An irritating weakness of written agreements is that they are really just words on a page until someone sues to enforce them. Lawsuits are time consuming and expensive, and not every wronged party will be able to clear the legal hurdles of proof required to receive a remedy.

But smart contracts are not afflicted with this weakness. Indeed, one of the most compelling reasons to use a smart contract is to ensure that human decision makers—with all their attendant unpredictability and uncertainty—are out of the picture. Upon activation, a smart contract becomes a closed system that automatically executes it code, and the parties no longer have any choice about whether they want to hold up their own ends of the deal. Property is transferred, workers are paid, and no one needs to worry about whether the other party will perform. As a pleasant side effect to this mandatory performance, the parties have no need to sue to force compliance or collect damages for breach.

Or at least that’s how smart contracts would operate in a perfect world. The real world is messier and more complex, which limits the utility of smart contracts. Smart contracts do bring a machine’s speed, reliability, and certainty to a transaction, but they are unlikely to replace traditional contracts. Here are two primary reasons why.

First, a smart contract will have a tough time capturing the parties’ entire agreement due to the natural limitations of coded languages. A smart contract is a program, which means it is written not in English but in one of the many programming language, such as Python or Java. It is solely this code which determines what a smart contract will do—any descriptive words that might appear on a user interface are irrelevant. Knowing this, if parties want a smart contract whose code captures their entire agreement, they would need to limit their agreement to the kinds of contractual terms a computer program is equipped to assess. For example, they probably could not include a clause requiring that a house be built to particular workmanship standards, since this requires a human’s assessment of the finished house.

Programs require defined terms and deterministic assessments, whereas business transactions frequently require flexible terms and subjective assessments. This limitation makes it unlikely that parties could capture in a contract’s code all the ambiguities and judgement calls that are frequently included in contracts. Yes, the combination of advanced AI and sophisticated third-party assessor programs (oracles) might eventually solve this problem, but for now it is difficult to imagine how a program would accurately assess whether a tardy supplier used his “best efforts” to deliver on time and thus deserves full payment despite his late shipment, or whether the construction of a house was performed to the contractual specifications.

The second limitation is that despite the name, smart contracts are not necessarily legally valid contracts. And an invalid transaction will just be reversed by the courts as soon as one party complains. While the self-executing nature of smart contracts means that the court cannot prevent the programmed transaction, the court can order the parties to execute an additional property transfer that restores what was taken or otherwise compensates for the loss. Say, for instance, that a smart contract is the only record of an agreement between two people. If the smart contract fails to meet the legal definition of an enforceable contract, either party could potentially sue to force the other to pay the equivalent of whatever money or property was transferred by the legally invalid smart contract.

Parties arranging a transaction could elect to take this reversal risk, proceeding without any written document, but such high-risk behavior seems unlikely (and unwise) in the context of high-stakes transactions. Overall, while smart contracts will ensure that the programmed transactions or transfers happen, traditional contracts will continue to be necessary in order to make those deals legally valid.

Even though traditional agreements will likely still be needed, this does not destroy the utility of smart contracts. Remember, the key feature of a smart contract is that it will execute transactions and transfers without the opportunity for human interference. A self-executing, self-enforcing program will increase certainty, reduce the need for party oversight, and save money on both sides of the agreement. The execution stage of the transaction is where smart contracts add value, and is where they should be used. Yes, smart contracts have limitations. But the most reasonable (and profitable) response to these limitations is to use smart contracts where they add value, not as an attempted replacement for traditional contracts.

-Brent D. Kapper

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