What is a smart contract and when is it useful?
By Cody Haricombe on 10 October 2019
Broadly speaking, a contract is an agreement entered by and between two or more parties, creating binding rights and obligations between them. Contracts can be tailored to meet the particular needs of the parties, and can be entered into in various ways, using various methods. This post considers generally the concept of "smart contracts", from a South African legal perspective.
Creating a binding contract
Under South African law, a contract has to meet the following minimum legal requirements in order to be binding:
- consensus – the parties must have a genuine, concurrent intention to create definitive, binding rights and obligations between them;
- capacity – each of the parties must be legally capable of entering into the contract (e.g. neither of the parties may be unassisted, unemancipated minors);
- possibility of performance – the parties must be capable of actually performing under the contract (e.g. the parties cannot agree that one of them must deliver to another something that does not exist);
- legality – the contract must comply with all applicable laws and regulations (e.g. the parties cannot agree to perform an illegal act, such as theft); and
- formalities – the entering into of the contract and the parties' performance under the contract must also comply with any additionally prescribed formalities, whether imposed by law or by the parties themselves (e.g. writing in plain and understandable language is required under the Consumer Protection Act, No. 68 of 2008).
1. Written contracts
Traditionally, the parties would meet the minimum requirements by recording the necessary details in a written document, and then tailor it by specifying their respective rights and corresponding obligations. Such document is then made into a binding contract once each of the parties have signed it with a so-called wet ink signature.
2. Electronic contracts
In the modern age, more and more parties are choosing instead to rely on the enabling provisions of the Electronic Communications and Transactions Act, No. 25 of 2002 (herein "ECT Act") to create binding contracts electronically. By way of example, the parties would dispense with the written document and wet ink signature, and rather contract by way of an exchange of emails confirming the agreement between them, or by way of electronic signature of a pdf document recording the agreement between them, or by the user of a transactional website electronically signing up to such website's terms and conditions via a tick-box on the website itself.
3. Smart contracts
While you might get a different description depending on whom you ask (think lawyer vs software developer), from a legal perspective a smart contract is best described, in simple terms, as a type of electronic contract. Similarly, the parties would dispense with the written document and wet ink signature, and replace these elements with appropriate computer code. The coding then typically translates into self-executing functions, which are intended to digitally and automatically facilitate, verify and/or enforce the parties' respective rights and corresponding obligations. In other words, instead of a set of detailed rights and obligations, a smart contract would contain a set of computer-coded, predefined conditional statements, with performance then occurring digitally and automatically in accordance with the "if this, then that" principle.
In the context of an agreement where Party A agrees to pay Party B a sum of money, and Party B agrees to receive that sum of money, whereas a written contract would likely require Party A to physically perform the act of making the payment to Party B (e.g. by handing the cash to Party B), a smart contract would likely instead stipulate that "if event [X] occurs, then immediately execute payment of amount [X] from Party A's bank account into Party B's bank account, by way of electronic funds transfer", without either party having to actually do anything themselves.
Pros and cons of contracting smart
There are several obvious advantages to utilising smart contracts, such as automation and speed of performance, greater security of contractual terms, automated contract management and streamlining of processes. Naturally, however, there are several disadvantages as well, such as:
- In certain jurisdictions, smart contracts could possibly be recognised as "electronic/digital agents" facilitating, verifying and/or enforcing the terms of the main agreement between the parties, as opposed to being recognised as the main agreement itself. Under South African law, having regard to the ECT Act, in particular the definition of "electronic agent" in section 1 (namely "a computer program or an electronic or other automated means used independently to initiate an action or respond to data messages or performances in whole or in part, in an automated transaction") and the provisions of section 20 (which enables and regulates automated transactions that employ such an electronic agent), either scenario is possible. On the one hand, as long as the minimum requirements are met and the coding covers every aspect of the agreement between the parties, then the smart contract would likely be recognised as the main agreement itself. On the other hand, it is also possible to have the coding cover only a portion of the agreement between the parties, with the smart contract portion then serving only to self-execute certain terms of the overarching main agreement;
- Lack of flexibility, in that once a smart contract is created, unless the coding permits otherwise, the smart contract itself and its self-execution is irreversible, leaving no room for often-occurring human error; and
- General drafting limitations, in that a smart contract would typically only be able to self-execute that which is clearly ascertainable directly from the coding itself. This leaves little/no room for open-ended or abstract contractual terms (here's looking at you generic good faith clause).
Looking at practical scenario, smart contracts are often utilised in the trading of cryptocurrency. This makes sense since cryptocurrency is a digital asset (as opposed to something tangible), payment and delivery from one party to another commonly occurs automatically via existing digital platforms (e.g. via blockchain technology), and all of these terms can be suitably recorded in the computer code itself.
When deciding whether or not to contract "smart", you must carefully consider the terms of your intended agreement, including whether these terms could be suitably recorded in computer code and whether the corresponding performance would be achievable via digital means and without human intervention. Thereafter, you would have to make sure that you put it all together in accordance with the legal framework currently in place for smart contracts.
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Please note that the legal topics informally discussed here are general discussions of certain aspects and therefore certainly not intended as legal advice. We look forward to discussing your particular case with you.