Disputes & Distributed Ledger Technology: A contract, no matter how smart, still needs to be legal and enforceable in the real world
In September 2020, the Law Society of England & Wales published “Blockchain: Legal & Regulatory Guidance” (the Guidance), providing technical guidance and suggestions on practice for legal practitioners dealing with blockchain and distributed ledger technology (DLT). This new technology is precipitating the rise of a new form of contract – the Smart Legal Contract (SLC) – a digitised version of a legal contract in which some or all of the agreement is to be performed automatically on algorithmic instructions, without the need for human action or verification.
In this article, we consider the Guidance’s recommendations and provide key considerations to take into account prior to entering into a SLC, to ensure the dispute resolution mechanism is fit for purpose. We discuss on-chain and off-chain dispute resolution mechanisms and permissioned and permissionless systems – terminology with which in house and external legal advisors will quickly need to become familiar as the legal landscape continues to change.
On-Chain Dispute Resolution
“On-chain” dispute resolution involves an automated dispute resolution mechanism allowing the outcomes of disputes to be enforced automatically, without requiring human intervention. For example, mechanisms whereby monetary compensation is automatically paid into the successful party’s digital wallet or remedial action is automatically effected within the DLT system (for example, reversal of trades between parties in the context of an ownership dispute) without the need to obtain consent from the unsuccessful party or resort to third-party enforcement procedures.
Examples of on-chain dispute resolution tools include (a) online “arbitration” (whereby dispute resolution procedures, which may or may not be similar to traditional “arbitration”, are incorporated within the code of an SLC), (b) crowd-sourced models (whereby anonymous users/nodes vote on the outcome, with a reward payable to those in the majority) and (c) AI-powered automated solutions (whereby predictive analytics determine the outcome).
The Guidance notes that on-chain solutions need to be “as legally robust as they are technologically sound” to avoid challenge by dissatisfied parties. Specifically, concerns include (a) the decision maker’s impartiality and independence (which can be complicated by platform pseudonymity and the limited pool of appointee candidates, which can only be drawn from those already with access to the system), (b) the ability of the decision maker to consider complex facts/arguments, and (c) whether automatic enforcement can accommodate appeal/challenge mechanisms. As a result of these concerns, it is unlikely that on-chain dispute resolution will displace traditional off-chain dispute resolution mechanisms completely.
Off-Chain Dispute Resolution
“Off-chain” dispute resolution generally refers to a combination of traditional forms of dispute resolution, lacking a mechanism for the automatic enforcement of a decision but with certain elements of the procedure remaining automatic. The applicable off-chain dispute resolution mechanism is an important matter to consider for entities establishing, and participating in, DLT systems.
Permissioned DLT Systems
In a permissioned DLT system, the establishing entity has the ability to prescribe the rules governing the parties’ participation, including the applicable governing law and forum with jurisdiction over disputes. Selecting the appropriate dispute resolution provision for a permissioned DLT system involves many familiar issues practitioners consider when drafting traditional contracts, including:Choice of governing law: the chosen law must recognise the status of the digital assets held on the relevant DLT system and the legality and enforceability of the SLC. English law is an excellent candidate, given that in principle a smart contract is capable of giving rise to legally binding obligations and can be analysed pursuant to “entirely conventional” legal principles.1
Choice of forum: consideration must be given to the appropriate forum to govern disputes arising out of the DLT system, i.e. (a) the courts of a particular state (and which state?), or (b) arbitration. As explained below, arbitration can be a particularly attractive option where enforcement across multiple jurisdictions may be required.
When considering a dispute mechanism involving litigation before national courts, as explained in the Guidance, the key considerations when making a choice of courts are:
- Enforceability: a judgment is not much use unless it is enforceable against real-world assets. Often, DLT will involve participants with assets across multiple jurisdictions, in which case it is important that judgments in the selected jurisdiction can be enforced internationally, for example, under the Recast Brussels Regulation2 (throughout the European Union), the Hague Convention3 (throughout signatory states), or under other international treaties or local law. This must be considered at the outset when selecting the court with jurisdiction over disputes arising from the DLT. Recording choice of court in a traditional written form is also advisable, to minimise the scope for disputes over the existence and enforceability of that agreement.
- Quality of the legal framework: the quality and expertise of both the lawyers and the judiciary in the jurisdiction of choice to engage with complex, novel and technical disputes is also an important consideration. English, Singaporean and Swiss courts, for example, have each demonstrated a willingness to grapple with disputes arising from cutting edge technology.
- Procedural rules in selected state: national courts with procedures aimed at limiting the potential for unmeritorious claims or defences (for example, summary judgment provisions, under which claims can be disposed of without requiring a full trial) can save time and costs should disputes arise. Cost-apportionment and security for costs provisions can also discourage unmeritorious claims.
As an alternative to selecting court litigation, arbitration is a popular option in the international community, and might be particularly attractive with respect to DLT, since an arbitral award might be more easily enforced across jurisdictions than a court judgment. Advantages of arbitration include:
- Enforceability: arbitration agreements and arbitral awards made by a tribunal seated in a New York Convention4 state are recognised and can generally be enforced under the national laws of the other signatory states to the New York Convention. Since more than 160 states have signed up to the New York Convention, arbitration proceedings can render an award which benefits from the world’s most wide-ranging cross-jurisdictional enforcement regime and which is unlikely to be overturned by the national courts where the assets against which enforcement is sought are located (subject to very limited exceptions).
- Other key benefits: arbitration also enables parties to tailor the proceedings to their dispute. Parties can, for example, select arbitrators with specific expertise, tailor bespoke procedures for their dispute and agree to keep proceedings confidential.
That said, arbitration does have some disadvantages. Arbitrators only have jurisdiction over parties to the arbitration agreement, meaning they cannot join third parties or consolidate proceedings without consent, and they do not have the same powers as courts to grant interim remedies in support of proceedings (such as injunctions) – albeit certain jurisdictions enable recourse to their national courts in support of arbitral proceedings, as explained below. In practice, there is also more scope for dissatisfied parties to delay arbitral proceedings, and tribunals’ powers of coercion are more limited than those of national courts.
If arbitration is selected as a mechanism to resolve disputes, as explained in the Guidance, the key points to consider include:
- Arbitration agreements should be “in writing”: this is a requirement under the New York Convention. Although the Convention provides examples of “agreements in writing”, it does not precisely explain what “in writing” means. As a result of this uncertainty, it is prudent to record an arbitration agreement in traditional written form, irrespective of whether the agreement is also reflected in the code of the SLC.
- Seat and procedural rules: the seat of the arbitration determines both the procedural law of the arbitration and the assistance obtainable from local courts in support of the arbitration. Select a seat that is both a party to the New York Convention and whose law recognises the status and enforceability of the relevant digital assets and limits the scope for unwanted interference from the courts in the arbitral proceedings. The arbitration agreement should also specify the relevant procedural rules for the administration of the arbitration (for example, for an arbitration seated in England, the rules of the LCIA are often chosen). Express wording on confidentiality can be included if that is considered desirable.
- Multiple parties/joinder: ensure the arbitration agreement permits the joinder of all participants on the DLT system should they be required as parties for effective resolution of the dispute (for example, if transactions are to be reversed or created on the distributed ledger to give effect to an arbitral award). Given the nature of DLT, express wording should generally be included to ensure any arbitral award rendered is binding on all participants in the DLT.
Permissionless DLT Systems
In contrast, there is considerable uncertainty as to whether a permissionless system (such those relating to cryptocurrency, like Bitcoin), which allows participants to join and leave at will, is able to impose binding rules on its participants. As such, if there is no expressly selected governing law or choice of courts, or the selection is not binding on the system’s participants, these issues will therefore fall to be determined by the conflicts of laws and jurisdictional rules applicable in courts seised of a dispute (i.e. the courts in which proceedings are brought). There is likely to be considerable divergence across national courts as to how these issues will be dealt with, meaning that disputes under such systems may be more complicated and more uncertain.
The rise of DLT is certain to lead to disputes, but it will also disrupt the manner in which disputes are resolved. Just as businesses are having to come to grips with new ways of conducting business, legal practitioners need to adapt to deal with new contractual mechanisms, including innovative dispute resolution solutions. As explained above, familiar considerations regarding governing law and choice of forum will still be relevant, but it is vital ensure the dispute mechanism is appropriate for the particular DLT or SLC. The Guidance provides a welcome framework to assist in-house and external practitioners in this brave new world.
1 UK Jurisdiction Taskforce Legal Statement on Cryptoassets and Smart Contracts, November 2019, paragraphs 136-148.
2 Brussels Recast Regulation of the European Parliament and of the Council (EU No 1215/2012).
3 Hague Convention on Choice of Court Agreements (2005).
4 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards (1958).