Innovation Law and Regulation 101: Navigating Smart Contracts

Foreword

Artificial Intelligence systems are set to be the next revolution, forever changing humans’ lives. This new phenomenon and its many effects will cause great changes in our society, which is why regulating is the first step toward ethical development. In fact, unregulated use of these technologies could give rise to negative consequences such as discriminatory uses and disregard for privacy rights. The challenges brought by the use of Artificial Intelligence urge legislators and experts to protect citizens and consumers as regulating becomes a priority if humans wish to protect themselves from unethical and abusive conduct. This series explores the topic of new technologies such as artificial intelligence systems and their possible regulations through legal tools. In order to do so, we will start with an explanation of the rise of new technologies and delve into the complicated question of whether machines can be considered intelligent. Subsequently, the interplay between Artificial Intelligence and different branches of law will be analyzed. The first chapter of this series of articles explored the possibility of granting AI systems with legal personality and the main legislative steps taken in the EU towards that direction. Moving into the realm of civil law the second chapter considered the current debate on the responsibility regime concerning the use and production of AI. The third chapter will discuss the influence that A. plays on contract law and the stipulation of smart contracts. The use of AI in criminal law and the administration of justice will be examined in the following chapter with a focus on both the positive and negative implications of their use. The fifth chapter will be dedicated to the use of Artificial Intelligence by public sector bodies. Finally, the complicated relationship between data protection and AI will be discussed in light of the EU General Data Protection Regulation.

The 101 series is divided into six articles:

1. Innovation Law and Regulation 101: Recognizing Silicon Minds

2. Innovation Law and Regulation 101: AI on Trial, Blaming the Byte

3. Innovation Law and Regulation 101: Navigating Smart Contracts

4. Innovation Law and Regulation 101: Silicon Justice

5. Innovation Law and Regulation 101: AI as Civil Servants

6. Innovation Law and Regulation 101: Defending Data from Silicon Eyes

Innovation Law and Regulation 101: Navigating Smart Contacts

Contracts are the legal tool used by individuals who wish to create, regulate, or extinguish an agreement, or more generally a relationship, between them. However, contracts are not an element of reality, instead, they are the result of human intellect and take different shapes and forms according to individuals’ intentions. For this reason, contracts are subject to change and can easily adapt to new methods of creation and execution based on time and context. Paper and pen were the first revolutionary technology which changed how contracts came to be. Nowadays, the current technology which is set to change contract law is Artificial Intelligence. The influence of Artificial Intelligence has a great impact on contract law resulting in the creation of new contracts or the execution of blockchain based contracts, widely known as smart contracts. These types of contracts demonstrate the role that Artificial Intelligence technology plays in contracts and show how vast the possibility of creating an intertwined connection between the two is. Moreover, Artificial Intelligence technologies have found their way into contract law by demonstrating their useful uses for a wide range of purposes. The use of Artificial Intelligence can in fact be useful in analyzing contracts, in order to protect consumers, but it can also be used in the creation of contracts, making agreements between individuals faster and cheaper. The great consequences of the use of Artificial Intelligence might, however, be shadowed by problematic aspects that arise in the current debate. This article will analyze the interesting and multifaceted phenomenon of the relationship between Artificial Intelligence and contract law, particularly showing how the former influences the latter. The first part will be devoted to smart contracts, a new type of contract based on blockchain technology. The advantages of smart contracts will be considered before turning the attention to the current challenges. Subsequently, this article will analyze how Artificial Intelligence techniques can be employed in the creation of traditional contracts. The benefits of its use will be explained to understand why the influence of Artificial Intelligence might be desirable. However, current problems and challenges will also be considered to understand what is necessary before moving forward.

Smart Contracts and Blockchain: A Definition

Smart contracts represent the ultimate frontier of the digital revolution. They are based on blockchain technology, first introduced by Satoshi Nakamoto with the advent of Bitcoin. Smart contracts were first proposed as computerized transactions executing contractual clauses of a contract in the 1990s by Nick Szabo (Szabo, 1997). Szabo explained the logic of smart contracts with the example of a purchase from a humble machine: the receipt of money acts as the necessary contractual conditions which gives rise to the execution of the contract, in this scenario the transfer of ownership of an item.

Smart contracts can be defined as self-executing contracts at the realization of predetermined conditions. Therefore, parties to the contract are free to set the requirements which, once fulfilled, give rise to the creation of a contractual relationship between them. Smart contracts can also be defined as intelligent agents: computer programs capable of making decisions in given conditions (Klovart, Poola & Rull, 2016). In practical terms, smart contracts enable the terms of the contract automatically without the need for a human intervention in the process. As mentioned above, smart contracts are based on a technology known as blockchain. This type of technology is defined as a distributed software system allowing transactions to be processed automatically. A blockchain appears as a public ledger made up of a block of chains that cannot be falsified or changed. Furthermore, the registration of transactions on blockchains is authenticated through the consensus of network users known as miners (Zheng, Xie, Dai, Chen, Chen, Weng, Imran, 2020). By employing this system smart contracts are stored and distributed in blockchains and, subsequently, executed without a trusted third-party intervention.

Smart contracts are considered beneficial for parties to a contractual agreement, as they make the whole procedure faster, traceable, and inexpensive. However, blockchains cannot be canceled or modified, meaning that once the contract has been entered by the parties it cannot be changed or revoked. This creates a benefit to one party of the contract who expects a certain action from the other party, but it may endanger the principle of contractual will and contractual freedom.

Figure 1: Properties of Blockchain Technology (Euromoney Learning, 2020).

The Life Process of a Smart Contract

The cycle of a smart contract, and generally of all contracts, consist of four phases.

Firstly the contract is created through negotiations between different individuals playing different roles. Smart contracts, differently from Artificial Intelligence generated contracts, need the intervention of human intelligence in the phase of creation but not in the phase of execution of the contract. For this reason, lawyers play a fundamental role in the drafting of the contract. Once the text of the contract is written, engineers will convert the contractual clauses, written in natural language, in computer language.

Secondly, smart contracts are deployed to platforms on top of blockchains (Sillaber & Waltl, 2017). From this moment on, parties to the contract can access the agreement through the blockchains. Furthermore, smart contracts, once deployed on blockchains, cannot be modified in light of the principle of immutability pertaining to blockchain technology.

Thirdly, smart contracts can be executed. As stated above, smart contracts are self-executing contracts, and their execution is the automatic result of the fulfillment of certain conditions. Particularly, once the contractual conditions are met, the contract is executed automatically. The transactions are finally stored in the blockchain (Koulu, 2016).

Fourthly, the executed smart contracts are completed. The new status of the parties is stored and updated in the blockchains.

Benefits of Smart Contracts

Smart contracts present many benefits to contract law and to the parties of a contract. The new technologies employed in smart contracts make them particularly advantageous for the parties and also solve some of the drawbacks of traditional contracts.

Figure 2: Functioning of Smart Contract (Euromoney Learning, 2020).

Smart Contracts as Fast Contracts

Above all, smart contracts are particularly effective for their velocity. In fact, the execution of smart contracts takes a considerably lesser amount of time with respect to traditional contracts. The reason for that is that smart contracts are self-executing. The parties do not need to take any action to request the execution of the contract as its execution is automatic once certain conditions are met. The role played by parties to the contract and their counselors is only relegated to the initial phase of the creation of a contract, however, it becomes unnecessary once the contract is stored in the blockchains. This also eliminates the dependence of the contract on intermediaries who would traditionally have to perform certain actions for the completion of the contract or to simply ensure that the contractual conditions are met. The absence of human intermediaries is relevant for the time needed for the contract’s execution.

The velocity in the execution of the contract is essential for the parties to a contract who wish to make the transactions as quick as possible, for example in the sale of items. This characteristic is also particularly relevant in the financial field in which smart contracts are more and more used. Businesses are therefore set to be forever changed by the employment of faster contracts requesting the total absence of human intervention for their execution.

Cost Reduction of Smart Contracts

The cutting down of costs is another highlight of smart contracts which may attract more people interested in their use. The lack of human intervention and the employment of miners’ consensus represents the reason why smart contracts are so inexpensive compared to traditional contracts. Smart contracts are based on a decentralized system that makes unnecessary the manual registration or verification of the contract and requires low costs of service and administration. In fact, the parties to a contract usually have to endure the costs of registration and compensate intermediaries for their tasks. Smart contracts are in fact referred to as peer-to-peer contracts for the lack of intermediaries in the contract execution. Another cost that is traditionally sustained by parties to the contract is the compensation for the notary’s work in handling contract registration and paperwork. However, being based on digital methods smart contracts eliminate another additional cost usually attached to traditional contracts. The use of smart contracts eliminates those costs while guaranteeing secure and fast contract executions.

Smart contracts are registered on blockchains and once stored can be viewed and accessed by the parties to the contract. This entails that smart contracts are globally accessible by individuals who only need to have an internet connection. For this reason, there is no risk of losing the contract and having to request a copy from the other party or legal professionals. The accessibility of smart contracts is relevant because it makes contractual relationships faster and less expensive by eliminating the role of contract intermediaries. The same characteristic also entails that people from different parts of the world can enter easily into contracts with one another without having to endure costs for transportation or adaption of the contract in different legal frameworks.

Figure 3: Smart Contracts (2muchcoffee, 2021).

The Absence of Risks in Smart Contracts

One of the greatest advantages of smart contracts is the reduction of risks usually borne by parties to a contract. The automation of smart contracts eliminates completely the need for intermediaries who, according to their human nature, are prone to mistakes. Computer language and technology are more secure methods of execution given that technology is less inclined to commit errors, especially those attributed to human nature such as those due to fatigue, emotions, or misunderstandings. The reduction of mistakes also reduces the need for costly and lengthy disputes that might be initiated to act against those who committed the mistakes. Furthermore, the immutability of smart contracts entails that the smart contracts and their contractual clauses cannot be altered or tampered with by any individual. The parties are therefore protected against alterations that might cause significant changes to their agreement and avoid future disputes.

Smart contracts are also decentralized, better-solving privacy concerns. There are no physical copies of a contract that might be read by unauthorized parties. The decentralized nature is, for this reason, an effective solution against data breaches. Furthermore, the digital storage of the contract makes it possible for the parties to have constant access to a secure copy of the contract which is protected against changes and without the need to initiate proceedings to establish the true content of the contract. As a last consequence of the risk-reduction nature of smart contracts, the promisee is shielded by the promisor’s non-compliance. In fact, smart contracts’ execution is automatic once the contractual conditions are met, leaving no possibility for noncompliance by the other party.

Challenges of Smart Contracts

As great as the benefits of smart contracts are, multiple challenges linked to the use of smart contracts arise. Some of the challenges in question will be analyzed to better understand how smart contracts can be employed and what risks they might cause.

Figure 4: Example of Smart Contract Transaction (Zhang & Liu, 2022).

Legal Capacity to Enter into a Smart Contract

Smart Contracts do not request the physical and simultaneous presence of parties to the contract. It may happen that a smart contract is entered by a person who does not have the capacity to do so. A minor for example might request to enter a smart contract even though he or she has no legal capacity to do so. The digital nature of smart contracts might give rise to such scenarios with the result that a contract would be considered legally void. However, it is still to understand how smart contracts can be stopped or modified once registered in blockchains. This leaves both the minor and the other contractual party exposed to damages as the former might not be able to fulfill his or her obligation and the latter might be left unsatisfied.

A similar situation might arise when a person enters a smart contract by lying about his or her identity. Once again, the law of most legal frameworks prescribes that a contract under mistake is void (Giancaspro, 2017). Yet, the same challenges mentioned above arise.

What About Free Will?

The absence of possibility for the promisor of the contract to not comply with the obligations entails that the parties' will in the contract is completely eliminated once it is stored in blockchain technology. Contracts are in fact legal tools based on the freedom and willingness to enter into a contractual agreement and their consent is a fundamental element for the validity of contracts (Craswell, 1995). By reducing completely, the exercise of consent and human will, smart contracts might breach one of the fundamental aspects of contract law. In traditional contracts, the non-compliant party is subject to the remedy actions taken by the damaged party who wishes to find his promisee fulfilled. Therefore, there is still protection for the damaged party to the contract. However, this protection is better balanced with the principle of consent which should govern both the creation and execution of a contract (Ruffo, 2020). The non-compliant party should be free to determine whether he or she wants to comply with the obligations contained in the contract or be subject to being held liable in court for the acts of noncompliance.

Figure 5: Elements of Contract (Business Jargon, n.d.).

Immutability of Smart Contracts

The immutability of smart contracts makes them impossible to be tampered with by unauthorized individuals. However, the same characteristic also entails that authorized parties to the contract cannot modify their agreement even when they both wish to do so. In fact, contracts are legal tools used by humans to regulate relationships and as such can be subject to changes during the course of time. Traditional contracts are not immutable, and it is permissible to modify the contractual clauses of the contract to adapt them to the real conditions of the parties. Commercial parties are inclined to conclude agreements with reference to ambiguous terms to leave the door open to future negotiations or modifications (Levy, 2017). While humans can adapt to ambiguity, computers cannot and therefore base the execution of contracts on precise conditions. For this reason, if the parties do not precisely define all contractual terms and clauses, the contract will still be executed but with a chance that it may not reflect their true intentions.

Furthermore, smart contracts cannot be altered even when mistakes have occurred in the creation of the contract. The parties to a smart contract remain obliged to a certain performance even when it is agreed by all parties that the text of the contract is incorrect. This puts great emphasis on the initial phase of the life cycle of a contract: its creation. It must be ensured that all parties agree to all contractual clauses as they will not have the chance to ask for its modification in a future moment.

Unstoppable Execution of Smart Contracts

The execution of the contract is also unstoppable when the contractual conditions are met. For this reason, the obligation cannot be subject to delay, once again reducing the exercise of free will for the parties to the contract. Furthermore, remedial actions might also be ordered by judges. In particular, injunctions ordered by courts request one individual not to make certain actions that might be at the heart of the contract. Therefore, even if notified, the party who receives the injunction ordering to cease a certain action is not capable of refraining from it if it is a contractual term of a self-executing smart contract (Giancaspro, 2017).

Figure 6: Example of Smart Contract (Zheng et al, 2022).

Human Interpretation of Smart Contracts

Contracts are also subject to interpretation by third parties such as judges who might be requested to settle disputes over the meaning and effects of contractual clauses. In traditional contracts, judges establish and determine the obligations and expectations of the parties to a contract by analyzing the literal meaning of the contract and the context in which the contract was created. This seems challenging in the interpretation of smart contracts. In fact, they are translated into code language which is not comprehensible by untrained professionals. It seems unlikely that judges with no background in computer science will be able to settle disputes on smart contracts. This scenario makes the need for the presence of computer scientists in courts imperative in order to finally create cooperation between the law and science.

Machine Interpretation of Human (Smart) Contracts

Smart contract codes and machines do not have the capabilities to understand human principles that might appear abstract and ambiguous (Murray, 2019). The interpretation of the contractual clauses and contractual conditions is made by machines in an objective way, with no reference to the context in which the agreement came to be. Differently from judges, machines do not have a true and complete interpretation of the contract, they merely execute the clauses. Article 1362 of the Italian Civil Code provides that the contract must be interpreted in order to understand the true intention of the parties by also evaluating their behavior. Therefore, the literal meaning of the contract is not enough to correctly establish the desires and intentions of the parties to the contract. Smart contracts might give rise to undesired results that differ from the real intentions of the parties (Raskin, 2017). It is likely that machines will be able to conduct a more human-like interpretation in the future, but as of now, it would seem contrary to contract law principles to let smart contracts be fully interpreted by machines without verification and interpretation by legal professionals.

Figure 7: Traditional Contract Template (eForms, 2023).

Artificial Intelligence in Traditional Contracts

Artificial Intelligence techniques might also prove beneficial or relevant in the creation and analysis of traditional contracts. Differently from smart contracts, these types of contracts are not based on blockchain technology but have a relation with Artificial Intelligence for other purposes than the phase of execution of the contract.

Formation of Contracts through A.I.

Artificial Intelligence is the capability of machines to emulate human intelligence. Humans have the capability, other than the capacity, to create contracts and enter into contractual relationships with other individuals. It can occur that individuals wish to be assisted by Artificial Intelligence machines in the creation of contracts. This might in fact be beneficial as there are a lot of advantages in using such systems.

Artificial Intelligence machines can analyze a large amount of data and easily predict how a contract on a similar matter will be stipulated. For instance, the parties to a contract might choose to use Artificial Intelligence systems to draft a contract for the renting of a house from one party to the other. Artificial Intelligence systems might achieve the result with no challenges, as they have access to thousands of similar contracts that they could simulate. Similar contracts contain similar clauses that are always considered in some types of contractual relationships. This would make drafting of contracts easy and inexpensive, but also particularly fast. People with no law background would not have to interact with legal professionals acting as counselors, reducing the costs and time employed in the drafting of contracts (Linarelli, 2019). Artificial Intelligence systems also do not commit human mistakes such as oversights as they are more effective than the human mind. This would give the possibility to many people to avoid sustaining high costs for the formation of a contract. Technology would become an asset for those who do not have the economic resources to compensate legal professionals for their aid. The key in using technology should in fact make traditional actions accessible to a wider range of people rather than restricting it. At the moment there are multiple websites on the Internet running on Artificial Intelligence algorithms that offer this service with low fees.

Figure 8: Drafting of A.I generated Contract (Lexion).

Can A.I Be an Agent of a Contract?

Despite the benefits of using Artificial Intelligence systems, the scenario of A.I generated contracts presents some challenges that need to be solved by both legislators and computer scientists before moving forward. Contracts generated by Artificial Intelligence systems might cause some to think of Artificial Intelligence as the agent of the contract. However, there are legal requirements for entering into a valid legal contract. The party to a contract must be a legal person with legal capacity. Machines, as of now, are not considered legal persons and do not have rights and obligations deriving from legal personhood (Linarelli, 2022). Machines do not have intentionality unless we consider their ability to act based on their programming intentionality. This has been made clear by prominent scholars, as explained in detail in the first chapter of this 101 series. The English mathematician Turing explained that Artificial Intelligence systems are intelligent because able to emulate human thinking (Saygin, 1999). In subsequent years, philosopher John Searle explained that machines are not intelligent as humans because they lack intentionality (Cole, 2023). They act in a certain way because instructed to do so, but cannot freely choose how to act. The lack of intentionality and the lack of legal personhood makes it impossible, from a legal perspective, to consider Artificial Intelligence an agent of a contract. Individuals might choose to use Artificial Intelligence to create contracts, but its use should be considered as a mere means.

However, even if considering Artificial Intelligence as means to enter into a contract, the party might complain about divergences between the instructions given to the machine and the contract in which the party entered. Computers are not able to understand ambiguous terms of human principles widely used in contract law such as “fairness” or “righteousness”. The outcome might be that the contract formed by Artificial Intelligence might not manifest the true intentions of the party. Furthermore, the party might take legal action for contracting under mistake or for failure to represent his or her intentions. This creates problems as to who is liable for the mistakes made by Artificial Intelligence systems. As they do not have legal personality, they also do not have rights and duties. It is logical that other people would be considered responsible such as the coder or the producer of the system. The legislators need, therefore, to take action in responding to the real challenges arising in our legal framework and finally create a precise system of liability surrounding Artificial Intelligence systems. An accountability framework is fundamental in helping parties to contract to make use of new technologies in contract law.

Figure 9: Alan Turing (Chaffin, 1929).

Another challenge in the use of Artificial Intelligence as representative agents in contracts is consent. Individuals might employ A. I generated contracts that do not request consent every time a new follow-up contract is created between the individual and another party. This is referred to by scholars as follow-up intent (Oliver, 2021). The party, for example, an entrepreneur that uses A.I.-generated contracts for online sales, does not manifest renewed consent before being bound by the terms of the contract (Oliver, 2021). Consent is a subjective element in contract law, deemed essential for the validity of the contract. Artificial Intelligence receives instructions on how to create contracts, but could easily change its parameters as time goes by as Artificial Intelligence systems are able to automatically learn and change. Furthermore, the black box phenomenon of Artificial Intelligence systems entails that Artificial Intelligence programs can never be fully understood. For this reason, their mechanisms might change with no possibility to understand why they did so. This also creates challenges for interpreting the contract in court as legal professionals would not have the possibility of analyzing contractual clauses written in computer language.

Conclusions

In conclusion, the use of Artificial Intelligence has proved to be greater than one could expect. The relationship between contracts and Artificial Intelligence is wide, yet complicated. Artificial Intelligence and new technologies, in this case, blockchains, can be employed to create new and different contracts known as smart contracts. These contracts are self-executing contracts that link the automatic execution at the fulfillment of predetermined contractual conditions contained in the contract. Smart contracts appear as fast, inexpensive, and secure contracts that make contractual agreements easy to develop and easy to execute. Their immutability, due to the storage contained in blockchains, reduces risks of noncompliance and avoids modifications by unauthorized individuals. Furthermore, the lack of need for intermediaries makes smart contracts attractive for the low costs that parties have to bear. However, the same characteristics act as a double-edged sword and pose a number of challenges. In fact, smart contracts are immutable, making it impossible for the parties to correct mistakes or change their contractual agreements. Furthermore, smart contracts eliminate the risk of noncompliance by completely eliminating any exercise of free will after the creation of a contract.

Figure 10: John Searle (Breindel, 2005).

Moreover, Artificial intelligence systems can be employed in the formation and creation of traditional contracts. The essence of machines makes it possible to draft contracts easily and with low costs. On the one hand, this might be particularly beneficial for those who do not have the economic resources to pay legal professionals. Furthermore, contracts would be created easily and fast by systems that have access to a wide variety of existing contracts. On the other hand, scholars have exposed some challenges such as the lack of consent and lack of legal personhood of Artificial Intelligence systems. The latter entails that machines cannot legally enter into valid contracts as they do not have legal capacity. However, even when employed as mere mediums it is important to understand the limits of Artificial Intelligence in representing the individual's true intentions.

The essay has illustrated the most relevant debates on the relationship between Artificial Intelligence and contract law. It is now necessary for the legislators to address said issues and challenges to create a precise legal framework that makes A. I generated contracts and smart contracts a beneficial resource for all.

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