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What Are Smart Contracts And How Do They Work?

In this article, we will analyze what are smart contracts, how they might be designed, and the challenges presented by them.

What Are Smart Contracts?

Smart contracts had a breakthrough with the advent of Bitcoin and the expansion of blockchain technology. First presented in 2008, the Bitcoin protocol was a thriving experiment in the use of decentralized ledgers, which form an important basis of smart contracts.
Currently, smart contracts are deemed an important part of the world of digital finance and the economy. The main idea claims that blockchain will replace the legal system as the utmost trusted third party. Rather than having a lawyer write an agreement to be executed by a judge, if one party does not
fulfil its obligations, the performance of the parties’ obligations is made automatically by the software. The software is automatically executed when the predetermined criteria are confirmed by the decentralized blockchain.

How Can They Be Designed?

From a legal perspective, smart contracts can be designed as strong or weak. Strong smart contracts have prohibitive costs of revocation and transformation, while weak smart contracts do not. In that sense, if a court can alter a contract after it has been enforced with relative ease, then it will be considered a weak smart contract. If there is a large cost to modify the contract in a manner that would not make sense for a court to do, then the contract will be characterized as strong.
Also, smart contracts can be categorized according to the way they are agreed upon. There are those smart contracts that are agreed in natural language where the obligations are translated into and executed by code and those where the obligations are defined by code. The second type is probably more challenging from a legal standpoint. Parties should consider which one would serve their needs better.

Thus, to design a smart contract the following things must be taken into consideration:

– Define which events have the potential to trigger the implementation of the contract
– Examine if any intakes are affecting the execution feasibility
– Identify the limitations of the blockchain platform
– Define the data aspects
– Establish conditions of execution considering the business logic

Considering this, a smart contract can vary from a simple contract to a very complex contract.

How Can A Dispute Be Solved?

Smart contracts that use blockchain or similar platforms bring important questions about which courts would have jurisdiction over any disputes related to it, and which law would be applied. Blockchains typically have a decentralized structure with no central controlling body. Also, smart contracts comprising blockchains entitle parties to transact between numerous jurisdictions. If the legal framework of a smart contract does not specify the governing law and jurisdiction, this could be a big challenge to a party aiming to enforce their rights through the courts.

To begin with, it is important to look at how courts will deal with the questions of jurisdiction and governing law since there is nothing that prohibits existing rules of determining jurisdiction from being applied.

In cases in which the parties stipulate the jurisdiction, courts predominantly respect that choice. With governing law, courts also accept parties’ express or implied choices. However, if the parties do not stipulate in the contract, different approaches can be taken: the courts where the defendant is domiciled will accept jurisdiction (that solution is useful if the identity of the defendant is known);a jurisdiction that has a close connection with the contract; the usual place of the party affecting the characteristic performance of the contract. However, this might be harder to specify if the characteristic performance is mainly digital.
One possible way of dealing with this is through the pre-specification by blockchain or other platforms of the jurisdiction and applicable law for any transaction that happens on it. Another option is for arbitration to provide a mechanism less connected to any specific jurisdiction, however, it is too premature to state whether such mechanisms will provide efficient enforceable solutions that could be applied to smart contracts.

Case Studies

One example of the use of smart contracts can be seen through a French insurance company that offered automatic flight delay insurance that was registered and enforced on the Ethereum blockchain. It triggered restitution as soon as a predetermined requirement, for example, a flight cancellation was fulfilled.
Another example is the starter interrupter combined with a decentralized ledger. Instead of programming the contract are so that its inputs and outputs are specified and performed by the creditor’s software, a car’s contractware can be programmed so that its inputs and outputs are specified and performed by a blockchain. Suppose the applicable term of the contract is that “If Edward does not pay Wilson100 euros by April 3rd at 6 p.m., then Edward’s car will be immobile, and Wilson can repossess.” The contractware will look for the blockchain for this transaction, and in case it finds it, will allow the car to start. If it does not find the transaction, it will stop the car from starting. Neither of the parties must trust the other for the contract to be performed. They must trust the neutral blockchain that is capable of executing the applicable terms. Below, we analyze a real case judged by the Federal Court of Germany, very similar to the case study proposed.

Case Law

The German Federal Court of Justice recently had to decide on a case (BGH, 26.10.2022 – XII ZR 89/21), in which a French bank that had been offering multiple leasing agreements started to offer different lease agreements for batteries to be used in electric cars. The bank’s general terms and conditions contained a provision that authorized the bank to turn off the recharging of the battery in case the lease agreement was ceased, especially, for a cause.

The court verdict does not determine how this blocking was technically accomplished. It just refers to digital remote access to the battery controls, made through the board computer of the car. If this remote entry was triggered by a smart contract is not specified. Still, smart contracts are put forward when the legal grounds for the judgment are examined.

When examining the topic of unlawful interference it is understood that under the general rules of the contract, the customer is obliged to submit the car’s battery after the cessation of the lease. However, a lessor’s right to access by way of self-help does not exist. This result is embedded in the legal distinction between property and possession/ownership, applied in German law. The German Civil Code states that whoever restrains the owner of possession without the owner’s desire or bothers the owner in possession, acts unlawfully unless the law particularly permits the deprivation or the disturbance.

In the case discussed, the lower court had ruled that the blocking of the recharging opportunity depicted an unlawful interference, since, by blocking the possibility of charging, the lessee’s power of influence is limited.

The Federal Court of Justice maintained the result of the lower court’s decision. However, the Federal Court of Justice did not rely on unlawful interference, instead, it was considered inappropriate that the blocking of the recharging possibility also precluded the customer from using the car, a much more valuable aid than the battery.

This case is relevant when discussing smart contracts because the Federal Court of Justice opined that “in this respect, digital intervention in the control of the rental object is no different from physical intervention in electronic or mechanical control of the object. The digital blocking of the charging option accordingly achieves the same result as its electronic or mechanical blocking.”

In other words, with the Federal Court of Justice not expressly relying on unlawful interference, and establishing that an electronic intervention can be unlawful, it shows that the use of a smart contract to automate a lease agreement, as the one in the case at hand, could likewise be challenged.

However, this case has its specificities, which may not prevent a different result in other cases. Anyway, the case shows that even new and disruptive technologies still must take into consideration the existing legal system.

Conclusion

Smart contracts are still at an early age and will need to be developed to be widely adopted in different complex contractual relationships. Meanwhile, it is important to think about how existing concepts and structures can be applied to this new technology, and how this new technology can bring challenges that will need new frameworks to deal with it.