FREE CHAPTER from ‘A Practical Guide to Smart Contracts and the Law’ by Lizzie Williams

CHAPTER TWO – WHAT IS A SMART CONTRACT?

  1. Overview

    1. This chapter examines the meaning of the term “smart contract”. Various meanings have been given to this term historically, which has created scope for confusion.

    2. For the purposes of this book, we will adopt the definition of “smart contract” given by the Law Commission in its Advice to Government:

Computer code that, upon the occurrence of a specified condition or conditions, is capable of running automatically according to pre-specified functions.”1

    1. Computer code is essentially a way of giving instructions to computers. When writing a computer code, usually, a programmer drafts the code in what is called “high level” source code, using symbols and words, and it is later converted into lower level, binary, “machine code”. Unless you are a coder, the “high level” code may be very difficult to understand, and almost no one would be able to interpret the binary “machine code”.

    2. However, sometimes a computer code will contain “natural language comments” – i.e. comments in ordinary English or another language – which outline the workings of the code. These comments make it easier for a new programmer to understand and amend the code later on, if that becomes necessary. As will be explored in Chapter 3, the natural language comments have potential utility in the context of smart legal contracts.

    3. The reference to “specified condition or conditions” indicates that the performance of the code is dependent on a condition or conditions being met, i.e. “If X occurs, then do Y”.

    4. Generally, after the computer code has been deployed, the code is self-sufficient and can run by itself. This is why a smart contract is often said to be “self-executing” – it runs automatically, without human assistance.

    5. Sometimes, the code will receive information from outside data sources which feeds into the action which the code is to take; these sources are often described as “oracles”. For example, a smart contract could be fed financial data from an oracle, and the code could be programmed to perform certain actions based on that data.

    6. Smart contracts are often said to be deployed on a “distributed ledger” or described as using “distributed ledger technology”. That is sometimes shortened to “DLT”.

    7. A distributed ledger is a shared record of data and transactions which is distributed geographically amongst a network of computers, rather than in one central place; those computers are called “nodes”. Each “node” processes every transaction that occurs and updates the ledger. The decentralised nature of the distributed ledger, which is spread around the globe, makes the record very secure and difficult to attack.

    8. Blockchain is a type of distributed ledger that uses cryptography to control new records in the ledger – or new “blocks”. With the Bitcoin blockchain, all blocks on the chain are cryptographically linked, and that means that it is almost impossible to alter the blockchain. That is why blockchains are often referred to as immutable ledgers of transactions.

    9. The distributed ledger technology has developed so that transactions and codes can be performed as well as recorded on the distributed ledger. For example, if a smart contract is deployed on the Ethereum blockchain, the terms set out in the smart contract code should be given effect to by the “nodes” on the network.

    10. There is a distinction to be made between “permissioned” and “permissionless” DLT systems. Generally, “permissioned” DLT systems are private rather than public, and they often have a central administrator who oversees the system. That is to be contrasted with a “permissionless” DLT system, where there is usually no central administrator, and where the ledger is usually public. That is the classic decentralised system. This distinction is potentially important because, where there is a central administrator, errors in the code may be able to be rectified by that administrator. Without such an administrator, that may not be possible.

    11. Smart contracts may increasingly be supported by other technologies in the future, but as things stand, they are most often deployed on distributed ledgers such as Ethereum.

  1. A note on NFTs
    1. One application of smart contracts is “non-fungible tokens” (NFTs). Put simply, NFTs are tokens which are bought and sold on distributed ledgers, and which are unique rather than fungible like cryptocurrency. Whilst NFTs are considered to be tokens, they are, at their core, pieces of code – smart contracts.

    2. The smart contract for an NFT is often created using ERC-721, which is a standard form of Ethereum smart contract that is used as a basis for NFTs. There are other similar standard forms (often known as “data standards” or “token standards”). For example, on the Tezos blockchain, the FA2 standard supports NFTs as well as other types of tokens.

    3. The NFT smart contract can be linked to a digital asset such as a digital artwork. As a result of this, often, an NFT will come to represent the asset to which the NFT is linked. Importantly, however, whilst NFTs are commonly assumed to be transferring ownership or intellectual property in the linked asset, in most instances, that is not the case. The rights being transferred will depend on the terms of the NFT in question, but in many cases, the “purchaser” of the NFT merely receives a limited licence to display a copy of the linked asset for their own personal use, rather than ownership of the asset in a legal sense.

    4. One of the key advantages which is often cited of using NFTs for sharing (whether via a licence or otherwise) digital assets is that the code can be drafted in such a way so that the original “seller” receives a percentage of all subsequent sales of the NFT, akin to royalties, and that continues indefinitely (or at least it should do; difficulties may arise when NFTs are resold on a different platform) (the Royalties Provision). Without smart contracts, it is more difficult for a “seller” to enforce this sort of arrangement contractually. We will consider some potential issues arising in relation to such a Royalties Provision later in this book.

    5. There is another layer to consider, which is the extent to which NFTs are not only smart contracts, but also property. In Osbourne v Persons Unknown,2 which involved the alleged misappropriation of NFTs, the judge was satisfied that there was “at least a realistically arguable case” that NFTs are “to be treated as property as a matter of English law3. As a result, a freezing injunction restraining the dissipation of the NFTs was granted in that case. Consistent with this, in the “Digital Assets: Consultation Paper” released by the Law Commission in July 2022, it was said that:

the starting point is that an NFT, as an individually identifiable crypto-token, is an appropriate object of property rights.4

    1. Similarly, it is likely that cryptocurrency is a form of property. In LMN v Bitflyer Holdings Inc. & Others5 Butcher J stated that:

There is a good arguable case that cryptocurrencies are a form of property. This is supported by the legal analysis in the Legal Statement of the UK Jurisdiction Task Force (‘Legal Statement’) paras. 71-84, referred to and adopted by Bryan J in AA v Persons Unknown [2019] EWHC 3556 (Comm) at [56]-[61]”.6

    1. The fact that NFTs and cryptocurrency are likely to be forms of property may have an impact on, for example, the law and jurisdiction applicable to a smart legal contract of which they are the subject (see Chapter 4) and the remedies available if a dispute arises (see Chapter 8).

  1. A note on DAOs
    1. Decentralised autonomous organisations” (DAOs) are decentralised organisations which are governed by their members. They may have commercial or non-commercial purposes. The protocols which underpin and provide the framework for DAOs take the form of smart contracts. DAOs are therefore a further application of smart contracts.

    2. The legal status (if any) of any given DAO will depend on its particular structure and features, but as a matter of English law, depending on the circumstances, a DAO may, for example, be deemed to be a general partnership, or an unincorporated association, or a purely contractual joint venture. The consequences of contracting with a DAO or its members will depend on its legal status. The Law Commission is considering the legal status of DAOs at the time of writing, following a call for evidence in November 2022.7

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1“Smart legal contracts Advice to Government”, Law Commission, November 2021, at page vii: https://s3-eu-west-2.amazonaws.com/lawcom-prod-storage-11jsxou24uy7q/uploads/2021/11/Smart-legal-contracts-accessible.pdf [Accessed on 18 December 2022]

2[2022] EWHC 1021 (Comm); [2022] 3 WLUK 718

3[2022] EWHC 1021 (Comm); [2022] 3 WLUK 718 at [13]

4“Digital Assets Consultation Paper”, Law Commission, July 2021, at para 15.16: https://s3-eu-west-2.amazonaws.com/lawcom-prod-storage-11jsxou24uy7q/uploads/2022/07/Digital-Assets-Consultation-Paper-Law-Commission-1.pdf [Accessed on 18 December 2022]

5[2022] EWHC 2954 (Comm); [2022] 11 WLUK 379

6LMN v Bitflyer Holdings Inc & Others [2022] EWHC 2954 (Comm); [2022] 11 WLUK 379 at [19]