What are Smart Contracts?
A smart contract is just like a traditional contract. However, in effect, it is a computer program that exists on a blockchain, carrying the terms of a transaction to which the parties agree. These automate the process of contract management and execution and are used largely today in the trade of crypto-assets. The aim of smart contracts relates to the elimination of avoidable third parties which played intermediary roles in transactions in traditional contracts. The effect of this is to minimize the chances of maliciousness and fraud.
Legal Hackers Lahore (a US based network of legal professionals working at the intersection of law and technology) describes smart contracts in the following words:
“Smart contracts are contracts stored in blockchains which allows them to be executed without intervention of brokers, notaries, agents and the like to make transactions. The powerful encryption of blockchains prevents anyone from being able to interfere with the code thus essentially making smart contracts efficient, neutral, mistake-free, safe, tamper-free, ensuring that the data is not lost or stolen. Time to do away with the tedious patwari system in Pakistan and shift land registration and transfer mechanisms onto blockchains?”
How Do Smart Contracts Work?
The transaction involves parties that have crypto-wallets, also less famously referred to as e-wallets. These wallets have a unique combination of words and phrases, which is called a “private key”. This private key is like the title of ownership to the wallet. Blockchain pairs this private key with a public key to ensure safety. Whenever parties are to enter into a smart contract, their wallets execute a transaction. The transaction stores on the blockchain, where the code of the smart contract gets executed and initiates actions required by the smart contract.[1] This contract is not modifiable because each block in a blockchain has a “hash”, which is a lengthy sequence of numbers unique for every block and cannot be hacked. If the block is tampered with, the blockchain recognizes this and ends the chain, making it apparent to everyone. One of the most extensively known blockchains is Ethereum, which uses the coding language “solidity”.
What Type of Property is a Crypto-Asset?
Crypto-assets include cryptocurrency, blockchain companies, cryptocurrency funds and initial coin offerings (ICOs). Not all of them are traded as securities.
In the absence of regulatory frameworks for cryptocurrency and crypto-assets, most governments prefer referring to them as virtual assets.
A crypto-asset is usually understood by looking at the rules of the system by which it operates. It is always exchanged subject to public and private parameters. A public parameter carries information related to the asset, while private parameters or keys play the role of digital signatures of the parties involved. While no official recognition has been seen in this regard in Pakistan, it can be seen in other jurisdictions like the United Kingdom. A key example from the UK is Zi Wang v Graham Darby, where the High Court has inferred that familiar legal principles apply to cryptocurrency as they do to other physical assets and has, therefore, applied traditional contract law principles.[2] The United States and other leading jurisdictions have also taken a similar stance. This shows that, more likely than not, Pakistani courts will be inclined towards giving crypto-assets the status of a digital asset that is contemporary to a “physical” asset.
Key Characteristics of a Crypto-Asset
Some of the systems relevant to crypto-assets have rules which have been devised in consideration of the consensus of its members. These systems are usually subject to consensus rules which determine the version of a distributed ledger that is conclusive. Only the transactions which comply with these rules shall be accepted and thus approved. Therefore, it would be the platform (referred to as a blockchain in technical terms) which would ascertain the nature of the crypto-asset. Amongst the key characteristics of crypto-assets are features like:
- intangibility;
- use of a distributed ledger;
- “cryptographic authentication”;
- rule by consensus; and
- decentralization.
Legal Status of Smart Contracts
We have seen a surge in the use of smart contracts worldwide over recent years, including in Pakistan, despite there being no legal guideline. There is little to no case law, statute or regulation in place which may attempt to cover matters related to smart contracts or their legal implications. Since smart contracts are a novel idea, there hasn’t been much endorsement of this mode of transactions due to a lack of underlying security. There has also been no conclusive statement covering this area from the National Information Technology Board (NITB), a body overlooking IT developments in Pakistan.
A provincial committee on WEB 3.0 had indeed been constituted by the Government of Punjab, including technology law experts like Advocate Anoosha Shaigan, COO of Courting The Law, to play a key role in suggesting regulations in this area and debrief the President of Pakistan on a regulatory framework, but the work of this committee seems to have been stalled owing to abrupt and excessive changes in government.
Necessary guidance in this regard may also be taken from the UK jurisdiction. In the UK, the LawTech Delivery Panel took a shot at addressing concerns regarding this novelty, publishing the Legal Statement on Crypto-Assets and Smart Contracts in November 2019. Even through the publication has no binding effect, it does have weightage as a valuable source of guidance for regulators in Pakistan. As per LawTech’s findings, a legally binding agreement does originate through smart contracts, capable of being upheld and enforced in English law. This supports the technology and authorizes smart contracts in the UK.[3] It also adds to the certainty around smart contracts in legal terms. While it is important to regulate smart contracts and crypto-assets through the use of laws, it is also important to put in necessary efforts to allow for a better use of such technology. This will also be of great use to Pakistan, in economic terms, as it will open the floodgates of IT opportunities for Pakistanis individuals and institutions.
Should Smart Contracts be Treated as Legally Binding in Pakistan? Pakistan’s Stance and Guidance from UK Law
There has been a surge in the use of smart contracts, but this has taken place without the necessary legal checks and balances. The lack of case-law, statute, regulation or legal authority governing this area of immense importance in current times creates uncertainty amongst the stakeholders and subjects of smart contracts, especially regarding their validity in the eyes of the law.
While Pakistani lawmakers have not cast an eye over this, the likely stance of Parliament and the courts in this regard may be predicted. As a matter of fairness—and rationality—smart contracts should be subject to Pakistani contract law since they are not distinct from traditional contracts in terms of the following requisite elements:
- The LawTech Delivery Panel in the UK has pointed out that smart contracts involve an objective agreement between the parties, as set out in the earlier case of Smith v Hughes[4] and later summarized in RTS Flexible Systems Ltd v Molkerei Alois Muller Gmbh & Co KG.[5]
- The requirement of certainty with regard to the terms is also met.
- Since smart contracts involve commercial transactions i.e. transactions of trade, the intention to be legally bound is also established.
- The requirement of consideration is fulfilled as well.
An understanding can be devised under this line of thinking that the provisions of Pakistan’s Contract Act 1872 and the Specific Relief Act are to apply in a manner identical to the physical contemporaries of smart contracts i.e. traditional contracts.
The terms of smart contracts, i.e. the computer code, are certain terms that lead to a contract of a special type for which the terms are “readily apparent”. LawTech suggests that smart contracts will likely become a new category.
The assessment of smart contracts may be done by looking at what the parties have actually intended. This will lead to a wide range of matters, for instance:
- where parties agree that the terms of their agreement be dictated by the computer code and they then abide by it; or
- there may be a contract where the code merely effects their agreement but the terms are not defined by it.
There may also be a combination of both these scenarios.
The panel regarded such analysis in the context of smart contracts as being “entirely conventional”, which is something that the judges do daily. This, however, does mean that the judges and lawyers will have to learn coding languages to be able to deal with such matters.
Contract law revolves around the notion of enforcing promises. In smart contracts, this is ensured with automatic execution by way of computer code. It also eliminates the possibility of:
- deliberate evasion from the terms of the contract by either party;
- disputes regarding factual circumstances; and
- disputes regarding the interpretation of terms.
This still involves the risk of an external factor such as a network or server breakdown or malfunction resulting from the code itself. This, therefore, necessitates the need for such disputes to be subject to adjudication.
Smart contracts should be subject to the ordinary rules of contract law. What needs to be in place for a promise to be enforceable, or any necessary action to be taken in this regard, includes the prerequisites to a valid contract. It also requires no presence of any of the vitiating factors such as:
- mistake;
- misrepresentation; or
- illegality.[6]
Smart Contracts and the Statutory Requirements for “Written” Contracts
As per the usual statutory regimes governing contracts, they are to be signed while, or alternatively, after being put into writing. The LawTech Panel suggested that such statutory requirements would merely be the starting point providing a sense of direction regarding the criteria that smart contracts and their codes would be expected to meet. The panel also established that the statutory in-writing requirement for smart contracts would be met where the code represented words and was visible either on screen or on paper when printed. This shows exactly how the requirements of a valid smart contract under Pakistan’s Contract Act 1872 would suffice.
The private key involved in smart contract terminology is a form of sequences, distinct for every e-wallet held by an individual. According to the panel, the private key amounts to a digital signature and, therefore, does authorize the smart contract. This requirement will still be met when the signature is a combination of signed messages and can be authenticated through the use of software. The panel reflected this view despite the parties maintaining anonymity or pseudo-anonymity during the verification of an agreement through their respective private keys. This strikes out any ambiguity that may be faced when this novel technology is introduced into the Pakistani jurisdiction.
Regulation Issues
Even though the panel stated that there wouldn’t be any difficulty in the identification of the terms included in a smart contract, it established the view that the terms would be easily identifiable by looking at the behaviour of the code. However, it may still be difficult to establish any sound presumption of the intention of the parties to be legally bound or an agreement between the parties. This issue may be the most obvious in the regulation of smart contracts, but it may be overcome by examining external evidence of intention.
A key procedure involved in smart contracts is that one of the parties, at least in bilateral contracts, has to trust the other blindly in accepting the contract extended by the other party. This does not go without the possibility of a party being misled. A Singapore case titled B2C2 Ltd v Quoine Pte Ltd [2019] involved the same issue. Neither did the company intend, nor did the programmer know about a discrepancy in the terms. The Singapore International Commercial Court held the smart contract to be valid because the mistake was not unilateral. This shows that vitiating aspects still apply like they do to traditional contracts. It can, therefore, be understood on a generic level that smart contracts operate on, and are subject to, the same principles and restrictions.
In Case One or More Parties to the Contract is Anonymous
While the panel has been certain regarding the smart contract being binding despite the anonymous or pseudonymous nature of the parties’ identities, this may be impractical as identity is important when suing for breach of contract. It may be possible for an unauthorized party to take part in the transaction by picking up the code forwarded by a contracting party to a distributed ledger platform.
The panel has considered this in the context of unilateral contracts and the legal standing of a decentralized autonomous organization (DAO), which is a blockchain management structure governed by rules encoded in the form of a computer program subject to control by the smart contract and its members. The panel has understood DAO to be like an unincorporated association where members are bound by joining the organization, regardless of whether or not they know the rules.
When Might Disputes Arise?
With regard to the potential disputes that may arise in the use of smart contracts in Pakistan, guidance can again be sought from the UK LawTech Panel’s suggestions:
- The panel iterated that the scope of legal intervention in smart contracts is likely to be narrower than that in traditional contracts.
- Upon the panel’s suggestion that the traditional English legal framework may be incapable of interpreting the code, the UK Jurisdiction Taskforce (UKJT) Digital Dispute Resolution (DDR) Rules may cover detailed principles regarding interpretation, including what the code would mean to a reasonable person and what it would mean to a computer.
- The court shall intervene where there is involvement of fraud, misrepresentation or duress.
Existing Rules on Digital Dispute Resolution
The UK’s LawTech Panel has advanced key suggestions in the form of UKJT Digital Dispute Resolution Rules, published in 2021, regulating smart contracts in the UK and making the automatic dispute resolution process binding.
- According to these Rules, any dispute calling for automatic dispute resolution into play, must be resolved by way of arbitration.
- Similarly, technical issues must be dealt with the help of expert(s).
- The time limits involved are also much shorter:
-
- response to a notice of claim to be filed in 3 days;
- followed by the appointment of a tribunal through the relevant institution as soon as possible;[7]
- the decision of the tribunal to be made within 30 days of appointment (where a time period has not been agreed between the parties);[8] and
- absolute discretion lying with the tribunal to decide the procedure to be followed.[9]
-
Resolving smart contract disputes through arbitration allows them to be better dealt with under a helpful arbitration regime.
- The decisions made under the UKJT Rules are not to be subject to appeal on any ground(s) other than those set out in the Arbitration Act 1996.
- It is up to the parties whether to adopt UKJT Rules by incorporating a provision within the contract or opting to do so once the dispute has arisen.
Other provisions:
- The UKJT Rules also set provisions for experts which are necessary for smart contract disputes with regard to the use of coded language.
- According to the UKJT Rules, multiple disputes involving several parties or contracts, or pertaining to the same outcome, or having resulted in the same breach/vitiation, are to be dealt together, subject to the consolidation rule.
- These Rules also cover the implementation of decisions, whereby a tribunal can enforce an award onto a smart legal contract using a private key.[10]
- The tribunal has wide powers to facilitate, alter, sign or even annul a digital asset subject to dispute.[11]
- The Rules also uphold anonymity, in furtherance of the confidentiality aspect of arbitration.
The Rules can be adopted by Pakistan or used as a source of guidance in resolving digital disputes pertaining to smart contracts.
Areas of Reform
- Coded terms must be comprehensible by the average consumer, for instance in business-to-consumer (B2C) contracts, in order to meet the requirements of transparency.
- Consumer protection laws will need to be streamlined in light of smart contracts.
- Smart contracts can be used by banks to issue loans or execute automatic payments.
- Certain insurance claims may be processed using this technology.
- Smart contracts may be used by postal companies for payment upon delivery.
- Smart contracts may be used by for land record keeping, where each person owns a copy of their own transactions, eliminating the need for an intermediary body, making processes cheaper and quicker.
- Pakistani lawyers, Tahera Hasan (Imkaan Welfare Organization) and Anoosha Shaigan (Courting The Law), have also been advocating for the use of smart contracts and blockchain technology to address human rights and humanitarian issues involving citizenship rights and the legal identities of stateless persons as well as their access to finance [watch discussion on Courting The Law].
- Pakistani lawyers, Barrister Ahmed Uzair (AUC LAw), Daraab Wali Furqan (AUC Law) and Barrister Taimur Malik (Courting The Law, Kilam Law) have explained how distributed ledger technology can help regulators and businesses in Pakistan [read article on Courting The Law].
The possible implementation of smart contract technology does not stop here and is incorporable in almost every aspect of the market.
Conclusion
A smart contract is an emerging technology which opens up a horizon of opportunities and solutions. Regulated adequately, it can be used to contribute to the effectiveness of everyday transactions. Blockchain technology can be used to keep records and maintain large databases while also eliminating unnecessary intermediaries and third parties and reducing corruption and delays. Therefore, Pakistan should be proactively paving the way to facilitate the incorporation of smart contracts as a legally endorsed mechanism.
References
[1] Handbook of Green Computing and Blockchain Technologies (Kavita Saini and Manju Khari eds, First edition, CRC Press 2022)
[2] ZI WANG v GRAHAM DARBY [2021] EWHC 3054 (Comm)
[3] Cryptoassets & Smart Contracts | Legal Statement | LawtechUK, 2022
[4] Smith v Hughes (1871) LR 6 QB 597
[5] RTS Flexible Systems Ltd v Molkerei Alois Muller Gmbh & Co KG [2010] UKSC 14 & 38
[6] McKendrick, E. Contract law. (Basingstoke: Palgrave Macmillan, 2021) 14th edition [ISBN 9781352012064]
[7] UKJT Rules at [8]. The “appointment body” is “the Society for Computers and Law”
[8] UKJT Rules at [12]
[9] UKJT Rules at [9]. The tribunal must exercise its discretion “fairly and impartially” while giving each party a “reasonable opportunity” to make their case
[10] 583 UKJT Rules at p 3
[11] UKJT Rules at [11]
The views expressed in this article are those of the author and do not necessarily represent the views of CourtingTheLaw.com or any other organization with which he might be associated.
