Smart Contracts – Another Feather in UNCITRAL’s Cap

By Aaheree Mukherjee*

Introduction

Blockchain technology first garnered notoriety for its use in the “Silk Road,” the first modern dark net, which was eventually shut down.  However, it continues to be popular; one of the most recent applications of blockchain technology has been in the form of “Smart Contracts.”  While there is significant ambiguity surrounding their legal role and functionality on a national and international level, Smart Contracts offer innovative features that make them cost-effective in cross border monetary transactions and international trade.

Some banking authorities have argued that Smart Contracts are legally binding agreements, but others say that Smart Contacts are simply a new form of preemptive self-help because of the ambiguities associated with the formation and enforcement of Smart Contracts.[1]  The Bank for International Settlements (BIS), however, recognized distributed ledgers as an innovation that could impact many areas, especially payment systems and services.[2]  The BIS also urged the central banks, regulators, and state legislatures to investigate the uses of distributed ledgers in payment systems and trade.[3]

One of the biggest players in developing international trade regulation is the United Nations Commission on International Trade Law (UNCITRAL), which has been developing regulations for electronic modes of communication in international trade and e-commerce for almost two decades.[4]  UNCITRAL has adopted several instruments guided by the principles of functional equivalence and technological neutrality to keep up with the growth of electronic trade relationships.  For the first time ever, an UNCITRAL instrument—the UNCITRAL Model Law on Electronic Transferable Records (MLETR) (adopted in July 2017)—explicitly accommodated distributed ledger technology in its explanatory notes.

This article assesses whether UNCITRAL model laws, conventions, and norms can resolve the question of whether traditional contracting principles applicable to electronic contracts apply to Smart Contracts and the underlying blockchain technology.  This article ultimately finds that a Convention may be needed to resolve certain issues such as jurisdiction over a transaction.

 

What are Blockchain and Smart Contracts?
The Blockchain is, in essence, a “distributed ledger system” that stores linked records in the form of time-stamped blocks.[5]  Each block is immutable, sequential, publicly visible, and confirmed by a consensus-based proof of validity.[6]

Smart Contracts are instruments coded to automatically execute when certain criteria are met.[7]  The parties “sign” the Smart Contract using cryptographic security procedures and deploy it to a blockchain.[8]  Blockchain-based Smart Contracts are typically “decentralized,” given the absence of a central database or register, and are self-executing and self-enforcing.  Smart Contracts however, differ from electronic contracts because the actual agreement is automated and embodied in computer code, rather than in words.[9]

 

Can Smart Contracts “fit” into the existing international framework?

Presently, an international legal framework tailored specially for blockchain technologies and applications does not exist.[10]  However, UNCITRAL has been developing law on the role of electronic modes of communication in international trade and e-commerce, beginning with the Model Law on Electronic Commerce (MLEC) in 1996, the Model Law on Electronic Signatures (MLES) in 2001, the Convention on the Use of Electronic Communications in International Contracts (ECC) in 2005, and, most recently, the Model Law on Electronic Transferable Records (MLETR).

 

Fundamental principles

UNCITRAL texts are drafted based on the fundamental principles of “non-discrimination,” “technological neutrality,” and “functional equivalence,” which make a prima facie case that blockchain can exist within the parameters of the existing UNCITRAL texts.[11]  The principle of non-discrimination ensures that a document will not be denied legal effect, solely on the ground that it is in electronic form, which provides clarity on the legal status of Smart Contracts.[12]  The principle of technological neutrality mandates that provisions be neutral to the technology used to keep up with rapid technological advances without further legislative work.[13]  Therefore, even UNCITRAL instruments adopted prior to its invention apply to blockchain.  The functional equivalence principle gives criteria to ensure that electronic communications are equal to paper-based communications.  Thus, Smart Contracts must satisfy traditional paper-based criteria, such as being a writing, original, and signed to be a valid contract under the UNCITRAL texts.

While Smart Contracts fall within the scope of existing UNCITRAL texts, two primary concerns remain.  First, these principles are neutral, but Smart Contracts do not fit into the traditional, paper forms of contract formation and execution.  Using a neutral framework may curb the novelties of Smart Contracts and their technological advancement potential.  Second, while electronic contracts are functionally equivalent to paper transactions, this equivalency is more tenuous in the case of Smart Contracts.  Rather than being simply electronic versions of paper transactions, Smart Contracts differ even more from paper transactions because they are created through computer code rather than words.

 

Contract Formation

The offer and acceptance in a transaction is expressed by “data messages” stored in a blockchain,[14] which is defined under the MLEC as information generated, sent, received or stored by electronic, optical or “similar means.”[15]  The definition of “data message” was, therefore, intended to apply to both existing communication techniques and all types of paperless messages including Smart Contracts.[16]

A Smart Contract satisfies the contracting principles of being a “writing” if its information is accessible for subsequent reference.[17]  The signature requirement is satisfied only if it is obtained by a method that identifies the person who approved the information contained in the data message that is reliable and reasonable in light of the circumstances and any relevant agreement.[18]  The signature requirement may be difficult for Smart Contracts to satisfy since the “signature” may just be a code entered into the software by one of the contracting parties.  Further, the purpose of a signature is to ensure that the signing party in fact intended to contract,[19] so a completely electronic environment without any human intervention may make establishing intent extremely difficult under the traditional norms.

Smart Contracts successfully satisfy the requirements of originality and retention of data messages, given the immutability of a blockchain network.[20]  MLEC provides that a reliable assurance as to the integrity of information contained in a data message must exist before the information is deemed to satisfy the requirement that a contract be presented in its original form.[21]  Blockchain technology is particularly apt to provide a reliable assurance as to the integrity of information since it is tamper resistant.

ECC, on the other hand, only provides for formation of a contract, to which the States may extend the functional equivalence principle by providing that the performance of a contract by an automated system may not be denied effect on the sole ground that no natural person intervened in each of the individual actions carried out by the automated system.[22]  Such an addition would improve clarity with respect to the validity of a Smart Contract but leaves ample room for interpretation and modification by the States.

MLETR enables the use of electronic transferable records for transferable instruments including bills of lading, bills of exchange, promissory notes and warehouse receipts provided that the electronic record fulfills the purposes and functions of the transferable instrument.[23]  A transferable record is a document that entitles the holder to claim the performance of the obligation indicated in the document and transfer the right to performance.[24]

The most important requirement for a transferable record is the guarantee of singularity.[25]  Since a transferable document embodies the right to claim the performance of an obligation from another, it is essential to prevent multiple claims from being made on the same obligation.  Therefore, the law generally requires that there be only one original copy of a transferable document in circulation.[26]  In the case of Smart Contracts, providing an absolute guarantee of non-replicability may not be technically feasible since the data is stored on various blocks on the blockchain network spread across various jurisdictions.  MLETR also seeks to prevent multiple claims by requiring the use of a reliable method to identify an electronic record as an electronic transferable record and establish an exclusive control of it.[27]  The “control” approach focuses on the use of a reliable method to identify the person in actual control of the electronic transferable record.  Blockchain technology is capable of replacing the administrator with an algorithm ensuring that the tokens recorded therein are subject to the exclusive control of their holders, i.e. the holders of the private keys.[28]  However, it is possible that a private key could be disclosed intentionally or accidentally and given the absence of a physical monitoring mechanism, an algorithm will only be able to monitor the entering of the private key and not by whom it is used.

MLETR also requires a reliable method to be used to identify the person to satisfy the signature requirement.[29]  A signatory may use a pseudonym, but the distributed ledger system must have the ability to link it to a real name to satisfy the requirement of identifying a signatory, but certain transactions require mandatory links to real names. [30]  For example, where signatures establish that endorsements are back to back under bills of lading, pseudonyms would be just as good as real names.  On the other hand, it is necessary to be able to link pseudonyms to real names when making a recourse against endorsees under bills of exchange or promissory notes.  The explanatory notes further suggest that factual elements outside the distributed ledger system may be relied upon to link pseudonyms to a real name, which is sensible because sensitive information is not ideally supposed to be stored on open ledgers.[31]

The fact finder will assess the reliability of the above-mentioned signature methods on an ex post basis.  Because it may be unforeseeable which methods pass the reliability test, it would be advantageous to compile a list of ex ante reliable methods to deter reliance on unreliable methods.  Such a list would need to be reviewed from time to time because neither the configuration of a central registry nor the algorithm of a blockchain is permanently fixed.

 

The Solution?

As the section above illustrates, a few aspects of the UNCITRAL texts provide for blockchain based Smart Contracts effectively, but not completely because the UNCITRAL provisions equate all digital based transactions with paper transactions.  While its application to electronic contracts has been successful over the years, the technological neutrality principle within the texts is insufficient to encompass all aspects of Smart Contracts.

If the UNCITRAL Model Laws must remain technologically neutral and adaptable to State level modifications it is arguable whether they can be easily amended to address Smart Contract concerns.  It may be easier for States with more developed Smart Contract regulations to adopt the model laws, but expecting States to develop such frameworks may be too remote a possibility for the present blockchain surge.  Further, implementation of the Model Laws can be barred by soft law enactments, which prevent them from binding a member State.  Often, the number of amendments made to a Model law by member States to align with its domestic laws defeats the purpose of the Model Law.  Therefore, UNCITRAL’s best approach to this issue may be an international convention catered to blockchain based transactions.

Existing tests address only the formation of Smart Contracts, but the convention would address formation, breach, and enforcement of Smart Contracts.  Both electronic and other material breaches of Blockchain based contracts must be addressed.  A consequent concern is Smart Contract dispute resolution with the primary focus being concern being which jurisdiction resolves the dispute.  A global conglomerate may use a Smart Contracting platform based in Switzerland with contracting parties in South Africa and India.  In that situation, which country’s regulators may proscribe rules governing such arrangements?  Which courts would have jurisdiction to adjudicate disputes between parties, and what law would the courts apply? Will court intervention be applicable at all?

Traditionally, the location of an asset or contract may determine the applicable legal standards for various questions relating to the transaction, such as whether a property right has been created.  When the goods are dematerialized financial assets with ownership recorded on a register, the place where the register is held or where the registrar is situated is deemed to be the situs of that asset.  Applying that principle to a register distributed across multiple jurisdictions raises a seemingly intractable problem as to where the situs should be,[32] which a Convention should chalk out.  This would also prevent any conflict of law issues, which are typical to cross-border transactions.

An alternative that mitigates confusion about the applicable legal standard would be including a choice of law provision in the contract itself.  In conventional banking transactions, the contractually agreed upon jurisdiction is the place where a suit is adjudicated irrespective of the transacting mechanism or location.  An explicit choice of law provision is especially important in a decentralized environment where the ledger can be situated anywhere in the world, or even multiple places simultaneously.  Including an exclusive governing law clause in a Smart Contract is critical to ensuring that parties have certainty about which jurisdiction’s law determines their rights and obligations and which courts will handle any disputes.  It would be ideal to choose a jurisdiction with some situs to the transaction, for example, where the head office of the bank is situated, to ensure there is nexus between the governing courts, the applicable laws and the transaction itself.  Especially for banks with larger, more sophisticated transactions, leaving choice of law issues to be determined after the contract is executed is undesirable as it may lead the banks needing to comply with contractual and banking regulations of multiple jurisdictions.

Because the reliability of the above-mentioned methods to determine jurisdiction and choice of law is assessed by adjudicators on an ex post basis thought should be given to the compiling a list of ex ante reliable methods.  Giving contracting parties some foreseeability as to which methods pass the reliability test would increase enforcement efficiency by deterring them from using unreliable methods.  Such a list would need to be reviewed from time to time because neither the configuration of a central registry nor the algorithm of a blockchain is permanently fixed.

 

Conclusion

With the growth of distributed ledger technology, the world is becoming a more interdependent yet disjunctive place.  Existing UNCITRAL works facially encompass Smart Contracts, but the flexibility of the medium translates to ambiguity for regulators and contracting parties.  As bigger, established players like banks step into the Smart Contracting market, ambiguities about which signature methods are reliable and where disputes can be adjudicated, must be resolved.  UNCITRAL and States should be concerned about uncertainty around validity and choice of law for Smart Contracts because they affect the feasibility of using Smart Contracts in cross border transactions going forward.  Greater legal certainty of outcomes may incentivize other financial players to step into the game.  For these cross-jurisdictional and international issues it is better to regulate than to litigate!

 


* Aaheree is an LLM candidate at Cornell Law School, where she is an Associate of the Cornell International Law Journal. She is enrolled with the Bar Council of Maharashtra, India, specializing in banking law, capital markets and structured finance.

[1] Max Raskin, The Law and Legality of Smart Contracts, 1 Geo. L Tech. Rev. 304 (2017); Alexander Savelyev, Contract Law 2.0: “Smart” Contracts As the Beginning of the End of Classic Contract Law, at 10 Higher School of Economics (2016) https://wp.hse.ru/data/2016/12/14/1111743800/71LAW2016.pdf.

[2] Haruhiko Kuroda, Governor, Bank of Japan, Innovations in Payments and FinTech: The Central Bank’s Perspective, Address at the Forum on Payment and Settlement Systems (Mar. 17, 2016) (transcript available at https://www.bis.org/review/r160317b.htm).

[3] Id.

[4] Stuart S. Malawer, Internet Trade and U.S. Commerce and Trade Policy, 2 Va. Law. 5 (June/July 1999), at http://www.vsb.org/docs/valawyermagazine/jun99feature2.pdf.

[5] Dennis Kennedy, Lawyers Get Ready, There’s a Blockchain Coming, Law Practice Today (Jan. 13, 2017), http://www.lawpracticetoday.org/article/lawyers-blockchain/.

[6] Id.

[7] William Mougayar, 9 Myths Surrounding Blockchain Smart Contracts, Coindesk (Mar. 23, 2016), https://www.coindesk.com/smart-contract-myths-blockchain/.

[8] Kristen Silverberg et al., Getting Smart: Contracts on the Blockchain, Institute of International Finance 2 (May 3, 2016), https://www.iif.com/publication/research-note/getting-smart-contracts-blockchain.

[9] Nik Custodio, Smart Contracts for Dummies, FreeCodeCamp (May 26, 2017), https://medium.freecodecamp.org/smart-contracts-for-dummies-a1ba1e0b9575.

[10] Riccardo de Caria, A Digital Revolution in International Trade? The International Legal Framework for Blockchain Technologies, Virtual Currencies and Smart Contracts: Challenges and Opportunities, United Nations Commission on International Trade Law (UNCITRAL) 7 (June 9, 2016), http://www.uncitral.org/pdf/english/congress/Papers_for_Programme/5-DE_CARIA-A_Digital_Revolution_in_International_Trade.pdf.

[11] UNCITRAL “UNCITRAL Model Law on Electronic Commerce (1996)”, (June 12, 1996), http://www.uncitral.org/uncitral/en/uncitral_texts/electronic_commerce/1996Model.html.

[12] Id.

[13] Id.

[14] UNCITRAL, UNCITRAL Model Law on Electronic Commerce with Guide to Enactment, Art. 11, U.N. Sales No. E.99.V.4 (1996).

[15] Id. at Art. 2(a).

[16] Id. at P. 31.

[17] Id. at Art. 6.

[18] Id. at Art.7.

[19] Id. at para. 56.

[20] Id. at Art. 9 and 10.

[21] Id. at Art. 8.

[22] UNCITRAL, United Nations Convention on the Use of Electronic Communications in International Contracts, at 15, U. N. Sales No. E.07.V.2 (2013).

[23] UNCITRAL, UNCITRAL Model Law on Electronic Transferable Records, at Art. 1(1), U.N. Sales No. E.17.V.5 (2017).

[24] Id. at Art. 2.

[25] Id. at Art. 10.

[26] Id. at para. 189, 190.

[27] Id. at Art. 11.

[28] Koji Takahashi, Blockchain Technology and Electronic Bills of Lading, 22 J. Int’l Mar. L. 202, 209 (2016).

[29] UNCITRAL supra note 14, Art. 9.

[30] UNCITRAL, UNCITRAL Model Law on Electronic Signatures with Guide to Enactment, at 29, U.N. Sales No. E.02.V.8 (2001).

[31] UNCITRAL, supra note 14, at 60.

[32] International Swaps and Derivatives Association & Linklaters, Whitepaper: Smart Contracts and Distributed Ledger: A Legal Perspective, (Aug. 3, 2017), https://www.isda.org/2017/08/03/smart-contracts-and-distributed-ledger-a-legal-perspective/.