Smart contracts are increasingly becoming a popular alternative to traditional contracts for businesses looking to automate when provisions of an agreement are executed. The goal is to reduce manual administration often needed for intermediation, arbitration and enforcement.
The global smart contracts market is estimated to reach $770 million by 2028, up from $145 million in 2020 (24.6% CAGR) and represents a growing opportunity for managed services providers and other tech companies. Here’s a detailed look at what smart contracts are, how they work, and what the benefits and challenges are—as well as answers to some most-asked questions.
What is a Smart Contract?
A smart contract is a contract written in blockchain code that automatically executes when certain predetermined conditions are met.
In order to understand what a smart contract is, it is necessary to first understand the legal definition of a contract. A contract is, in its simplest terms, an offer for an offer: one party makes an offer to do something of value for the second party and the second party accepts the offer and agrees to provide something of value in return. In order for a contract to be legally enforceable there must be:
- A meeting of the minds
- Offer and acceptance
- Exchange of consideration (something of value)
- Capacity (each party must be mentally capable of choosing to enter into the agreement)
Contract law in the United States is governed by state law—there is no federal contract statute. There are, however, model laws that have been adopted in many states. Those laws include the Uniform Commercial Code (UCC) and the Statute of Frauds. Most states have also passed laws that allow some component of a contract to be electronic, such as electronic signatures. Those laws include the Uniform Electric Transactions Act (UETA) and the Electronic Signatures Recording Act (E-Sign). All contracts must comply with the laws as adopted by the state in which the contract is written or, in the alternative, the particular state designated as governing.
Some states, such as Arizona, Illinois and Tennessee, have laws that specifically hold smart contracts to be enforceable. Other states have those laws pending.
Examples of Blockchain Use and Smart Contracts
You might be familiar with blockchain technology (and if not, here’s a glossary for beginners developed by CompTIA’s Blockchain Advisory Council). The most basic example of a smart contract is a vending machine. Consider:
- The offer: I’ll deposit money into the machine if the machine gives me a snack
- The consideration: the money that is deposited into the machine
- The acceptance: the machine takes the money and delivers the snack.
This is all done electronically, without any English language document directing the parties.
There are many industries that make use of blockchains now, particularly industries in which a supply chain is involved. Those include:
- Oil and gas
- Food distribution
- Pharmaceutical distribution
- Dispute resolution
- Insurance Companies
- Banking and Finance
An example in the last category is JP Morgan Chase, which has filed for a patent application describing a distributed ledger-based version of floorplan lending, a revolving line of credit that allows car dealers to borrow against retail inventory.
In addition, here are some examples of how blockchain use will evolve into smart contract use:
Supply Chains. Smart contracts can track a product from the second it is put on a truck or delivered to a destination, and other key details. Once the product is delivered, payment is released according to the terms of the contract to everyone along the supply chain. A smart contract can also direct that a commodity be reordered when it falls below a certain number.
Flight Insurance. The only thing more aggravating than a delayed flight is trying to collect under a flight insurance policy. Smart contracts are now used by some airlines to simplify the process. Flight details are loaded into an app. If a flight is delayed by a specific number of hours, the passenger is automatically notified with compensation options. The passenger chooses one and the payment is automatically sent to their credit card.
Real Estate. Residential real estate transactions are complicated and require many calls and emails among the buyer, seller, attorneys and real estate agents. Smart contracts simplify the process. Upon certain conditions being met, title searches can be ordered, escrow can be deposited or released, and other conditions can be satisfied without necessitating that either side make a phone call or click “send.”
Benefits and Detriments to Using Smart Contracts
Is a smart contract appropriate for your transaction? The answer is, as you might guess, it depends. There are times when a smart contract is an ideal option for your needs, but other times when it’s not.
There are multiple benefits to using smart contracts. For one, it can automate processes that previously had to be done manually, specifically when a condition is met, and a next part of the contract is executed. In addition, they can eliminate the go-betweens in many scenarios and potentially cut significant costs.
Smart contracts can also provide immutable, specific information about the performance of the contract, including times, dates, weights and measures, for conditions in the contract. Finally, smart contracts can imbue full trust between parties because the transactions on the blockchain are immutable and transparent, preventing any potential fraud or mistakes.
Of course, there are several disadvantages as well. For example, there is no room option in a contract for estimates or judgment calls. In other words, nothing can be “deemed satisfactory” to meet a condition of the contract.
In addition, parties cannot edit the terms once the smart contract is coded. This means that errors or bugs in the code cannot be corrected, and the contract can’t be stopped once executed. Parties can add to the code, changing what exists, but this is usually time-consuming and expensive.
Perform a Cost/Benefit Analysis to Determine What’s Best
It’s important to weigh the costs of each situation to determine if smart contracts make the most sense.
The parties must pay attorneys who understand the framework and also pay coders to write the code. They may also have to pay oracles, third parties who will verify that a certain condition of the contract has been met. The parties should also purchase insurance against errors. (This will be discussed below.) The costs should be measured against the potential savings of all or part of the transaction being self-executing.
After a contract has been executed, it’s important to watch the “gas” mileage. Some platforms have a limit—they charge a fee based on a particular number of transactions or lines of code executed. If you have loops running a certain number of times you may run out of “gas” and the execution of the smart contract might stop until an additional fee is paid.
Are Smart Contract Enforceable in a Court of Law?
It is important to take note of or, if possible, to choose which jurisdiction is governing. Are there statutes, cases or regulations in your jurisdiction that specifically recognize smart contracts as enforceable under the law? If not, are there statutes, cases or regulations that provide if electronic signatures are legally binding?
Several states in the U.S. have enacted laws specifically governing the enforceability of blockchain-based contracts, and a number of others have recognized the existence and enforceability of such contracts through legislation or jurisprudence.
As of early 2022, at least 33 states and Puerto Rico have pending legislation. Seventeen states enacted legislation or adopted resolutions. For example, New Jersey introduced a “Virtual Currency and Blockchain Regulation Act” in November 2021. If enacted, the bill would establish a regulatory framework for New Jersey virtual currency businesses, create provisions governing the use of blockchain with certain business entities, and create incentives for virtual currency businesses in the state.
In New York, Assembly Bill A3760 was introduced that would allow signatures secured through blockchain technology to be considered electronic signatures.
Industry Regulations May Limit Smart Contracts
Does your industry have regulations that permit, limit or govern the use of smart contracts? Be mindful of regulations that are applicable to your specific industry.
Be especially cautious if your blockchain transaction involves cryptocurrency or NFTs. The SEC issued rulings in several cases that certain NFTs are “securities” and must be regulated as such, even though the parties were required to acknowledge that the purchase was not for investment purposes.
Don’t Forget the Little Details
Think carefully before choosing a blockchain developer and platform. Consult an expert when determining which blockchain code to use.
The parties should clearly define coding standards, review and test procedures, and how the parties will agree when the code is ready to deploy, as well as who will bear any transaction costs of running the smart contract on the applicable blockchain.
It’s also wise to be as specific as possible when describing the terms of the contract to a developer. A developer is not a lawyer and cannot be asked to understand the intent of the parties or the law that applies.
In many cases, there may be a text template which is sufficient. In other situations, new code will have to be written. If that’s the case, the parties (or each party) will need a trusted intermediary. If the coder is not a lawyer, it may be necessary to strip down the terms of the contract to a “term sheet” that can be agreed upon by the parties ahead of time. The parties can also agree ahead of time on the person/firm to be entrusted with the coding.
Insure Yourself Against Mistakes
The parties may need to insure themselves against the possibility that the terms of the contract are not properly reduced to writing.
Assess whether the terms of the contract rely on off-chain information (for example, temperature, market indices, price fluctuations, or judgment calls.) If so, agree with your counterparty on an “oracle” to verify this information. Oracles are human, so they are fallible. Because of this, be careful when selecting one.
Additionally, parties might consider building contingencies into the terms of their agreement in case an oracle makes an error, because one error could wreak havoc on entire transactions. These steps may include instituting a “kill switch,” shutting off automatic execution of the contract or appointing a backup oracle to take their place. It could also include creating a side agreement that governs the contract if something goes wrong.
Parties should purchase insurance against such failure or create an indemnification scenario. Build in specific provisions (or execute ancillary agreements) to manage risk and liability issues. These may arise in a variety of different contexts, including coding errors (and developer liability for same), execution failures, force majeure, hacks, etc.
Test, Build and Evaluate the Contract First
As with any other agreement, run through every possible legal and technical scenario to ensure that the contract and the code do what is intended in every anticipated situation. It is possible that parties will agree upon the terms of a contract and agree that the code written to affect those terms was accurate. However, the agreed upon code may bring about an unanticipated or not-agreed-upon result.
Businesses are likely to be interested in the option of blockchain-led smart contracts once they understand how they work and the benefits (and challenges). With that in mind, it’s incumbent upon MSPs to educate themselves on blockchain and smart contracts in order to initiate conversations with prospects and customers and answer their questions.
For more on smart contracts and other blockchain-related resources, join CompTIA’s Blockchain Technology Interest Group!
Lisa W. Spiegel, Esq., is associate executive director, continuing legal education, for the New Jersey State Bar Association.