Article 2: Legal Aspects of Blockchain Technology — Does a Smart Contract Replace a Physical Contract?

Authors: Markus Kaulartz, Jonas Gross, Constantin Lichti, Philipp Sandner, Daniel Holk

In this article, we analyze from a legal perspective whether a smart contract can replace a physical contract set up between various business parties. We differentiate in our legal assessment between 1) the smart contract itself being the text of the contract, and 2) the smart contract only being used to execute a contract concluded elsewhere. Furthermore, we offer suggestions for the practical implementation. The article analyzes German laws.

Preamble

This article is the second publication of the series “legal aspects of blockchain technology” by the Frankfurt School Blockchain Center (FSBC), Datarella, and CMS Hasche Sigle. This research is part of the KOSMoS project, a research project funded by the German Federal Ministry of Education and Research (BMBF) under the funding code 02P17D020. The Frankfurt School Blockchain Center gGmbH and Datarella GmbH are part of the “KOSMoS” consortium. Together with partners from the industry (Schwäbische Werkzeugmaschinen GmbH, Alfred H. Schütte GmbH & Co. KG, ASYS Automatisierungssysteme GmbH), academia (Universität Stuttgart, Hochschule Furtwangen), and software development (inovex GmbH, Ondics GmbH), they create a blockchain-based solution allowing manufacturing companies to establish a DLT-based framework for producing machines in order to (a) execute dynamic leasing contracts, (b) provide transparent maintenance documentation and © ensure high-quality documentation of manufactured products.

Introduction

One of the advantages of using blockchain technology to store information and manage business processes is that smart contracts can be used. Smart contracts specify a set of promises digitally in a protocol that automatically executes the terms of the contract (Szabo, 1996). In programming terms, smart contracts are comparable to “if-then” functions, which define specific actions if a particular event takes place. Technically, smart contracts have three key features: 1) programming capabilities, 2) they can define the properties of money, and 3) they enable tokenization. An example: One can think of a situation in which, if the delivery of a good has been successful (“if”), a subsequent payment is made automatically (“then”). Smart contracts become particularly relevant in the context of issuance and trading of securities because they have the potential to “codify” the rules applicable to such securities.

Due to the term “smart contract” one could assume that smart contracts replace physical contracts. However, this only holds under very restricted conditions. In this article, we discuss under which circumstances it is legally possible for a smart contract to replace a physical contract, but also outline how smart contracts are used from a legal perspective in practice.

The combination of smart contracts and physical contracts

Whether a smart contract can replace a physical contract depends on whether the smart contract itself is the representation of the parties’ will or is only used to execute a contract concluded with ordinary means.

Figure 1: Differentiation of smart contracts in a legal sense

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Source: Own illustration.

The smart contract as a contract in the legal sense

First, we will examine whether a smart contract can constitute a contract in a legal sense, i.e., whether the parties can write a contract text in code and thus conclude a legally binding contract.[1]

A contract in the legal sense is concluded by two corresponding declarations of intent. As a rule, it is irrelevant how such declarations of intent are expressed — apart from possible mandatory formal requirements, such as in the case of real estate purchases. This principle results from the freedom of contract guaranteed in Article 2 (1) of the German Constitution. As an example: If a person in a bakery points silently at a bread, she expresses the intent to conclude a purchase contract for a bread. However, this is different if a hotel guest points to a bread on the breakfast buffet. These interpretations result from the objective view one has to take when assessing legal actions (§§ 133, 157 German Civil Code (BGB)): All circumstances of the individual case have to be taken into account and it has to be evaluated how the general public would construe the given statement of a person. In principle, therefore, it is irrelevant what exactly the person making the declaration actually intended.

We can apply this principle also to blockchain transactions using smart contracts: If a party signs a blockchain transaction and a smart contract is used in this context, the code of the smart contract could be used to interpret the content of the declaration the signee expresses. For example, if the smart contract indicates that the blockchain transaction is to be used to pay a leasing rate and the smart contract subsequently gives the party access to a machine, signing the blockchain transaction could be seen as an offer to conclude a lease agreement. Details could then be read from the code of the smart contract and perhaps other objective criteria.

However, in order for the smart contract to validly represent the parties’ will to conclude an agreement as stipulated in the code, the contracting parties would have to be aware that they make a declaration in the legal sense when signing the contract (so-called “awareness of declaration”, Erklärungsbewusstsein). In practice, this will typically not be the case. [2] The code of a smart contract is not easily understandable to everyone [3] and one may have doubt that a person signing a transaction actually and in detail knows the contents of a smart contract, understands it, and signs it with the intention to conclude a legally binding agreement without any reference to any text written in a natural language like English or German. This, of course, solely depends on the individual case, but we are convinced that in practice this case remains exceptional and it is not advisable to build business models on the assumption that the smart contract code can be the basis for a legally binding contract, solely representing the will of the parties.

Execution of a contract through smart contracts

From a legal perspective, blockchain transactions and thus also smart contracts should be interpreted in light of their operation, for example, the transfer of a token or storage of information. Smart contracts are thus typically used in the execution of contracts, not in the conclusion of contracts. Smart contracts can be used, for example, to transfer a security via an exchange under applicable security terms or to conduct payments in order to fulfill obligations under a lease agreement. The latter is implemented in the leasing use case of the KOSMoS project. These payments can also be made automatically after predefined conditions are met, e.g. after a machine has been used.

Use cases for smart contracts

Given that a smart contract is usually an instrument of executing the legal contract in a legally compliant way, a smart contract could be used to enforce a physical maintenance contract or a leasing contract. Both use cases are utilized within the KOSMoS project.

It is not possible to provide a general answer regarding which concrete contractual performance can be executed through smart contracts. One requirement is certainly that the relevant performance stipulated in the legal agreement can be performed via a blockchain, in contrast to obligations that require a real-world action, like repairing a machine. Therefore, smart contracts can be qualified as suitable means if digital assets, which can be represented by tokens, are subject to the agreement. This, for example, applies to all crypto securities or stablecoins.

If a smart contract is used to perform an obligation contractually agreed upon between the parties, it must be ensured that this performance exactly corresponds to what has been agreed upon legally. It is important to understand that the legal and the smart contract can run parallelly but the smart contract executes the performance agreed upon in the legal agreement. [4] If this is not the case, the obligation is not fulfilled. Typical scenarios in which the smart contract code deviates from what has been agreed upon in the legal agreement are those where the legal agreement uses undefined terms (for example “pay duly in advance”) or a statutory provision applicable to the agreement has not been implemented in the code (for example consumer withdrawal rights).

Deviations between smart contract and legal contract

This raises the question on how to proceed if the smart contract (i.e., the execution of the contract) differs from the contract in the legal sense. [5]

Example: In a framework agreement, the parties state that the leasing rate for a machine is 5 EUR per minute. However, an amount of only 4 EUR per minute has been coded in and transferred via the smart contract.

In this case, the creditor is still entitled to the payment of the leasing rate, minus the amount already paid. The creditor can enforce this claim beyond smart contracts in the “old world”. The creditor can also withhold her remaining services with reference to the outstanding debt (so-called right of retention), and can, of course, demand default interest on the outstanding amounts (§§ 286, 288 BGB).

In practice, we advise to document the exchange of delivery and payment well, so that even if errors should occur, outstanding claims could be fulfilled easily. For this purpose, smart contracts need to be designed in such a way that they can fulfill obligations also triggered by single transactions. This would, for example, allow the settlement of monetary claims without having to leave the system.

Practical note: In case a conflict arises as to which services of the smart contract have been fulfilled and which obligations have been contractually agreed upon, a resolution mechanism can be helpful. [6] Therefore, setting up a framework agreement with various stages for conflict resolution is crucial. In the first stage, it should be agreed upon which party’s representatives will bindingly decide on conflicts, as well as on the basis of which procedures and databases these decisions will be made. In the second stage, a mediator could try to resolve the conflict. In the last stage, an arbitration tribunal could (must) be called upon. The basis would be an arbitration clause included in the framework agreement . Through this solution, the conflict does not need to be brought before a state court but can be decided by a private arbitration court which would ideally be staffed with arbitrators who have the necessary expertise and, in particular, technical knowledge.

How to connect a smart contract with a legal agreement

In principle, it is irrelevant how a debtor fulfills her obligations, i.e., whether she pays a monetary debt in cash, by bank transfer, or by using a smart contract (unless explicitly agreed upon otherwise). The challenges are, therefore, the same as with physical contracts: Thus, it must be possible to clearly assign the obligations to a concrete obligation or contract but also to a concrete debtor and creditor.

There are no legal requirements on how this connection should be made. Rather, based on practical considerations and concrete implementation, it should be examined how a smart contract and a legal agreement can be connected in the most sophisticated way. This is possible by drafting the document which represents the legal agreement in such a way that there is no doubt regarding the debt to which the smart contract corresponds.

Practical note: We advise to attach references to the corresponding contracts i.e. clearly connect the legal agreement through its text (code) with the smart contract and vice versa. The smart contract could also be included as an appendix to the text of the legal agreement. Furthermore, debtors and creditors should be clearly identifiable, for example through their public keys.

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About KOSMoS

KOSMoS is a research project funded by the German Federal Ministry of Education and Research (BMBF) under the funding code 02P17D020. More information about the project can be found on the website.

Remarks

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Dr. Markus Kaulartz used to be a software developer and is now a lawyer at CMS Hasche Sigle. He specializes in IT and data privacy laws and focuses on challenges arising from the increasing digitalization (FinTech, Blockchain, Smart Contracts, AI, SaaS, etc.). Since Markus’ clients are both innovative startups and tier one global players, he has gained much experience in advising on legal issues of future technologies and new business models, such as blockchain and artificial intelligence. Markus has particular tech expertise and insights that contribute to his legal advisory practice. His input is often sought where challenges arise at the interface of technology and law. Markus is co-editor of the legal handbook on smart contracts and the legal handbook on artificial intelligence and machine learning.

Jonas Gross is a project manager and research assistant at the Frankfurt School Blockchain Center (FSBC) and also works for the KOSMoS research project. His fields of interests are primarily crypto currencies. Besides, in the context of his Ph.D., he has been analyzing the impact of blockchain technology on the monetary policy of worldwide central banks. He mainly studies innovations as central bank digital currencies (CBDC) and central bank crypto currencies (CBCC). You can contact him via email (jonas.gross@fs-blockchain.de), LinkedIn (https://www.linkedin.com/in/jonasgross94/) and via Twitter (@Jonas__Gross).

Constantin Lichti is a research assistant and project manager at the Frankfurt School Blockchain Center (FSBC), and also works for the KOSMoS research project. Furthermore, he is responsible for project proposals and grants as well as studies published at the FSBC. As a doctoral candidate his research interests cover blockchain themes in the light of digital transformation processes, especially the adoption of blockchain technology as well as the emergence of the global token market and digital business models based on blockchain technology. He graduated from the Technical University of Munich with a master’s degree in industrial engineering and management. You can contact him via email (constantin.lichti@fs-blockchain.de) and LinkedIn.

Prof. Dr. Philipp Sandner is head of the Frankfurt School Blockchain Center (FSBC) at the Frankfurt School of Finance & Management. In 2018, he was ranked as one of the “Top 30” economists by the Frankfurter Allgemeine Zeitung (FAZ), a major newspaper in Germany. Further, he belongs to the “Top 40 under 40” — a ranking by the German business magazine Capital. The expertise of Prof. Sandner, in particular, includes blockchain technology, crypto assets, distributed ledger technology (DLT), Euro-on-Ledger, initial coin offerings (ICOs), security tokens (STOs), digital transformation and entrepreneurship. You can contact him via mail (email@philipp-sandner.de), via LinkedIn (https://www.linkedin.com/in/philippsandner/), or follow him on Twitter (@philippsandner).

Daniel Holk is a research assistant at the Frankfurt School Blockchain Center (FSBC) at the Frankfurt School of Finance & Management. His fields of research include crypto currencies and the industrial application of digital money. He is part of the iBlockchain project which conducts research on industrial use-cases for digital money, as well as of the Digital Euro Association, a community aiming to accelerate the introduction of the digital Euro. He graduated from the University of Erfurt with a bachelor’s degree in International Relations and Economics. You can contact him via mail (daniel.holk@fs-blockchain.de) and LinkedIn.

Endnotes

[1] For further information on this question see in detail Möslein in Braegelmann/Kaulartz, Rechtshandbuch Smart Contracts, Chapter 8.

[2] In addition, there are also concerns resulting from the application of the laws on general terms and conditions (AGB-Recht), see Riehm in Braegelmann/Kaulartz, Rechtshandbuch Smart Contracts, Chapter 9.

[3] Möslein in Braegelmann/Kaulartz, Rechtshandbuch Smart Contracts, Chapter 8, para. 24.

[4] Möslein in Braegelmann/Kaulartz, Rechtshandbuch Smart Contracts, Chapter 8, para. 23.

[5] Blocher in Braegelmann/Kaulartz, Rechtshandbuch Smart Contracts, Chapter 10.

[6] Kaulartz/Kreis in Braegelmann/Kaulartz, Rechtshandbuch Smart Contracts, Chapter 19.

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