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

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.

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.

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]

Principle: Freedom of contract

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.

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.

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]

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.

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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Endnotes

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

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Jonas Gross

Jonas Gross

Jonas Gross is Chairman of the Digital Euro Association (DEA) and Head of Digital Assets and Currencies at etonec. Further, Jonas holds a PhD in Economics.