Written by: Aaron Krowne
Smart contracts—self-executing agreements encoded onto blockchain networks—are revolutionizing business processes across industries like finance, real estate, and supply chain management. These contracts automatically execute the terms of an agreement once predefined conditions are met, reducing the need for intermediaries and promising greater efficiency, transparency, and security.
However, as with any transformative technology, smart contracts present significant legal challenges. Issues surrounding enforceability, jurisdiction, regulatory compliance, and privacy concerns have left businesses and legal professionals navigating uncharted territory. This article will explore these legal challenges and provide insight into how law firms like Industria Business Lawyers LLP (IBL) can help businesses overcome these hurdles and unlock the potential of smart contracts.
Understanding Smart Contracts: How They Work and Their Applications
Smart contracts are essentially digital contracts written in computer code that execute automatically when specified conditions are met. These contracts operate on decentralized blockchain platforms, meaning that once deployed, they are tamper-proof and can execute without human intervention. For instance, in the case of decentralized finance (DeFi), a smart contract can automatically release funds when certain conditions are met, such as reaching a target price in a cryptocurrency exchange.
This level of automation provides significant benefits:
- Reduced Intermediaries: Traditional contracts require lawyers, escrow agents, or brokers to oversee the execution of terms. Smart contracts eliminate the need for these intermediaries by executing the terms automatically, saving time and reducing costs.
- Transparency: Smart contracts provide a high level of transparency. Since the contract terms are encoded on the blockchain, they are visible to all parties involved and cannot be altered without mutual consent.
- Security: The decentralized nature of blockchain makes smart contracts resistant to tampering. Once deployed, the contract is immutable, providing strong security against fraud.
Despite these advantages, the legal landscape around smart contracts is still evolving, and their adoption raises several important legal questions.
Defining Smart Contracts in Legal Terms
One of the most significant challenges surrounding smart contracts is defining them within existing legal frameworks. Traditional contract law is well-established, with a contract typically being defined as a legally enforceable agreement between two or more parties involving an exchange of promises. However, smart contracts differ significantly in their structure and execution, raising questions about how—or even if—they can be classified as contracts under traditional legal standards.
In most legal systems, a valid contract requires several key elements: offer, acceptance, consideration, and mutual intent. In smart contracts, these elements are encoded into the contract itself, but this raises several issues:
- Offer and Acceptance: In traditional contracts, offer and acceptance are often clearly documented through written or verbal communication. In smart contracts, these concepts are embedded in the code, making it difficult to verify if all parties fully understood the terms or the code itself.
- Consideration: This refers to something of value exchanged between the parties. In the context of smart contracts, the transfer of digital assets, tokens, or services often serves as consideration, but verifying this can be challenging when dealing with intangible assets.
- Mutual Intent: In traditional contracts, mutual intent is often established through negotiations, emails, or written agreements. In smart contracts, the terms are pre-set and executed automatically, making it harder to establish whether both parties intended to enter into the agreement in the same way they would with a traditional contract.
Courts are still grappling with how to apply these traditional legal concepts to smart contracts. Without clear legislative guidance, it’s uncertain whether all types of smart contracts meet the legal requirements of enforceable contracts, and this uncertainty is a significant barrier to widespread adoption.
For example, in Commodity Futures Trading Commission (CFTC) v. Ooki DAO (2022), the CFTC pursued action against Ooki DAO, a decentralized platform that operated using smart contracts for leveraged and margin trading. The CFTC claimed that Ooki DAO’s activities violated federal commodity trading regulations, arguing that the organization’s smart contracts – because they were accessible by U.S. persons and did not include 28-day expiration limits – enabled illegal trading without proper registration. A key consideration in this case was the jurisdictional question of the required level of activities of Ooki DAO token-holders that would confer legal liability and make participating persons potential defendants. The CFTC asserted that any token-holder who voted in the DAO bore the requisite liability, and it sued all such persons. However, the case ended in default, and never proceeded to adjudication on the merits. This case underscored the challenges courts face in determining the enforceability and regulatory compliance of smart contracts, as traditional legal principles may not fully address the decentralized, code-based nature of these agreements. Additionally, the UK Jurisdiction Taskforce’s Legal Statement on Cryptoassets and Smart Contracts provides guidance on how smart contracts may fulfill contract law requirements under English law, though it stops short of offering full legal clarity. These examples highlight the evolving but still ambiguous stance of legal bodies on smart contract enforceability.
The Jurisdictional Maze: Where Do Smart Contracts Reside?
Blockchain technology is decentralized by nature, meaning that transactions executed via smart contracts can occur across multiple jurisdictions. This raises a crucial legal question: Which jurisdiction’s laws apply to a smart contract if a dispute arises?
Traditional contracts are usually subject to the laws of a specific jurisdiction, based on where the parties are located or where the contract was signed. However, with smart contracts, the decentralized and global nature of blockchain complicates this:
- Cross-border Transactions: A smart contract executed between two parties in different countries could be subject to conflicting legal frameworks. For instance, one country may recognize smart contracts as legally binding, while another may not.
- Choice of Law: Some smart contracts include a “choice of law” clause that specifies which jurisdiction’s laws will apply in the event of a dispute. However, enforcing these clauses in the context of decentralized, global transactions remains difficult.
The lack of clarity around which legal frameworks apply to cross-border smart contracts creates significant risks for businesses, particularly those engaging in international transactions.
Enforceability: Are Smart Contracts Legally Binding?
One of the primary concerns surrounding smart contracts is whether they can be considered legally binding. While they are capable of executing agreements automatically, it’s not always clear if they meet the legal requirements necessary for enforceability under existing laws.
Code as Contract: Smart contracts are essentially lines of code that execute predetermined actions, but unlike traditional software, they are explicitly intended to serve as enforceable agreements, often without any traditional legal terms or user agreements attached. While proponents argue that this code alone can represent a binding agreement, the situation is more complex in legal contexts. In traditional software, users are typically bound by a clickwrap or browsewrap agreement, clearly outlining terms, liability, and the user’s acceptance of potential consequences. These agreements are considered enforceable because they indicate an explicit acceptance of risks and responsibilities by the user.
Smart contracts, however, lack these formal agreements; they execute automatically without explicit user confirmation beyond initial deployment. The code alone is often intended to serve as the agreement, making it difficult to prove whether all parties fully understood or accepted the terms embedded within it. While there may be online Terms of Service associated with the relevant smart contracts, the ability to bind smart contract users to these terms may be questionable. Courts may therefore struggle to assess intent and liability, especially when the smart contract’s code is complex or ambiguous. This gap between traditional user agreements and the “code-is-the-contract” approach in smart contracts creates a legal grey area, as it is often unclear whether users activating a smart contract truly accepted all embedded terms and potential risks as they would in traditional software contexts.
Meeting Writing Requirements: In many jurisdictions, certain types of contracts, such as those involving real estate or large financial transactions, must be documented in writing to be enforceable. Smart contracts, which exist only as code, may not meet these requirements. While some jurisdictions are beginning to recognize digital contracts, the recognition of smart contracts remains inconsistent, and their enforceability may vary depending on the jurisdiction. For instance, in the United States, several states like Arizona and Tennessee have passed laws recognizing the enforceability of smart contracts, affirming that contracts created through blockchain technology carry the same legal weight as traditional contracts. Conversely, in other jurisdictions like the European Union, while there is ongoing discussion around the legal status of smart contracts, the EU’s regulatory framework—such as the upcoming Markets in Crypto-Assets Regulation (MiCA)—has yet to establish clear guidelines specific to their enforceability. This patchwork approach means that businesses operating across borders may face differing legal interpretations and risks when using smart contracts.
Without a clear standard for interpreting and enforcing smart contracts, businesses adopting this technology may face legal uncertainty, especially when disputes arise. However, it’s worth noting that international transactions almost always carry inherent legal ambiguities, due to conflicts of laws between jurisdictions. One example of an organized attempt to deal with this situation is seen in global financial frameworks like those of the International Swaps and Derivatives Association (ISDA). The ISDA, which governs international swaps transactions, has developed extensive contract forms to address cross-border legal conflicts in derivatives settlements. Yet, despite well-developed provisions like these, legal ambiguity and uncertainty often remains – particularly when the laws or regulations of jurisdictions overtly conflict, or lack unified standards. Similarly, smart contracts may one day benefit from a similar framework to standardize terms and reduce some legal ambiguity, although a complete elimination of uncertainty is likely unrealistic.
The Issue of Immutability: Error and Unforeseen Circumstances
A hallmark of blockchain technology is immutability—once a smart contract is deployed, it cannot be altered. While this feature provides security and transparency, it also poses significant challenges, particularly when errors or unforeseen circumstances arise.
In traditional contracts, if a mistake is made in drafting or interpreting terms, parties often have recourse to renegotiate or seek legal remedies, such as contract reformation or rescission. (However, this flexibility is not guaranteed; if a mistake benefits one party, they may refuse to concede or correct it, leaving the other party without relief – but by default, “paper” contracts are more flexible.) In contrast, smart contracts lack the flexibility to accommodate disputes or renegotiations once executed, as their terms are automated and immutable by design – unless adjudication features are built-in. However, even then, there may be flaws or shortcomings in the resolution methodology that leaves some parties dissatisfied.
The case of Polymarket exemplifies this situation. Polymarket is a blockchain protocol where outcomes of smart contract-based markets pertaining to real-world events are determined through weighted voting, allowing large stakeholders to influence results regardless of actual outcomes. For instance, in the October, 2024 “Israel attacks Iraq” market contract, votes from high-stake participants swayed the result to “YES” despite “NO” being the real-world outcome – leading to a loss for smaller investors who had accurately forecasted the outcome. This incident highlights how smart contracts, without built-in mechanisms for dispute resolution or correction, can lead to outcomes that are misaligned with factual events or equitable intentions.
Moreover, if there is a coding error that causes the contract to execute incorrectly, reversing the transaction can be extremely difficult, if not impossible. This immutability can lead to unintended outcomes, and parties may have little recourse to correct the mistake without deploying a completely new contract, often at significant cost.
This lack of flexibility is particularly problematic in industries like real estate or finance, where contract terms may need to be adjusted in response to changing circumstances. Traditional contract law allows for the renegotiation of terms when unexpected situations arise, but smart contracts are not designed to accommodate such changes, potentially leading to disputes and legal challenges.
One potential solution, which has been used by some publishers of smart contracts, is to have a mechanism to object to an outcome (which could be due to a fault in the smart contract), appealing to an arbitration provision. However, such a mechanism is far from standard among all live and operating smart contracts, and as mentioned, may itself have significant flaws.
Regulatory Challenges: How Governments Are Struggling to Keep Pace
Governments and regulatory bodies worldwide are still playing catch-up when it comes to regulating smart contracts and the blockchain technology they rely on. The decentralized and autonomous nature of blockchain presents unique challenges to regulators, who are accustomed to overseeing centralized intermediaries and traditional contractual arrangements.
Lack of Standardized Frameworks
One of the major challenges facing regulators is the lack of a standardized regulatory framework for smart contracts. Different countries have taken varying approaches to regulating blockchain and cryptocurrency, but few have addressed the specific legalities of smart contracts in detail.
For example, the European Union has introduced the Markets in Crypto-Assets (MiCA) regulation, which seeks to provide a comprehensive framework for regulating blockchain technologies, including cryptocurrencies and tokens. However, it does not fully address the unique legal challenges posed by smart contracts. In contrast, the U.S. still lacks a unified federal framework, with much of the regulatory burden falling to individual states.While some states have passed legislation recognizing smart contracts and blockchain records, these regulations vary widely. However, there are steps toward greater consistency, such as the recent introduction of UCC Article 12, which aims to provide clarity on digital assets and their treatment in commercial transactions. UCC Article 12 addresses issues like ownership rights and security interests in digital assets, providing a standardized approach to governing these assets across state lines. Although still in its early stages, Article 12 could serve as a foundation for broader federal regulations, state laws and commercial standards on smart contracts in the future, offering more clarity and uniformity to businesses operating in multiple states.
This patchwork of regulations makes it difficult for businesses operating in multiple jurisdictions to ensure compliance. Without clear legal guidelines, companies may inadvertently violate laws, leading to significant legal liabilities.
Privacy and Data Protection
Another regulatory concern is the intersection of smart contracts and privacy laws, most notably, the General Data Protection Regulation (GDPR) in the European Union and the California Consumer Privacy Act (CCPA) in the U.S. Both of these laws give individuals the right to have their personal data erased under the “right to be forgotten” or “right to deletion” provisions. However, blockchain’s immutable nature makes deleting data embedded on-chain via smart contracts nearly impossible, leading to potential conflicts between smart contracts and privacy laws.
Ensuring that smart contracts comply with these stringent data protection laws is a major challenge for businesses, especially those operating across multiple jurisdictions.
Consumer Protection: Could Smart Contracts Exploit Users?
In addition to regulatory challenges, smart contracts also raise concerns about consumer protection. Traditional contracts are often subject to consumer protection laws, which ensure that individuals have the ability to challenge unfair terms or void contracts entered into under duress. However, the automatic execution of smart contracts can limit the ability of consumers to dispute an agreement or seek recourse.
For example, in traditional financial services, consumers can often contest charges or transactions they believe to be incorrect. With smart contracts, once a transaction is executed, it may be difficult to reverse. This lack of flexibility could leave consumers vulnerable to exploitation, particularly in industries like DeFi, where smart contracts are increasingly being used to manage complex financial transactions.
Regulators may need to develop new frameworks specifically addressing consumer rights in the context of smart contracts to ensure that individuals are not unfairly disadvantaged by this technology.
How Industria Business Lawyers LLP Can Help
Navigating the legal complexities of smart contracts can be daunting for businesses, particularly as regulatory frameworks continue to evolve. Industria Business Lawyers LLP offers expert guidance in addressing the legal challenges associated with smart contracts, helping businesses ensure compliance and reduce legal risks.
Our team of legal professionals specializes in blockchain and cryptocurrency law, offering services that include:
- Smart Contract Creation and Review: We can help design, review, and optimize smart contracts to ensure they meet legal requirements and mitigate risks.
- Dispute Resolution: In the event of a dispute, we provide expert legal advice to help resolve issues related to the enforceability or execution of smart contracts.
- Cross-border Contract Enforcement: We assist businesses in navigating the complex legal landscape of cross-border smart contracts, aiming to make agreements more enforceable across multiple jurisdictions.
Conclusion
While smart contracts offer the potential to revolutionize the way agreements are made and executed, they also present significant legal challenges that cannot be ignored. Issues surrounding enforceability, jurisdiction, privacy, and regulatory compliance make it essential for businesses to seek expert legal counsel when adopting this technology.
At Industria Business Lawyers LLP, we understand the complexities of smart contract law and can provide the guidance businesses need to navigate this evolving landscape. Contact us today to learn how we can help your business successfully adopt smart contracts while minimizing legal risks.