Smart Contracts: A discussion for lawyers on Capacity and the role of consideration

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Smart Contracts: A discussion for lawyers on Capacity and the role of consideration

Capacity to contract is, typically, a constitutive element to the formation of a legally binding contract which can be recognised by law and enforced by Courts. This requirement denotes that a person is considered by law as able and competent to enter into a contract, because such person possesses the competence to bind themselves through the contract.

Typically, all adults of sound mind are deemed capable to enter and be bound to a contract.  However, the law usually recognizes certain categories of people that are deemed to lack the ability to enter into a legally binding contract. Such categories are introduced, because the law recognizes that parties should be bound to a contract, when they are capable to understand their actions or inactions. Age and mental (in)capacity are broadly recognized as the factors that determine the existence of capacity to contract.

Although the mere use of the terms “smart contract” alludes to the existence of a contract, i.e. a legally binding agreement which can be recognised by the law and be enforced by the courts, not all smart contracts may be recognized as such. To qualify as a contract, smart contracts must possess all these essential elements that are recognized by domestic contract law as requisite elements to the formation of a contract which can be recognised by the law and be enforced by the Courts.

Capacity to be bound to a smart contract, would mean the competence and ability of a person to be bound to a smart contract. To be recognized as a binding legal contract recognised by the law and enforceable by the Courts, the parties should possess such capacity, i.e. they should be recognized by law as competent to enter into the said contract.

To determine whether parties have the requisite capacity to be bound to smart contracts it is necessary to be able to identify these parties. Only then could it be ensured that they possess the ability, as recognized by law, to be bound to the said contract.

Minors are broadly deemed incapable of entering into legally binding contracts. Who qualifies as a minor is a matter determined by domestic contract laws.

There are several exceptions to the above principle. Contracts entered into by minors in relation to the purchase of necessaries, including but not limited to food, accommodation and clothing, are considered legally binding. What counts as necessary may vary depending on the circumstances, the minor involved, and all the factual elements in place.

Contracts for employment, and education, to the extent that they are beneficial to the minor, may also be recognized as legally binding contracts.

Minors may enter smart contracts, but such smart contracts will not be regarded legally binding and enforceable, unless the contract law exceptions, as explained above, apply. This happens because contract law deems minors to lack the essential capacity to enter legally binding and enforceable contracts. Again, the exceptions recognized by contract law will apply to smart contracts as well. Therefore, for example, if a minor enters a smart contract to purchase necessaries, then, if all the other required contractual elements are present, this smart contract will be legally binding. In other words, the same contractual restrictions that apply to minors in “traditional contracts” shall apply to them in smart contracts, if such are to be considered legally binding and enforceable.

Mental incapacitation of a person means that law deems such person incapable to enter into a contract because of some psychological or mental disability. People with incapacity or impairment in their mental state, are not able to understand the act and consequences of entering into a contract and, thus, lack the capacity to contract.

In these cases, persons with mental incapacitation are not bound by the contract, provided that the other contracting party was aware or ought to have been aware of their incapacitation. The mentally incapacitated party must prove their incapacity. Expert evidence may need to be adduced to this end.

A mentally incapacitated party to a smart contract, if such a smart contract is to be regarded legally binding and enforceable, is under the same capacity-related restrictions as it is in “traditional contracts”.

An issue that might arise, however, is that a smart contract would be executed and performed regardless if this smart contract may be regarded legally binding and enforceable. A possible scenario that arises in relation to mentally incapacitated people in a contract setting, is that these people (typically through a legal guardian) may rely on their incapacitation and escape performance of their contractual obligations. This is possible because their agreement is not legally binding due to their incapacity. In the context of smart contracts, which are automatically executed, mentally incapacitated people will not be able to escape performance of a smart contract. Even if this smart contract is not legally binding and enforceable, its self-executing nature will ensure its performance. In this context, it seems that if a judge were to review a smart contract case, involving a mentally incapacitated person, then she would find such smart contract not legally binding and enforceable. However, it is hard to see how this judge could then intervene and reverse the performance of the smart contract, in order to allow the mentally incapacitated person to escape performance of the said smart contract.

Being under the influence of various substances may impair people’s mental capacity to the extent that they cannot understand their actions. Thus, the law in certain cases regards people that are clearly under the influence of some substance, either alcohol or drugs, as incapacitated. In other words, they cannot be deemed to possess the necessary capacity to contract.

The same considerations that are relevant to mentally incapacitated persons, in general, apply to this category of incapacitated persons. If a person is under the influence on the extent that the law regards such person as incapacitated, then this smart contract is not legally binding and enforceable. The same concerns that arise in relation to mentally incapacitated people seem to have application for people acting under the influence.

In case parties are considered to lack the legal capacity to enter a smart contract, then such smart contract will, most probably, be voidable, i.e. one party may, at their election, repudiate the contract. In other words, once a party is deemed to lack the legal capacity to enter into a smart contract, that party may have the option to repudiate the contract and be restored to the position it would have been prior to the execution of the contract. For a smart contract to be regarded as legally binding and enforceable, then surely the design of the smart contract should accommodate the possibility of repudiation and restoration of the parties to the position they had before the execution of the contract. The automated and self-executing nature of smart contracts needs to be considered in relation to the voidability element that a smart contract should provide for, in case it is regarded legally binding and enforceable.

A contract may be legally binding only if it entails consideration. The provision of consideration by one party to the other means that a set of promises is exchanged between the parties and the provision of some value is involved in this exchange. Consideration need not be adequate but only sufficient, meaning that consideration given by one party does not need to be equivalent to what is exchanged. Still, consideration must have some kind of value.

Following the above, consideration in smart contracts means that for a set of promises (as codified, reflected in code or represented in code) made between the parties involved, some kind of value must be exchanged. The exchange element present in other contracts shall still apply to smart contracts if they are to be recognised by law as legally binding contracts. Therefore, consideration in smart contracts would operate as the element, whereby promises between the parties are exchanged for some value.

Another important role that smart contract consideration may have, is that it serves as evidence of the existence of a contract at an any given point in time. This happens, because smart contracts are stored in platforms, where data are permanently held, since they cannot be erased.  Therefore, the existence of consideration in the code may be proved and consequently the existence of a contract may be ensured at accordingly, provided all other requisite elements are present.

 

Consideration in contracts may take various forms: money payment, provision of services, taking or refraining from taking a particular action. Accordingly, consideration in smart contracts may take any form that the law would recognize as valid (for example, to be recognized as a smart legal contract, consideration would have to be sufficient, albeit not adequate and it would have to be of some value). Any terms stipulating the provision of consideration in contracts could possibly be represented through relevant smart contract codification. Codification in smart contracts could be made in any form anticipated for contracts themselves.

What is important to highlight is that, in smart contracts, there is probably a greater scope of what might constitute valid consideration, by virtue of the technological evolution and digitalisation. In specific, cryptocurrencies may constitute valid consideration in the context of smart contracts, so that these contracts may be considered legally binding and enforceable. Cryptocurrencies or digital coins, as alternative to fiat currencies could work as consideration, in the same way as fiat currency does. For example, instead of making a promise to pay a specific sum in say euro, an analogous promise could be made but in the form of digital currency, say bitcoins. Tokens could also function as consideration (the nature of consideration in this case will depend on the function of the token in question). Further, cryptographic assets, which constitute digitalised representations of real-world objects or claims, or rights, could also amount to consideration. That cryptographic assets could digitally represent any tangible or intangible asset, or object, or claim, or right, whatsoever, demonstrates that any form of consideration provided in conventional contracts might be easily digitalised and provided for in smart contracts.

 

A contract consists of an enforceable set of promises which involves the exchange of some value. The requirement of consideration ensures that an exchange of some value has occurred between the parties. For this reason, only if there is consideration can a set of promises be regarded as enforceable. Such promises are called “reciprocal promises” because they entail the provision of consideration.

A gift, on the other hand, involves a promise by the promisor to benefit the promisee on a voluntary and gratuitous basis. The promisee in this case offers no consideration in return. This means that no exchange of value occurs; consideration is absent. Failure to perform the actions anticipated under a gift does not result in breach of a contract, because no contract has been formed. Therefore, the party that has not given any consideration, cannot enforce the performance of the gift. This happens because the promise was not given on a reciprocal basis, which would involve the exchange of value.

The same principles that apply to real-life gifts, made in non-coded form, seem to have potential application to smart contract gifts. A smart contract may consist of a non-reciprocal set of promises, whereby the promise is only given on a gratuitous basis. In much the same way as this would not be regarded as a valid contract in traditional contract law terms, this would also not be regarded as a smart legal contract. This, however, does not mean that the smart contract gift will not be performed. Indeed, smart contracts are executed automatically. Even if a smart contract gift is not legally recognized as contract, it will still be performed.

 

The interesting part about smart contracts is that in the absence of consideration, smart contracts would still be executed, since smart contracts are self-executing. (See this point in relation to gifts at 7.5.3.). Obviously, smart contracts lacking consideration would not be considered contracts, but they would still be executed and performed. Therefore, consideration would not determine the performance of the smart contract, but it would determine the legality of a smart contract, i.e. whether it can be regarded as a contract.

In the absence of consideration in a contract, the promisee cannot enforce the performance of that contract. As stated, if we are to examine smart contracts by the same principles of contract law to determine their legality, then, where and when a smart contract is formed, no contract has been formed in the absence of consideration. Yet, the difference is that in the absence of consideration, a promise could still be executed, through the medium of the self-executing smart contract. The promisee in this case, would not have to enforce the performance of the contract lacking consideration. The promise would be self-executed and performed.  Of course, a smart contract lacking consideration would still be executed due to its automatic nature but would not be regarded as contract but rather as an executed transaction.

One might argue that the self-executing aspect of smart contracts might diminish the relevance and importance of the requirement of consideration in relation to these contracts. One important legal implication of the absence of consideration in agreements is that there is no mechanism for the promisee to enforce the agreement, because such agreement is not a considered a contract and thus it is not legally enforceable. In smart contracts, however, the promisee does not have to enforce the promise considering that such promise will be executed automatically through the smart contract software, regardless of the presence of consideration.

 

Despite the absence of a written contract, the self-executing characteristics of a smart contract may enable parties to establish enforceable rights in equity. These enforceable rights will allow a party who has suffered substantial detriment after relying on another party’s promise, to seek relief from the courts. This section will address how certain characteristics of smart contracts may support the view that a smart contract is indeed a promise at-law.

A promise in contract law constitutes the undertaking or agreement to perform or refrain from performing a certain act. Contract law recognizes promises as legally enforceable only if they involve consideration. Therefore, not all promises are legally enforceable. (To that end, see also 7.5.4.). To be sure, a promise given in return for another promise based on the exchange of some value is legally enforceable. Legal enforceability of promises depends on them being reciprocal and given as consideration.  In case a set of legally enforceable promises arises, a contract is formed.

If a promise is not given in return of a reciprocal promise, then, most probably no contract has been formed. This means that such a promise is non-enforceable in law. It should be noted, however, that equity might intervene and require the enforcement of a promise, even if no consideration was given in return. The doctrine of promissory estoppel is pertinent in this regard. Where the promisor makes a promise to the promisee, the promisee reasonably relies on such promise to her detriment and the court deems that it would be unconscionable to allow the non-enforcement of the promise, then the promisor is obliged to carry out the said promise.

To determine whether a smart contract may be regarded as a promise the difference between legally enforceable promises and non-legally enforceable promises shall be maintained. For a smart contract to be regarded as a contract, the relevant promises constituting the said contract would have to be legally enforceable, i.e. they would have to involve consideration.   In the absence of consideration, such promises would not be enforceable in law (although equity could ultimately render them enforceable). This means that a promisee would not be able to enforce these promises by relying on contract law principles.

In a smart contract, however, a promise given without consideration can still be executed. A non-legally enforceable promise will still be performed owing to the automatically- and self-executing nature of smart contracts. The automatic- and self-executing nature of smart contracts would ensure performance of the promises, regardless of whether consideration has been given, and thus regardless if these promises are regarded as enforceable by contract law.

A promisee in the case of smart contracts would not have to rely on an equitable basis to enforce the promise, because the promise would be performed automatically. Yet, even if the promisee would need to rely on such equitable basis, then in the context of smart contracts a promisee would be able to successfully rely on the equitable ground of promissory estoppel much more easily than in the context of traditional contracts. This is because the promisee could easily prove that she reasonably expected the promise to be performed, considering that performance of promises is automatic. Therefore, promissory estoppel could be established in a much easier way than in traditional contract law.

Smart contracts may be said to consist of, at least in part, a set of promises. The self-executing feature of smart contracts guarantees, at least to a great extent, the performance of these promises and offers much greater certainty and trust between the parties making the relevant promises. Therefore, in a smart contract a party would not be able to avoid performance of their promises with the same ease as in contracts.

 

Again, promises in smart contracts are performed automatically. People currently entering traditional contracts with no intention to honour their promises would be prevented from entering to smart contracts. The moral hazard associated with people entering contracts without intention or viable prospect to perform their part of bargain is surely reduced with smart contracts. In this way, one could argue that smart contracts are more likely to be concluded between parties that expect to have their promises performed. Smart contracts could introduce and help enhance a culture of morally-conscious and contract-honouring business agents. Breakdown in business relations is to be, of course, anticipated in any context, yet the automatic performance of smart contracts should go a long way towards rendering business promise-making a kind of moral convention.

In a conventional business setting with traditional contracts, there appear, many times, problems of credibility between the contracting parties. Entering into a contract and making a promise to perform or refrain from performing a certain act does not guarantee the performance or accordingly non-performance of such act. Even though non-performance of a valid contract brings about sanctions and gives rise to potentially large compensations, credibility issues between contracting parties are pervasive in the business world. Credibility issues associated with the risk of non-performance of contracts may result in higher transaction costs, the inclusion of high penalty provisions in contracts and, even, reluctance to contract in the first place.

Smart contracts may present the opportunity to reduce or even eliminate issues related to lack of credibility as to the performance of contracts. Since smart contracts are automatically executing technologies, contracting parties will make promises to which they will have to adhere. Breach of smart contracts is possible, yet considerably reduced to a very low degree. Trust and certainty would increase between business transactions. That no intermediary would be needed to enhance trust and certainty in business transactions is another benefit provided by smart contracts. Smart contracts functioning as credible commitments would result in economic and time efficiency in business transactions. A party’s commitment and promise would be much more credible, since once the smart contract is entered, parties would, typically, not be able to go back on their promises.

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