Old Cargo in New Vessels: A Simple Guide to Smart Contracts

INTRODUCTION

Smart contracts are poised to reshape the way many businesses negotiate, store, and execute their agreements. In 2024, smart contracts – which store and execute agreements on a Blockchain – made up USD $2.02 billion in global transactional value, with projections forecasting that figure to reach USD $815.86 billion by 2034.

In light of this rapid growth, this article looks to explore the ‘what, why, and how’ of smart contracts from the practitioner’s point of view, preparing them for a new frontier in commercial law by providing a list of best practices to adopt.

I: The What, How, and Why of Smart Contracts

1. What is the Blockchain?

In simple terms, the Blockchain is a shared and immutable digital ledger. It records transactions and digital token (or asset) holdings in a publicly accessible register. This register is composed of a network of separate and independent nodes (computers) which must operate as a consensus to host and record information on the register.[1]

2. What is a smart contract?

Smart contracts are programs composed of “if…then…” instructions that are sent to a Blockchain to automatically execute certain actions when specific preconditions are met and verified. Once the program is triggered and executed, and the transaction is completed, the Blockchain is updated.

While smart contracts are not in and of themselves legal agreements, they have become an increasingly common platform for the storage and execution of legal agreements.

Information contained on the Blockchain cannot easily be tampered with. The transactions taking place, as well as the digital asset holdings of those involved in the transaction, are always publicly accessible to others on the Blockchain. And once information is coded onto the Blockchain, its operation relies solely on the satisfaction of preconditions reported to and then verified by the Blockchain, dispensing with the need for further action by either party to the agreement.

There are two types of smart contracts that are used in commercial transactions. The first type sees the entire agreement, including the corresponding consideration, secured on the Blockchain. This is known as an internal smart contract. The second type sees the smart contract play a complementary role, acting as a secondary agreement responsible for governing (and more importantly executing) specific terms and conditions related to a primary, text-based agreement. This is known as an external smart contract. This article’s focus will be on the former, since it is where the most difficulties arise with respect to a lawyer’s day-to-day practice.

At present, internal smart contracts require absolute precision and objectivity in its terms. Given the Boolean nature of the contract’s underlying logic, there is no room for intersubjective or interpretive terms to the agreement. They must be fashioned as if-then statements. However, as Artificial Intelligence (“AI”) and Blockchain technologies continue to see further synergistic applications, the potential for more complex smart contracts executing conditions that rely on ‘reasonableness’ and other variable terms may be possible.

3. How do smart contracts operate?

To better understand how precisely smart contracts work, it may be of benefit to provide a step-by-step process of its formation and execution. First, the parties must agree to the terms and conditions of the agreement itself. Second, the parties must agree to use the Blockchain in relation to their agreement. This is where the bifurcation between internal and external smart contracts takes place. Third, the parties must pay a transaction fee to have the smart contract coded onto a given Blockchain. Finally, with the smart contract formed, the parties would have to agree to a specific mechanism by which the Blockchain can verify that the preconditions have been met. This mechanism is known as an Oracle – a third-party that receives, verifies, and pushes ‘off-chain’ information onto the Blockchain, confirming that a precondition has been met and a specific consequence can be triggered.

4. Why do businesses use smart contracts?

Businesses use smart contracts because of the certainty, efficiency, and accessibility they offer.

First, smart contracts ensure individuals and organizations engaged in commercial transactions can do so with a negligible risk of uncertainty about terms and conditions. Agreements on the Blockchain generally cannot be amended afterwards. This encourages both parties to exercise a high degree of diligence in both drafting the language of the agreement and coding it onto the Blockchain, knowing subsequent amendments require a high threshold to be met. Most importantly, given the Boolean logic of smart contracts, the prospect of an agreement being executed improperly is excised from the equation.

Second, smart contracts provide certainty about the actual execution of the agreement upon performance. With the exchange of consideration between parties entrusted to the Oracle and Blockchain, the possibility of one party refusing to compensate the other upon the fulfillment of a predicate condition, is foreclosed entirely.

Third, smart contracts minimize the transactional costs – in time and dollar value – that come with reliance on intermediate parties to execute and enforce an agreement.

Fourth, smart contracts increase accessibility by allowing commercial entities to engage with the world of Decentralized Finance (“DeFi”) – a market consisting of financial institutions who run all their operations through smart contracts.

II: Best Practices

The following is a non-exhaustive series of best practices that solicitors and litigators alike should be mindful of as they work on cases and transactions involving smart contracts.

1. A Matrix of Agreements

Lawyers should advise their clients to strike an agreement ahead of time with the counterparty on whether they intend to form an internal or external smart contract on the Blockchain. Lawyers should also advise their clients to strike an agreement with the party entrusted to code the parties’ intentions onto the Blockchain as well as the Oracle responsible for confirming and validating performance of the smart contract’s terms and conditions.

2. Paper Trails

Lawyers should advise their clients to have a paper-based version of their internal smart contract drafted and shared between the parties in case an interpretive dispute arises later down the line. It is strongly advised that lawyers do not instruct their clients to settle for an entire agreement clause in a smart contract, given the high probability that the agreement’s code may malfunction or vary from the instructions of either of the parties.

Lawyers should record the communication of their client’s (and counterparty’s) intentions to the programmer as the latter builds the code for the smart contract (whether internal or external). This ensures that, if the parties (or one of the parties) do not believe their intentions were accurately reflected in the code making up the smart contract, there is a point of reference available to correct input errors.

Once a smart contract has been coded onto the Blockchain, lawyers should advise their clients to secure written representations from the programming party confirming that their code functions as contemplated and communicated by the parties.

3. Insuring against the Unexpected

Lawyers should advise their clients to acquire (if available) smart contract insurance where the agreements involve a large transaction value and operate at a high level of complexity to protect against the variety of risks that come with conducting business on the Blockchain. Lawyers should also review any and all agreements with the third-party programming company and Oracle to ensure liability for coding or confirmation errors are appropriately distributed or insured against. Finally, lawyers should advise their clients to require minimum balances in the parties’ smart wallets should they be of a scale and sophistication that involves moving funds around in high frequencies to maximize available liquidity.

CONCLUSION

Smart contracts will inevitably disrupt the ground on which the entirety of business law rests, and while this may offer novel opportunities, it also introduces a great deal of chaos. It is important that lawyers in Canada (and abroad) prepare themselves for this coming disruption. This article serves as an important step in that process.

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