatement of an insurance policy. The court stated that a computer operates based the information and directions supplied by its human programmers. If a computer does not think like a man, it is a man’s fault.
There are not so many helpful cases regarding this question; however, if a smart contract is regarded more as an automated rather than autonomous electronic agent, the problem may be avoided.
Offer and Acceptance
An offer is an act on the part of one person whereby one person gives another the legal power of creating an obligation called contract. Acceptance is the exercise of said power conferred by the performance of some act or acts. An offer functions as a manifestation of willingness to enter a bargain, so made as to justify another person in understanding that his assent to that bargain is invited and will conclude it, while acceptance is a manifestation of assent to the terms thereof made by the offeree in a manner invited or required by the offer. Offer may take a form of promise or performance, while in some cases acceptance may take the form of silence.
Most of the scholars agree that smart contracts have no problems with offer requirements, but there are some specifics related to the acceptance. Smart contract code can be posted to a ledger as an offer. An individual can say they will initiate a smart contract, which may be a regular contract in a legal meaning, but until the program initiates, there is no smart contract and acceptance comes through performance. Once an action is taken to initiate acceptance, such as by sending control over a certain amount of money to the smart contract, offer and acceptance are present.
Regarding the acceptance, there are the same requirements as to electronic agreements. For an electronic agreement to be accepted, the terms must be adequately communicated to the counterparty and cannot be hidden somewhere within the software. The same applies to an external smart contract. Agreement in a natural language and agreement represented virtually should be as much identical terms as possible, and a counterparty shall be aware of all terms that will be automatically enforced, otherwise there is no acceptance.
Nonetheless, there is an opinion that the initialization of the software agent (activation) that merely executes pre-defined conditions does not represent offer and acceptance by itself. However, if A sends B a message saying: “I offer to you that I will initialize this software agent and the actions of the software agent represent my legal obligations to you. Do you agree?”, and B then responds: “I agree”, the requirements for offer and acceptance would be satisfied.
If a software agent (electronic agent) operates non-autonomously, it is not a problem for a contract to be formed. We can compare software agents based on the smart contract code to vending machines. A vending machine is a technology that helps to provide an offer to the world. When we insert a coin into a vending machine, it does not ask whether somebody offers us a can of soda, and we do not respond that we accept the offer. Nevertheless, when somebody buys soda via a vending machine, a valid contract is formed.
Smart contracts can easily comply with offer, acceptance, and consideration requirements. Requirements of intent and mutual assent may represent a problem; however, not so complicated smart contracts that are performed as it was intended by the parties can comply with such requirements. Usage of electronic agents is not a problem if the smart contract is not autonomous. Hence, at least some smart contracts may fall within the current contract law definition of contracts.
Disclaimer: This feature, as well as the three exclusive articles released earlier, were kindly contributed by Mykyta Sokolov and are published as is without any major editing.
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