Legal Challenges Associated with the Adoption of Smart Contracts in the Industry 4.0 (February 2020)

The German government recently issued a strategy paper dealing with legal challenges connected to the implementation of the blockchain technology in German industry, in particular the obstacles associated with the adoption of smart contracts as part of industry 4.0. This article will highlight the recent developments, essential legal challenges and will return to the respective approaches introduced by the German government to address the downsides associated with the implementation of smart contracts.

 

Between a Cypherpunk Vision and the Industrial Implementation

The term “smart contract” has its roots in the mid-1990s. Nick Szabo introduced the concept as “a computerized transaction protocol that executes the term of a contract” (see for instance here). The term “smart contract” significantly gained popularity with the introduction of the Ethereum blockchain and other distributed ledgers serving as background architecture in order to realize the cypherpunk vision described by Szabo nearly 25 years ago. This point marked a technological breakthrough, as on this basis there was no longer any need for an intermediary to operate the electronic transaction apparatus. Additionally, at least on a conceptual level, the operation of smart contracts on the ground of distributed legers eliminates the need for traditional state institutions of enforcement.

Since the introduction of blockchain-based smart contracts, the adoption of the technology has considerably progressed. In the initial phase, a growing open source community operated the technology – more or less – within a sandbox environment on the basis of a fully public distributed ledger with a consensus mechanism accessible by anyone in the world without limitations, such as the Ethereum blockchain. At the current stage, businesses are beginning to operate consortium distributed ledgers controlled by a corporate intermediary arbitrary defining the scope of read and write permissions to preselected entities. TradeLens, a supply chain platform in the logistics sector rolled out by Maersk and IBM, serves as an example for such a collaboration (between a variety of different actors such as cargo carrier, port authorities or terminal operators. The platform contains smart contracts in order to regulate cross-organizational processes such as import and export clearances (see here).

 

Functions of Smart Contracts From a Legal Perspective

In general, smart contracts may serve as mechanisms to enforce contractual arrangements. Additionally, especially when based on blockchains, they are effective instruments to document and control the performance of the respective arrangement, which the contractual parties have concluded via traditional legal instruments such as written agreements and which they translated into computer code afterwards. The technical enforceability of smart contracts should not lead to the conclusion that those technical instruments are legally enforceable in every case. In light of the principle of contractual freedom in the European Union, however, it is open to individuals or businesses to conclude legally binding contracts by incorporating the arrangement into computer code.

In any case, at least at the current stage, the transformation of contractual arrangements (whether they are directly legally binding or enforcing an underlying contract) into computer code of a smart contract is associated with a broad spectrum of obstacles, which may jeopardize the legal and commercial interests of individuals or businesses using such a technical solution.

 

Transparency

The use of self-enforcing computer code, as an instrument to reflect contractual arrangements, is associated with transparency shortcomings at least for users without an in-depth technical understanding. That may unfold a significant impact, especially where smart contracts trigger an indefinite number of transactions, for instance in the sphere of e-commerce vis-à-vis consumers or in the context of machine-to-machine communication. The German government suggests addressing these perils with information obligations connected to the provision of smart contracts. Additionally, certification procedures carried out by official or accredited bodies on a voluntary basis may be introduced in order to promote the acceptance of the technology.

 

Reversing Transactions

The lack of transparency results in further implications where the respective smart contract operates on the basis of a public blockchain (such as Ethereum). These types of distributed ledgers share the characteristic that the database is not only publicly available to everybody, but, the validation procedure is also totally devoid of permission and allows access by every potential user. This essential feature is made possible by sacrificing the ability of any participant to arbitrarily reverse transactions executed on the basis of such a blockchain. In light of this, any misrepresentation of arrangements in the computer code will be executed by the respective smart contract and irrevocably written into the distributed ledgers (see the DAO hack).

The irrevocability of transactions can additionally result in commercial implications where the underlying agreement between the parties is invalid in light of the applicable statutory stipulations such as a conflict with consumer protection law or formal requirements. In general, AI-based decision-making struggles with the interpretation of undefined legal terms in the context of the respective case, which illustrates the need for human involvement, e.g. by interacting with dispute resolution bodies as so-called oracles feeding the smart contract with external input – prior to the execution of the self-enforcing mechanism.

 

Interoperability and International Standardization

A further obstacle for the broader adoption of the technology is the interoperability of the different systems, which are or will be available on the market. A broad spectrum of distributed ledgers with a variety of technical modalities already exists today. The nature of a smart contract essentially depends on how they interact with the respective distributed ledger. In light of this, several working groups are developing an international standard for blockchains and distributed ledgers (so-called ISO/TC 307, see here). This is supposed to cover further topics such as data protection, security and governance as well.

Additionally, the German government introduced the idea to establish a smart contract registry that will list contractual constellations (initially) in the energy industry regulated by such technical solutions and thus facilitate the recording and systematization of smart contracts implementation in the respective industry sectors.