Nexus: smart contracts

The UK Government sheds light on the status of cryptoassets and enforceability of smart contracts (Part II)

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In his foreword to a legal statement issued by the UK Jurisdiction Taskforce (UKJT), Sir Geoffrey Vos, Chancellor of the High Court, is confident: “cryptoassets and smart contracts undoubtedly represent the future”. The IPKat has previously reported on the UKJT’s analysis of the cryptoassets as a property, see here. This post will provide an overview of the UKJT’s guidance on the enforceability of smart contracts.

Are smart contracts enforceable?

As with the cryptoassets, the UKJT avoids formulating a precise definition for smart contracts, seeking instead to identify their novel and distinctive features. A smart contract is performed automatically without human intervention, which requires its terms to be embedded in a computer-readable code. Generally, there is no need for a party to either promise performance or resort to law to enforce a promise by the other party.

However, in UKJT’s view, the scope for legal intervention in smart contracts may be much reduced, but not entirely eliminated:

“[…] there will always be a risk that performance is affected by an event external to the code, for example, a system failure, or that the code operates in an unexpected or unintended way, and in such cases any dispute must be capable of adjudication.”

According to the UKJT statement, the automaticity of a smart contract does not preclude it from satisfying the conventional contract requirements, such as: (i) two or more parties objectively reaching agreement as to the terms that are sufficiently certain; (ii) parties objectively having an intention to create a legal relationship; and (iii) the grant of mutual consideration. This makes a smart contract capable of having contractual force, though the specific determination may depend on the on the parties’ words and conduct, just as it does with any other contract.

How would an English court interpret a smart contract?

UKJT has relied on the modern approach to interpretation of commercial contracts: “it means what it says”. Unless the contractual terms are unclear, contradictory or ambiguous, a court will rarely depart from the language of the contract in ascertaining its meaning. A smart contract consisting solely of code with no natural language, in UKJT’s view, in most circumstances can be seen as sufficiently clear without there being any justification to depart from it. But this will not always be so. In such circumstances, ambiguities will be resolved by looking at the contract as a whole, as well as relevant admissible evidence regarding what the parties objectively intended their respective obligations to be, i.e. using ordinary and well-established legal principles.

What happens if a smart contract is between anonymous or pseudo-anonymous parties?

UKJT is confident that there are no requirements under English law for parties to contract knowing the real identity of the other party. In fact, it is a commonplace practice in agency, unilateral contracts or auction scenarios. Therefore, a smart legal contract between anonymous or pseudo-anonymous parties is capable of giving rise to binding legal obligations.

Does a private key amount to a signature?

A statutory signature requirement “is highly likely to be capable of being met” by means of a private key. UKJT compares a private key with an electronic signature, which has a similar function and generally satisfies the statutory signature requirement. It notes—

“The key question is not what the signature looks like [e.g. is comprised solely of a signed message using signature authentication software confirming the validity of the signature], but whether or not it is clear that the party intended to authenticate the full terms of the document.”

Does a smart contract meet “in writing” requirement?

In UKJT’s view, to the extent the code can be said embodying words and be made visible on a screen or paper, it will likely fulfil the statutory “in writing” requirement. The analysis may be less straightforward when the code is represented by machine-readable code and is not comprehensible without an expert translator. UKJT rejects the human comprehension argument on the premise that an expert translator is also needed to understand foreign human languages. Thus--

“We believe however that in very many cases the terms of the relevant contract will not be contained in the code itself; instead, the correct analysis will be that the parties have agreed to be bound by the effect of whatever the code does, rather than by what it says.”

Why does it matter?

Uncertainty has been a major obstacle to the mainstream adoption of cryptoassets and smart contracts. Even though UJT’s legal statement has no binding effect, it relies on technical, legal, judicial and academic expertise, hence it is meant to provide some comfort and possibly point to market confidence for the benefit pf technological and legal communities as well as the global financial services industry. The next step is for the UK Law Commission to consider whether statutory regulation in this area is necessary.

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The UK Government sheds light on the status of cryptoassets and enforceability of smart contracts (Part I)

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Following several rounds of consultation, The UK Jurisdiction Taskforce (UKJT) has issued a legal statement on the status of cryptoassets and smart contracts under the English and Welsh law. [The IPKat has previously written about the potential challenges of smart contracts here].

Cryptoassets as property

UKJT has concluded that cryptoassets are to be treated in principle as property, based on the following reasoning:

- They have all the indicia of property;

- Any novel or distinctive features, such as intangibility, cryptographic authentication, use of a distributed ledger, decentralisation, consensual governance, or that they are “pure information”, do not disqualify cryptoassets from being classified as property.

Ownership analysis

The term “property” describes a legal relationship rather than an object, as follows:

“It is a way of describing a power recognised in law as permissibly exercised over the thing”. The fundamental proprietary relationship is ownership. The UKJT has pointed out that “a cryptoasset cannot meaningfully be treated as property unless it is possible in principle to determine who owns it, and how ownership is transferred.”

A cryptoasset is typically represented by two data parameters, one public and one private. The public parameter contains or references encoded information about the asset, such as its ownership, value and transaction history. The private parameter (the private key) permits transfers or other dealings in the cryptoasset to be cryptographically authenticated by digital signature.

Knowledge of the private key confers practical control over the asset. Therefore, a person who has acquired knowledge and control of a private key by some lawful means would generally be treated as the owner of the associated cryptoasset. However, specific circumstances and the rules of the relevant system may alter such determination.

In order to make a transfer within the cryptoasset system, the transferor typically modifies the public parameter, or generates a new one, so as to create a record of the transfer. The transferor then authenticates the record by digitally signing it with the private key.

At that point, the cryptoasset becomes linked to the private key of the transferee and is therefore under the transferee’s exclusive control. Once the transaction is recorded in the ledger, it becomes irreversible and any attempts by the transferor to transfer the cryptoasset again should not be accepted by the consensus (see below).This so-called on-chain transfer is not really analogous to the delivery of a tangible object or the assignment of a legal right, where the same thing passes, unchanged, from one person to another. Instead, the transferor typically brings into existence a new cryptoasset, with a new pair of data parameters: a new or modified public parameter and a new private key. The data representing the “old” cryptoasset persists in the network, but it ceases to have any value or function because the cryptoasset is treated by the consensus as spent or cancelled, so that any further dealings in it would be rejected.

A transferor may also transfer the knowledge of the private key (an off-chain transfer). In this case, no new key is generated and the transaction is not recorded in the ledger. Such transfers may be more complicated, because they may give rise to a situation where more than one person knows the private key and so can exercise practical control over a cryptoasset.

UKJT then discusses how cryptoassets align with the indicia of property that have been established in National Provincial Bank v Ainsworth:

“Before a right or an interest can be admitted into the category of property, or of a right affecting property, it must be definable, identifiable by third parties, capable in its nature of assumption by third parties, and have some degree of permanence or stability”.

Certainty, exclusivity, control and assignability have also been identified in case law as characteristics of property rights (see Fairstar Heavy Transport NV v Adkins). Here is what UKJT has to say:

- The public parameter of a cryptoasset, interpreted in accordance with the rules of the relevant system, is sufficient in principle both to define the asset and to identify it to any person having access to the system network;

- The requirement for control and exclusivity is satisfied by the cryptographic authentication process, which allows the holder of a private key to deal in the cryptoasset, and therefore to control it to the exclusion of others.

- There is no reason to doubt that cryptoassets are by their nature capable of assumption by third parties. In that sense, they are also assignable, even if: (i) some of the methods of assumption and assignment may be novel and (ii) identifying the legal owner in particular cases may not always be straightforward.

- Cryptoassets are clearly designed with the aim of being transferable between system participants. Cryptoassets appear to be as permanent as conventional financial assets, which may exist only until they are, for example, cancelled, redeemed, repaid or exercised.

- The consensus mechanism raises two issues relating to stability: (i) the time required for the consensus to form and (ii) system forking. However, even without resolving those issues, cryptoassets are sufficiently stable to be treated as property, at least for a commercial cryptoasset system with a significant number of participants, an established history of transactions, and a generally stable set of rules.

Disqualifying features discussion

The courts have historically been reluctant to treat informationper se (as opposed to the medium on which it is recorded) as property. This is based on the rationale that information is not exclusive in nature, i.e. it can be easily duplicated, used simultaneously by different people, and cannot be alienated, which makes it difficult to exercise control and determine an ownership interest. However, in UKTJ’s view, the transaction ledger and consensus mechanisms preclude such difficulties by preventing double-spending or simultaneous control.

Such reasoning applies to the cryptoasset viewed as a conglomeration of public data, private key and system rules. It does not apply to the private key viewed in isolation, which is “no more than an item of pure information and, like a password or a telephone number, it cannot in itself be treated as property”.

Another potential difficulty might arise from the fact that the law has traditionally recognised two distinct types of personal property: things in possession and things in action. A cryptoasset is not a thing in possession because it not tangible and so cannot be possessed. Does it mean that since an intangible thing is not in action, it may not be a property at all?

This Kat barely contains his excitement while exploring the new depths of the property concept

A cryptoasset does not itself embody any right capable of being enforced by action, such as a debt or contractual right. This is because, in a fully decentralised system with consensus rules, such as Bitcoin, the participants do not undertake any legal obligations to one another.

UKJT concludes as follows:

“[T]he fact that a cryptoasset might not be a thing in action on the narrower definition of that term does not in itself mean that it cannot be treated as property. Our view is that if a cryptoasset does not embody a legally-enforceable right or obligation then it is neither necessary nor useful to classify it as a thing in action. If it is necessary to classify it at all, then a cryptoasset is best treated as being another, third, kind of property”.

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Nexus

The UK Government sheds light on the status of cryptoassets and enforceability of smart contracts (Part II)

The UK Government sheds light on the status of cryptoassets and enforceability of smart contracts (Part I)

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