Julian Clark Global Senior Partner
Shipping gets smart
On 25 November 2021, the UK Law Commission published its Advice to the UK Government on how English law currently applies to smart legal contracts. Subsequently, on 16 March 2022, the Law Commission published its report on electronic trade documents, together with draft legislation that would implement its recommendations to allow for the legal recognition of trade documents such as bills of lading and bills of exchange in electronic form.
The Law Commission undertook these projects at the request of the UK Government, which sought recommendations on potential reform of English law to allow for emerging technology. The Law Commission also intends to publish consultation papers on digital assets and cryptocurrency, as well as conflict of laws and emerging technology, during the course of 2022.
These projects reflect the increasing awareness at international, governmental, legal and industry levels that technological advances require consideration of whether the law needs to be reformed and how industry working practices might be adapted to accommodate emerging technology.
This paper considers the potential for using smart legal contracts in shipping and highlights some of the benefits and the challenges.
Distributed ledger technology (DLT) allows a database of information, records and transactions to be shared and managed simultaneously by an entire network of participants across multiple locations. All participants within a network can have their own identical copy of the ledger. Any changes to the ledger are reflected in all copies. The security and accuracy of the assets stored in the ledger are maintained cryptographically through the use of ‘keys’ and signatures to control who can do what within the shared ledger. Entries can also be updated by one, some or all of the participants, according to rules agreed by the network. The ledger, therefore, provides an accurate record of all the information contained on the blockchain, and of the history and validity of all the transactions.
Blockchain is a form of DLT. Data is stored in “blocks” that contain data relating to a transaction. These blocks are then “chained” together to form a record of the information, hence the name "blockchain”.
While traditional databases are centralised in one place and administered by a single person or body, a blockchain database decentralises all the data in the database so that there is no single master copy of the database, no single authority who authorises changes to it and consequently no possibility of anyone altering the data without the consent of all the participants.
In some instances, information may be required from sources that are not on the blockchain. These sources are referred to as “oracles”. Oracles usually push information onto the blockchain at predetermined times. In shipping, oracles can for example provide weather data or information on location of shipment.
As well as being a database that records transactions, blockchain can also process transactions, by acting as a platform on which code can be executed: so-called smart contracts.
What is a smart legal contract?
A smart legal contract is a legally binding contract in which some or all of the contractual obligations are defined in and/or performed automatically by a computer program. Automating a contractual obligation enables contractual performance to occur without the need for human intervention.
Smart contracts usually follow a conditional logic with specific and objective inputs i.e. if X occurs, then Y results. In other words, a trigger event causes the smart contract to execute automatically without the need for intermediary involvement.To use an example given by the Law Commission by way of illustration:
“Alice (as seller of the goods) is bound to load the goods onto a ship nominated by Bob (as buyer of the goods). It is a term of the contract that Bob must nominate the ship suitable for loading by a certain date. Once Alice receives notification of the relevant ship for loading, Alice will load the goods onto the ship. Upon submission of proof that the goods have been loaded, the smart legal contract will automatically transfer the purchase price to Alice.”
As a further example, parties to a smart sales contract can set it up so that when the seller’s bank confirms receipt of payment by logging it on the blockchain, the system will automatically send a notification to the seller’s distribution arm to ship the goods to the buyer.
There are three main types of smart legal contract, as identified by the Law Commission:
- Natural language contract in which some or all of the contractual obligations are performed automatically by computer code. The code does not define the parties’ obligations but is merely a tool that the parties use to perform the obligations. This is currently the most commonly used form of smart legal contract.
- Hybrid contract in which some contractual obligations are defined in natural language and others are defined by computer code. Some or all of the contractual obligations are performed automatically by computer code. Natural language terms can be incorporated in an accompanying natural language agreement, or in natural language comments included in the computer code.
- Contract recorded solely in code, in which all the contractual obligations are defined in, and performed automatically by, computer code. There is no natural language version of the agreement.
Law Commission’s Advice on smart contracts
In summary, the Law Commission concluded that English law, as it currently stands, can accommodate the use of smart legal contracts without the need for statutory law reform. Current legal principles can apply to smart legal contracts just as they do to traditional contracts, with a few exceptions (e.g. deeds). English common law is sufficiently flexible that it can be developed by the English courts in order to accommodate any novel legal and factual scenarios that arise in relation to smart legal contracts.
In the Law Commission’s view, any potential uncertainties and novel issues arising in relation to specific contracts could be addressed by the parties including express terms dealing with them. The Law Commission also stated that contracts recorded solely in code were those most likely to prove challenging from a contract law perspective, in terms of determining whether and when a binding legal agreement is formed and how that contract can be interpreted. However, it also commented that solely code smart legal contracts are likely to be rare in practice because commercial contracts are usually too nuanced to be reduced solely to code. On the other hand, the most common form smart contract – natural language contract with automatic performance by code – does not raise any novel legal issues in terms of contract formation and interpretation.
The Law Commission also expressed the view that the statutory definition of “writing” was wide enough to accommodate emerging technologies so that an “in writing” requirement could in principle be satisfied. A digital signature is also capable of satisfying a statutory requirement for a signature in most cases.
The Law Commission recognised that complicated cross-border jurisdictional issues can arise in view of the multipartite/multi-jurisdictional nature of most smart legal contracts and recommends that parties entering into a smart legal contract expressly include a governing law and jurisdiction provision in the contract. It also acknowledged, however, that the application of existing private international law rules to smart legal contracts is complex and it will, therefore, consider conflict of laws and emerging technologies in a separate project.
Law Commission’s Report on electronic trade documents
In its report, the Law Commission noted that international trade is worth around £1.266 trillion to the UK. Global container shipping is estimated to generate billions of paper documents a year and digitalising trade documents could generate £25 billion in economic growth by 2024 and free up £224 billion in efficiency savings. However, outdated processes and market practices mean that nearly all documentation in international trade transactions is in paper form even though the development of technologies such as DLT make electronic trade increasingly feasible.
In part, the industry remains traditionally committed to paper documentation because English law does not currently permit an electronic document to be possessed, with the result that it does not have the same legal status as a paper document. Paper trade documents that are capable of possession can bring with them legal rights in relation to bailment, possessory security interests and wrongful interference with goods (conversion). The lawful holder (possessor) of a paper bill of lading is entitled to claim delivery of the cargo and has title to sue the carrier for loss of or damage to the goods.
The report, therefore, makes recommendations that are intended to enable trade documents in electronic form to be used in the same way as their paper counterparts. The Law Commission has also produced draft legislation setting out certain gateway criteria that a document in electronic form must satisfy in order to qualify as an electronic trade document that is capable of being possessed for these purposes. The Law Commission intends that electronic trade documents that satisfy the stated criteria and can be possessed should be treated in law in the same way as paper trade documents. This means that the law that currently applies to paper documents would also apply to electronic trade documents and there would be no need for two separate legal regimes with equivalent effects.
The Law Commission focused its report on a limited category of trade documents, although the scope of its recommendations was not limited to them. These documents are: bills of exchange; promissory notes; bills of lading; ship’s delivery orders; warehouse receipts; mate’s receipts; marine insurance policies; and cargo insurance certificates.
The report also acknowledges that even if English law is reformed to allow for the legal recognition of electronic trade documents, other jurisdictions might take a different view. Given the cross-border nature of international trade transactions, the Law Commission recommends allowing for change of medium from electronic to paper documentation or vice versa.
Following on from this report, the UK Government announced that a draft bill to legally recognise electronic trade documents was part of its legislative agenda for 2022/2023.
Some ongoing initiatives
There are currently a number of software platforms being used for international trade (include trade finance) transactions that allow multiple parties to securely exchange documents and conclude agreements with each other. In essence, the parties enter into a contract with each other whereby they agree that transferring a trade document in electronic form will put the transferee in a similar position to that of the holder of the equivalent paper trade document.
In broad terms, there are two types of system, DLT-based and non-DLT based. As indicated above, DLT-based electronic documents can be transferred between participants without the need for a central authority, with transfers recorded on a secure ledger which is for all practical purposes permanent. The data recorded on the ledger is said to be “immutable”. TradeLens is an example of a blockchain (i.e. DLT) system providing a digital shipping platform to which some of the world’s largest carriers have signed up.
Other, non-DLT, systems have a central registry and are administered centrally. Users sign up for accounts which are accessed with a password or other security credentials. Documents with unique identifiers are allocated to a particular user account upon issue or transfer, and the relevant user can hold or transfer the document. BoxTech’s Global Container Database, for example, allows container owners/operators to register their entire container fleets in a central data repository, making key container technical details instantly available to trading partners and other users in the supply chain. MSC, CMA CGM and Maersk are all said to be members of BoxTech.
Since 2011, the International Group of P & I Clubs has approved a total of seven electronic bill of lading systems, although uptake by members reportedly remains limited. Further, and as recognised by the Law Commission, the contractual frameworks provided by these private systems will only bind participants and not third parties (whereas e.g. the rights of a paper bill of lading holder will be effective against non-parties). The enforceability of these contractual frameworks also remains untested in the English courts.
In 2017, the United Nations Commission on International Trade Law (UNCITRAL) adopted a Model Law on Electronic Transfer Records (MLETR), aimed at enabling the legal use of electronic transferable records both domestically and across borders. MLETR was designed to either be adopted as is or to be used as a basis for domestic legislatures to enact their own equivalent laws. However, only a handful of jurisdictions have so far done so, among them Bahrain and Singapore.
The key advantages of smart legal contracts have been much discussed. In essence, these have been articulated as costs and efficiency savings, environmental benefits as well as enhanced security.
However, there are also concerns that training on and implementation of the relevant technology will incur significant costs, at least during the transitional phase. There are additionally heightened cyber security concerns associated with the digitalisation of contracts. Parties will, therefore, need to think carefully about risk allocation for cyber hacks, as well as system (or oracle) failures if and when they enter into smart contracts.
Governing law and jurisdiction issues are also key. The use of global and decentralised platforms for implementing smart legal contracts means that there are likely to be divergent views and potential uncertainty as to applicable law and jurisdiction in relation to a digital transaction, unless the parties have expressly provided for this in the agreement. As already highlighted also, different jurisdictions may recognise smart contract to varying extents. It is, therefore, to be hoped that the Law Commission’s planned review of conflict of laws and emerging technology will shed useful light on potential solutions to anticipated problems.
Smart contracts are most suited to straightforward contractual transactions such as ensuring payment upon the occurrence of certain triggering events or imposing financial penalties if certain objective contractual conditions are not satisfied. These are actions that do not require human input and are, therefore, easy to automate. Blockchain is best suited to rights and obligations that are binary in nature. Where things start to get more complicated, or where a contract is ambiguous or requires flexibility, then automated processes are not ideal.
Smart contracts are not as flexible as traditional contracts because they do not allow in the same way for non-quantifiable clauses and conditions or for unforeseen events. Bespoke clauses will, therefore, be more complicated to incorporate or implement effectively and must, in any event, be agreed upon from the outset because of the very restricted scope for interfering with the blockchain. Any subsequent changes to a contract e.g. to allow for force majeure events or new sanctions regulations, may need a new contract to be executed, amending or replacing the previous one.
This inability to easily modify or indeed to terminate a contract by consent is a downside of using blockchain technology to execute smart contracts. Amending a smart contract may prove complex and involve much higher transaction costs than a traditional text contract. There may also be an increased margin of error, meaning that any amendments do not accurately reflect the modifications that the parties intended to implement.
The self-executing nature of smart contracts also means that the parties may not be able to resolve any issues that arise in a commercial way and through negotiations. By way of illustration, the parties to a sale of goods contract may have incorporated a late payment provision in their contract. In a traditional form contract, where one party is in breach of an obligation, the counterparty may choose not to enforce the relevant penalty for various commercial considerations. So if payment is made late in respect of one delivery, the seller can decide to excuse the breach by not terminating or omitting to charge a late payment fee or additional interest. A smart contract will not necessarily allow an ad hoc decision of this type and late payment might automatically trigger a financial penalty or suspension of a customer’s account. Similarly with late or part performance, there may be no flexibility within the smart contract to allow for the parties’ broader commercial dealings.
In a charterparty context, the parties might have expressly incorporated a standard form or individual bespoke clause from the outset dealing e.g. with late or non-payment of hire (such as the BIMCO Non-Payment of Hire Clause for Time Charterparties 2006). However, the owners might wish to renegotiate the consequences if they wish to preserve a potentially valuable relationship with the charterers but this may not be so straightforward with a smart contract. Automated processes might not, therefore, reflect the way in which commercial relationships operate in the business world.
Under English law, so long as the parties have agreed the essential terms of a contract and intend to be legally bound by their agreement, they can leave ancillary terms to be decided later on. Smart contracts limit the scope for leaving certain issues to be resolved at a later stage in order to allow the parties flexibility to tailor their contractual arrangements according to future developments or to allow for unanticipated events. They may also not allow for contractual provisions that require a value human judgment to decide whether certain conditions have been fulfilled (e.g. material adverse change, best endeavours, reasonable endeavours, force majeure etc.) or where a non-binary choice is required.
On the other hand, smart contracts can reduce the risk of non-compliance. A party that threatens not to perform its contractual obligations (non-delivery, non-payment etc.) in an attempt to pressure the counterparty to renegotiate more favourable terms may find itself prevented from doing so because contractual obligations execute automatically. There is also a lot to be said for contracts that do not allow for ambiguous provisions that often lead to disputes as to their interpretation and effect and result in costly litigation. It may indeed prove a useful discipline for contracting parties to give proper thought at the outset to their express contractual rights and obligations, rather than leaving important matters undecided.
The role of the courts
The English courts are expected to play a key role in resolving disputes related to smart legal contracts. English law and jurisdiction are the preferred choice in international commercial contracts, including shipping contracts, and express English law and jurisdiction clauses are likely to be incorporated into many smart contracts.
The Law Commission is confident that the English courts, applying English common law principles and referring to past English cases, will be able to resolve any legal issues that arise out of or in relation to smart contracts similarly to the way in which they have traditionally done with paper contracts.
Certainly, natural language contracts with automatic performance by code are not expected to raise any unusual problems. However, in relation to hybrid or solely code contracts, novel issues may arise in relation e.g. to determining an intention to create legal relations or interpreting the terms of the smart contract. The Law Commission envisages scenarios where the Court may have to assess the nature and the purpose of the platform on which the code is deployed and the nature of the transactions executed by the code.
The Court will also need to consider how to apply the usual principles of contractual construction to coded terms. The English courts take an objective approach to contractual interpretation i.e. they do not ask what the parties themselves meant by the language they used, but what the language would have meant to a reasonable person, equipped with all the background knowledge available to the parties at the time the contract was made.
The Law Commission proposes the “reasonable coder” test i.e. what a person with knowledge and understanding of code would understand the coded term to mean. An expert coder would explain the effect of certain combinations of words and give a reasoned opinion as to what the code appeared to instruct the computer to do. This would provide the Court with an insight as to what the parties intended the code to do, regardless of the computer’s ultimate performance.
Parties would nonetheless be well advised to set out a natural language explanation of how they intend the code to operate and to expressly provide that the natural language explanation forms part of the contract.
There may also be practical difficulties in e.g. rectifying coded terms where these are recorded on an immutable DLT system. One potential solution is for a revised code to be deployed on the blockchain. Where the code has already executed, it may be too late for rectification. The Court may then need to award a different remedy e.g. damages. In situations where rescission would have been the appropriate remedy, a second transaction may have to be entered on the blockchain, reversing the first.
In relation to electronic trade documents specifically, the courts will need to consider how to adapt certain legal concepts applicable to paper trade documents to the digital form. The Law Commission’s draft legislation is silent on issues such as what constitutes possession, timing of transfer of possession, delivery, rejection and acceptance etc. Instead, it was considered appropriate to leave it to the courts to fit existing common law principles around digital subject matter.
Taking a non-interventionist approach, the Law Commission has not recommended any particular technology or computer system. Therefore, it will be for the courts to decide whether a system used by the parties is sufficiently reliable to satisfy the criteria for a legally valid electronic trade document. The English courts have previously considered what constitutes a reliable computer system (for example, in the Post Office Horizon litigation) and so there is precedent for such an exercise.
Some jurisdictional issues
The Law Commission highlighted some jurisdictional issues that could arise in the context of smart legal contracts in the absence of an express choice of English jurisdiction by the parties.
Firstly, the physical location of a defendant may not always be clear because a party may enter into a smart legal contract on a DLT system without knowing the identity of the counterparty. This makes it difficult to found English court jurisdiction based on the defendant’s presence within the jurisdiction.
Secondly, the contract’s place of formation may be relevant to determining jurisdiction. Different elements of a smart legal contract may be dispersed across a variety of jurisdictions and a number of legal systems may potentially be engaged, making it difficult to decide where the contract was concluded.
Thirdly, could third party coders be regarded as agents of one or both contracting parties for the purposes of concluding a contract on their behalf? The Law Commission thinks that this could be the case, depending on the exact nature of the relationship.
Fourthly, if the smart contract provides expressly for applicable law, this could be a factor in determining the appropriate court jurisdiction. In the absence of a choice of law clause, the Court will need to determine with which legal system the contract is most significantly connected. This is a fact-sensitive inquiry and novel considerations arising in the context of smart legal contracts could involve the location of any private key or the domicile of the central administrator if the relevant ledger is permissioned.
Fifthly, smart legal contracts may present unique challenges when seeking to found jurisdiction based on the place where the contract was breached. Identifying the geographical location of a contractual breach may also be harder where the contractual obligations concern a digital asset rather than a physical asset with a clear real world location.
The Law Commission acknowledged that the issue of digital location was amongst the most significant jurisdictional challenges in relation to emerging technology and indicated that it would carefully consider this problem as part of the conflict of laws and emerging technology consultation.
For the shipping and trade communities specifically, the next key development will be the enactment of UK legislation recognising the legal validity of electronic trade documents. It is anticipated that this will happen within the next legislative year and, if it does, it could likely lead the way for other jurisdictions to follow suit.
Additionally, the Law Commission’s forthcoming consultation on conflict of laws and emerging technology will be of great interest to the wider legal and commercial sectors. Jurisdictional issues can prove a real obstacle to the favourable resolution of disputes. Post-Brexit, the UK can no longer rely on the EU jurisdictional regime under the recast Brussels Regulation or the Lugano Convention, which operates on the basis of mutual reciprocity between EU states. There are now also a wider range of circumstances in which leave to serve proceedings out of the jurisdiction will be required. Nonetheless, the English courts are well used to dealing with tricky jurisdictional disputes and parties can minimise jurisdictional disputes by including express law and jurisdiction clauses in their smart contracts.
Blockchain is not a passing trend in the global maritime industry. Key players in the global shipping industry have for some years been cooperating with each other, and with advanced technology providers, to find digital solutions appropriate for their shipping transactions.
One such initiative is TradeLens, mentioned above, the blockchain-enabled digital shipping platform jointly developed by Maersk and IBM that went live in 2018. Among others MSC, CMA CGM, Hapag-Lloyd and ONE have joined TradeLens, which enables participants to digitally connect, share information and collaborate across the shipping supply chain ecosystem. TradeLenseBL provides a secure and streamlined process for the issue, transfer and surrender of original bills of lading. A number of banks and other financial institutions have also joined TradeLens for the opportunities it offers them in digitalising trade finance transactions.
The Global Shipping Business Network (GSBN), incorporated in Hong Kong in 2019, is another blockchain shipping network that aims to digitalise trade. Founding shareholders include Hapag-Lloyd, COSCO Shipping Lines and OOCL. GSBN initiatives have so far included a blockchain cargo release solution involving an electronic bill of lading, as well as collaboration with a Hong Kong trade finance network, eTradeConnect.
Also worth mentioning is the Blockfreight blockchain platform aimed at the freight and logistics sectors, the key features of which include smart contracts and a tradeable token to pay for transactions fees that is secured by the bitcoin blockchain.
These are just some of the many industry initiatives currently underway that are creating an increasingly digitalised shipping sector. Clearly, the future of shipping is smart and digital.
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