When properly designed, tested, and deployed, smart contracts can provide increased transparency, enhanced security, and more efficient transactions. But what happens when smart contracts fail? If proper safeguards are not in place, smart contracts can introduce new risks into a transactional relationship or an organization. This article explores some of the technical, operational, and legal risks that can arise during smart contract deployment, as well as potential disputes that can arise between parties to a smart contract.
Unique Challenges That Arise from Smart Contract Use
Smart contracts use blockchain technology to automate performance, create secure records, and reduce reliance on certain intermediaries. These features can enhance transparency and help limit some types of fraud. At the same time, flaws in the code, data inputs, or overall system design can create significant uncertainty, expose parties to unexpected losses, and make it harder to determine who is responsible when something goes wrong. Blockchain-based systems can create novel challenges when disputes arise, especially if the parties do not fully understand the technology or fail to take steps to reduce risk. The following are some of the unique challenges involved with smart contract use:
Technical Complexity
To fully understand how the code functions and prevent issues, parties may need professionals with technical backgrounds and knowledge of blockchain systems to thoroughly vet the smart contract before and after deployment. Conflict can arise when one party interacts with a smart contract but fails to verify that the code matches the party’s understanding of the agreement.
Decentralized, Cross-Border Transactions
Blockchain enables decentralized systems and allows cross-border transactions with minimal reliance on intermediaries. However, this can create legal complications when smart contracts are executed with unclear governing law or jurisdiction, especially where the parties have not specified these terms in advance.
Permanence & Immutability
One of the key benefits of smart contracts can also create risk. Once actions are executed on a blockchain, they can be difficult to alter or erase. Disputes can arise if a smart contract is deployed incorrectly and there is no practical mechanism to reverse or remediate the transaction.
Accountability Challenges
Blockchain-based transactions are often conducted between unknown or difficult-to-identify participants. There may be limited clarity about which individuals or organizations are accountable in the event of problems. Accountability can become even more complicated when developers, platform operators, wallet providers, data providers, users, or decentralized governance participants each play a role but responsibility among them is not clearly assigned.
Limited Legal Frameworks
Smart contracts are still an emerging technology, with widespread adoption limited to a few key industries. Legal systems are still adapting to the rise of smart contract disputes, and enforcement varies by jurisdiction. Smart contracts may not be automatically enforceable as legal contracts. In practice, they are often best paired with a traditional written agreement that addresses governing law, jurisdiction, dispute resolution, audit obligations, data inputs, and remedies. If parties lack a written agreement, it can complicate conflict resolution.
The Most Common Smart Contract Disputes
To reduce risk and the likelihood of disputes, smart contracts should be properly designed, audited, tested, and monitored before and after deployment. Even with these safeguards, disputes can still arise when a smart contract fails to perform as expected, when the parties disagree about what the code was intended to do, or when the contract is exploited through manipulative, misleading, or unauthorized conduct. Alternative dispute resolution services (such as arbitration) can provide an effective mechanism for resolving conflicts arising from smart contract deployment. Below are some of the most common types of smart contract disputes.
Disputes Over Coding Errors and Bugs
Even seemingly minor coding errors in a smart contract can lead to vulnerabilities or poor execution. One party may claim that coding errors led to the execution of unfavorable terms, to the incorrect transfer of funds or digital assets, to a privacy breach, or to other irreversible negative consequences.
Security Vulnerabilities & Hacks
A security vulnerability in the smart contract code or blockchain infrastructure can lead to serious consequences, including unauthorized access, exposure of personal, confidential, or financial information, or theft of funds or digital assets. Due to the nature of blockchain-based systems, disputes may arise because one party has little or no recourse to directly recover lost funds. As a result, one party to a smart contract may seek monetary damages from the other party to compensate for the consequences of the hack. Disputes may also involve whether a party failed to implement reasonable cybersecurity safeguards, respond promptly to a known vulnerability, or disclose risks before the smart contract was used.
Interpretation Disputes
Disputes may arise over how the smart contract code is executed and whether the software program’s behavior aligns with contractual intent. If the smart contract is paired with a written contract that satisfies the requirements of applicable contract law, one party may challenge a discrepancy between the written contract and the executed code. Even in the absence of a written contract, a dispute-resolution framework can still help determine whether the smart contract’s execution accurately reflected the parties’ agreement and expectations.
Disputes over External Data and Oracle Failures
Smart contracts often rely on external data sources (i.e., oracles) to execute agreements. Although the oracle itself may be external to the blockchain, an oracle failure or inaccuracy can cause major problems, such as improper execution of a smart contract, resulting in an irreversible loss of funds. For example, incorrect pricing data or delayed shipment information could trigger a payment that one party believes should not have occurred.
Fraud and Exploitation
Although blockchain-based systems are often used to reduce fraud, a bad actor can use a smart contract to engage in fraudulent, manipulative, or misleading conduct. A bad actor might manipulate transaction timing, exploit a code loophole, withdraw funds in an unexpected or unauthorized way, or mislead users about what they are approving. If one party fails to audit, test, and verify the smart contract code properly, there’s an increased risk of malicious or opportunistic behavior.
Off-Chain Performance Disputes
Many smart contract deployments in automated B2B workflows are connected to real-world processes, such as shipments and deliveries. Even if a smart contract executes perfectly, disputes may arise if one party fails to uphold their obligation. For instance, if a digital agreement is executed automatically but the physical goods involved in the transaction arrive defective, one party may decide to seek a remedy.
How to Resolve Smart Contract Disputes
Because smart contract disputes involve legal intent and technical execution, the choice of forum for dispute resolution can significantly affect how the dispute is understood and resolved. Recognition of smart contracts still depends heavily on the jurisdiction, and courts and regulators are still developing approaches to code-based agreements. Pursuing traditional litigation to resolve a smart contract dispute may require parties to address highly technical issues before a court that may not have specialized, or any, experience with blockchain systems, digital assets, or code-based execution. For these reasons, parties may benefit from a forum that allows technical issues, commercial context, and legal intent to be considered together.
While legal frameworks to address smart contract disputes are still taking shape, alternative dispute resolution (ADR), including arbitration and mediation, can be well-suited for technically complex conflicts. Unlike litigation, ADR gives parties meaningful input into selecting a neutral arbitrator or mediator with relevant industry knowledge and experience in handling technically complex matters. ADR can provide parties with a fair, structured, and methodical process for resolving their dispute. Mediation can provide a less adversarial path to resolution, while arbitration can offer a structured, private, and expert-driven alternative to litigation. Both processes may help preserve business relationships, depending on the nature of the dispute.
The American Arbitration Association® (AAA®) provides a flexible, specialized forum for resolving disputes involving smart contracts, blockchain technology, digital assets, and complex commercial systems. Our expert arbitrators and mediators include attorneys, retired judges, and industry professionals with experience addressing conflicts arising from decentralized systems and digital assets. Explore our Smart Contract dispute services and learn more about how our ADR framework can help parties navigate complex tech disputes efficiently, fairly, and with confidence.