Legal Basics of Smart Contracts

What are Smart Contracts?

Smart Contracts are computer codes created in a blockchain, like Ethereum or NEAR Protocol, that facilitate the verification and execution of settings when certain conditions are met. These smart codes allow the exchange of money, property rights, or anything else of value in an automated, transparent way and without the necessity to trust third parties, which avoids the need for intermediaries. The characteristics of Smart Contracts include their immutability, autonomy, cost-effectiveness, speed, and transparency.

The way users interact with a smart contract is very different from a traditional written agreement. As they are computer codes programmed on a blockchain, their functionality could be incomprehensible to an average person. The best way to explain what smart contracts are is with the example of the vending machine, which is regularly used to illustrate the concept to newcomers. When the buyer selects the product he wishes to buy, the vending machine checks the availability of the selected merchandise. If the product is not available, the machine indicates it to the buyer. On the other hand, if it is available, the vending machine shows the price that the user must pay. When the user enters the required quantity, the machine delivers the product automatically, instantly and without the intermediation of third parties. If we extrapolate this example to a code developed on a blockchain, we have a Smart Contract.

Here’s a quick example of a smart contract for EtherBank written in Solidity, one of the most widely used smart contract programming languages:

Image provided by ResearchGate

It is imperative that countries adopt similar legislation in order to adjust the procedures and interactions with SC. A lack of global synergy among regulations could hinder the adoption of this amazing tech. In the example above, the smart contract checks the balance of a sender, deducts it from the user account, and transfers it to a recipient. Pretty straightforward and simple.

Advantages of Smart Contracts

The main advantage of Smart Contracts is they allow the automated execution of processes that previously required delegating the trust to authorize the operation to a third party. Due to the novelty in this type of coding, its true potential hasn’t even been scratched. Because they are autonomous, it is the user who adheres to the agreement by relying on the protocol rather than a banker, broker, or other intermediaries having to negotiate the terms of the contract.

Smart Contracts allow the development of decentralized applications, or Dapps, which do not require a traditional infrastructure to operate but are developed as automated processes on a blockchain. Since it is deployed in a blockchain and is automated, users must exercise caution when interacting with a smart contract. The confirmation of the operation can be verified without the need to wait hours or authorization by a third party. It is a very unusual level of transparency, specifically in the world of finance.

Disadvantages of Smart Contracts

Many mistakes have been made and lots of users have lost their funds due to a poorly coded contract which has allowed hackers to breach a protocol and steal all the digital assets stored in the smart contract.

That’s why it is very important to interact with smart contracts that have been audited by third-party analysts to find any glitch or error that could allow these kinds of losses and breaches. Another disadvantage of smart contracts is related to their very own nature. Since they’re coded in sophisticated computer language for the average citizen, users don’t really understand what’s “under the hood”. They just have to trust in a protocol coded by a complete stranger that promises to keep their assets safe and return some percentage as a profit.

This level of anonymity, immutability, and automation in the processes come with a heavy burden since it is up to the user to trust the coder, verify the legitimacy and interact with the SC, taking full responsibility for others failures in case of impermanent loss of funds or breach to the protocol.

As mentioned in one of our previous articles about Data Protection and Blockchain in the European Union, the immutability of the records in a DLT or blockchain could be incompatible with data protection regulations and user rights to amend or delete their data that are handled by data processing managers, so this is something that could cause issues in the near future once more smart contracts are deployed.

Use Cases for Smart Contracts

Almost every process that requires an intermediary to verify an operation or process could be affected or even replaced by SC, and wherever it can be applied to reduce costs and increase efficiency, we’ll see one created for these purposes.

Smart contracts have the ability to transform industries and even public administrations. That is why they are already being used in industries such as healthcare to protect sensitive data from patients; supply chain management to trail every interaction of a product from its conception to availability for buyers; real estate to track the ownership of properties or insurance to reduce claims fraud. The most common use is finance, to allow the democratization and access to capital, savings, and even loans to users that could not be accepted in traditional finance. This opens up basic requirements such as a minimum capital for opening a bank account, not being able to provide payroll, and other prerequisites, to the average person.

Although the main application of SC has been in Decentralized Finance (DeFi), we have seen the emergence of applications such as Decentralized Exchanges (DEX) like Uniswap, a new model of corporate governance in the form of DAOs, the Play-To-Earn model for video games like Axie Infinite, or the digital representation of rights and property through Non-Fungible Tokens (NFT).

In the public sector, smart contracts are being used to replace traditional voting with a blockchain-based voting system, allowing full transparency and immutability of results recorded on the ledger. They are also being used for intellectual and industrial property registries to track changes and expirations of these rights, reducing costs and increasing efficiency. Some people even think they could be used for the management of pension funds. Only time will tell the extension and full capacities of SC.

Legal complexities of Smart Contracts

From a legal perspective, SC faces lots of challenges and concerns that require a solutions-based approach and strategy as soon as possible. While regulators are focusing on determining the KYC & AML rules that exchanges must comply with or the tax treatment that digital assets must-have, we advocate for a better path to the legal issues that result from creating, extinguishing, or interacting with SC. Let’s tackle and discuss some of these juridical topics.

• Applicable Law and Jurisdiction

It is fundamental to establish which jurisdiction and applicable law must be enforced when creating, extinguishing, modifying or interacting with an SC, both from the perspective of the user and the developers of the code. Why is this important? Because the first thing we need to know in case of a legal claim or lawsuit related to the SC is the jurisdiction and applicable law that would reign the legal action or arbitrage.

As a general rule, acts performed by a person are subject to the law of the domicile where such acts were performed but the rules of applicable law and jurisdiction of SC are not regulated by any state, thus we have to apply general principles of law when we address these issues.

• Liabilities

Considering SC are digital enforceable agreements coded in a blockchain, they shouldn’t be exempt from contractual liability in case of wrongful coding or execution that results in damages to third parties. All the contracting parties are obliged to comply with certain parameters that cannot be exempted, even if the contract is verbal, traditionally written or programmed in a blockchain.

In the event of damages resulting from a dreadful SC, who’s responsible for the damages? Is it the developer of the code? Are the blockchain developers jointly and severally liable for this action? Could the SC developer abandon his contractual liability with a simple disclaimer stating that it is not responsible for damages caused to third parties? These are important questions that need to be addressed and answered. We personally don’t think a disclaimer could limitate or completely erase the liability of developers of an SC nor that the user is solely responsible when interacting with a SC.

• Similarities to Conditional Agreements

Traditional written agreements have been around for centuries. Their rules are set in stone and known by lawyers for years, but when it comes to digital agreements coded in a blockchain, the guidelines are blurred since we don’t have a precedent for this type of programmed arrangement. The counterpart to the SC in traditional law would be conditional contracts as they share lots of similarities with this form of arrangement. SC also shares correlations with adhesion agreements in which one of the parties does not have the ability to modify any contractual conditions and is only obliged to accept or reject the prerequisites settled by the other party, in this case, the developer of the SC.

For example, there are rules that determine the creation of a contract: an offer, acceptance, and considerations but after the contract is created, certain conditions must be met for this agreement to be valid and binding. An authentic consent, certain object, and lawful cause are some of the conditions that contracts must have in order to be legitimate. Does this mean we should translate these rules to the digital world? Could a person without valid consent (such as a minor) operate with an SC?

This debate of the legal implications of SC was discussed by the EU’s Working Group in a document named “Legal and Regulatory Framework of Blockchain and Smart Contracts” in which they mentioned two different types of SC: Smart Legal ContractsSmart Contracts with legal implications[1], defining them as:

• “Smart legal contracts are SC on a blockchain that represents — or that would like to represent — a legal contract, along with the issues that involve.
• Smart contracts with legal implications are artifacts/constructs based on smart technology that clearly has legal implications.”

If these codes represent virtual agreements, we think the contractual rules should be honored by developers and users when creating or interacting with SC because they are the basis for the foundation and validity of private agreements, regardless of the form it takes- whether it is verbal, written or programmed.

One of the matters that concern all cryptocurrency users is surely taxation. The tax treatment of crypto gains, trading and holding in general represents a challenge for users tax filing involved in this sector. Even more so if the benefits generated by this activity are not produced in the place where the user has tax residence or if there is an obligation to declare them as capital gain or as income tax from work performed.

In Tax Law there is a general rule by which most countries are governed and it is the Principle of Self-Assessment. Through this principle, all citizens are responsible for declaring their assets to the corresponding tax authority. It is not the authority that interferes in the economy of the person, but rather the citizens have the obligation to tell them how much money they have earned in each year or fiscal quarter.

For most countries, the simple possession of digital assets is not subject to tax; it is equated with the possession of goods such as a painting or a car. If you have a car or painting and it rises in value over time, you don’t need to pay taxes for this event. Only when there is a sale of the assets and a profit or loss is generated is when the taxable event occurs and needs to be declared to the competent fiscal authority as capital gains. But then again, each country is classifying these digital assets as they see fit. For instance, in Portugal crypto gains that come from buying and selling are not a taxable event and they don’t have to be declared as such. On the other hand, if someone receives tokens instead of cash for performing a job, these gains might be subject to income tax, as they are derived from the execution of an activity, and also if they correspond to the individual’s main recurrent activity (like trading crypto), this income obtained from such activity could be subject to Portuguese tax.

Digital assets can generate different types of taxable events:

1. Gains or losses obtained from the purchase and sale of digital assets when exchanged from crypto to FIAT currency;
2. Gains derived from sales of products or services in crypto;
3. Receiving commissions for providing services related to procuring crypto.

Another very important subject related to the tax treatment of crypto-assets is Double Taxation. Double taxation is defined as the imposition of more than one tax on the same income. It occurs when there are compensations in different territories and each country applies an income tax on all benefits received, without considering that another country has already taxed those earnings. When it comes to receiving tokens as an income for a job performed we need to fully understand this matter since we don’t want to pay taxes twice for the same income.

• Inheritance

What would happen if a person dies and their digital assets are invested in an SC? How could their legitimate heirs claim them? Some people have thought of developing a form of digital wills but the validity of these documents is subject to one very important condition: they must be notarized agreements. A private agreement for the disposition of goods after death is not valid without the presence of a notary who grants it public faith and rightfully certifies what is happening.

So, it begs the question, what then? What happens with these funds? If they’re amassed in a centralized exchange like BINANCE or Coinbase, you could initiate a process to retrieve them but when it comes to owning them in a decentralized wallet like Metamask, things are more complicated. Without the seed phrase or password to access these funds, we’re afraid you will end up losing all of them since right now we don’t have the means to retrieve them. We need to create more tools and solutions that allow legitimate heirs the possibility to claim digital assets from Dapps, SC and wallets of a deceased person.

• Current legal status

Most countries don’t have any kind of regulations or laws related to SC but some have taken the lead in defining and classifying what SC are. The first country to issue specific legislation on SC was Belarus in 2017 through the Decree №08/2017. In said decree, SC were defined as “a program code designed for the operation in the LEDGER of transaction blocks (blockchain), or other distributed information systems for the purpose of automated execution and/or settlement of transactions or making other legally significant actions”. Other countries have followed them ever since, including Italy and some states of the USA, like Arizona or Tennessee but still, we’re far away from having a global legal framework that regulates SC.

In Europe, The European Union Blockchain Observatory & Forum published a report called “Legal and regulatory framework of blockchains and smart contracts” in which it urges the European Commission to adopt a unified regulation of Blockchain and SC in order to create the least legal friction possible among States. The Working Group specified a series of rules that should be taken into consideration when the countries start preparing their legislations (and especially, their legislators) related to this subject. The Group exhorts countries to harmonize their regulations and to invest in education about Blockchain for their legislators and officials to prevent disagreements between them regarding this matter.

It is imperative that countries adopt similar legislation in order to adjust the procedures and interactions with SC. A lack of global synergy among regulations could hinder the adoption of this amazing tech.

It is imperative that countries adopt similar legislation in order to adjust the procedures and interactions with SC. A lack of global synergy among regulations could hinder the adoption of this amazing tech.

Where are we going?

Initiatives like NEAR Legal Guild are fundamental to tackle and solve these juridical obstacles. Although some advances have been made, we feel that the legislators are focusing too much on the tax treatment and AML rules while leaving these important subjects unattended. It is imperative for regulators to work hand-in-hand with Blockchain lawyers and experts in finding solutions that work for every party involved in SC.

The EU Working Group has done a tremendous job in clarifying some of these questions but their work has not become a European regulation that fully coordinates, harmonizes, and standardizes these subjects throughout the continent. We still have to educate and work side-by-side with regulators and officials, especially with legislators which will be responsible for issuing the laws related to SC.

The good news is that most countries are starting to pay attention to this matter and they seem to understand the importance of a global legal synergy among international regulations. Who knows if in a couple of years we’ll have an international treaty that governs Blockchain and SC at a supranational level!

Conclusions

We were able to identify some of the most notorious legal issues related to SC and propose potential solutions to some of these controversies, although there are still lots of topics unattended that will continue to appear as the development and use of this tool increases. We still have a long way until we have proper legal guidelines to work with, which is why groups like NEAR Legal Guild are relevant for assisting in the development of the necessary juridical frameworks for developers and creators to focus on creating and innovating. To the extent that more projects continue to be developed and SC continues to demonstrate their usefulness, beyond the applications that we have today, other legal problems will continue to arise that will be addressed by jurists and experts.

Our main job continues to be to educate and analyze these points to determine what interests, challenges, or legal conflicts may arise from the use of this new tech, and address them as precisely as possible. For now, we have to evaluate each SC project individually to determine whether there is a violation of the law or if the interests of third parties are affected by the development but hopefully one day we’ll have an international legal framework to approach all the juridical intricacies that arise from the usage and development of this tool in a clear and effective way.

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IVAR CIFRE