Smart contracts – how important are they to the future of legal practice? Part 1

What is a smart Contract? What makes a smart contract different from any other electronic contract?

In 1996 Nick Szabo defined smart contacts as “a set of promises, specified in digital form, including protocols within which the parties perform on these promises”.[1] This definition came about long before blockchain technology, which originated with a white paper created by an individual or collective under the pseudonym of Satoshi Nakamoto in 2008.[2] Hence, Szabo’s definition is not specifically a definition of a smart contract operating on the blockchain.[3]

Szabo used vending machines as an example of a “primitive ancestor of smart contracts”.[4] Using a vending machine depends on a human party actually tossing some coins in and making a selection.[5] In a smart contract however, the performance of the contract on both sides of the transaction is totally automated without any human intervention (apart from initially writing the code that is).[6] Perhaps a preferable definition is that “smart contracts are self-executing electronic instructions drafted in computer code”.[7]

These contracts being written in code and designed to execute automatically have a variety of characteristics that are a different to traditional contracts.

  • Completely electronic.[8] Smart contracts must be completely electronic to be self-enforcing otherwise they would depend on someone clicking a button or delivering some tangible property, undermining the entire point of the technology. This means that smart contracts are limited to contracts that “relate to digital assets (such as cryptocurrency), or to digital manifestations of offline assets, title to which is registered in Blockchain.”[9]
  • Conditional.[10] Although every contract stipulates conditions to be fulfilled in one way or another, because smart contracts are written in code there is no room for ambiguity or subjectivity. All aspects of the contract are written as conditional statements, essentially, if this then that.[11]
  • Predicted outcomes.[12] The combination of self-enforcing contracts and the conditional nature of the contracts mean that outcomes are guaranteed and can be predicted upon the occurrence of certain events.
  • Irrevocability.[13] Once the contract is on the blockchain it cannot be altered or stopped.[14]

How it actually works

A contract written in code and uploaded on the blockchain,[15] when the conditions of the contract are met, then the program automatically triggers the actions stipulated in the code. The contract itself is comprised of “the program code, a storage file and an account balance”.[16] The account balance can send and receive money in the form of cryptocurrency that exists on the blockchain, [17] such Ether on the Ethereum blockchain platform. Funds are distributed in accordance with the contract.

An example of a contract is one that is programmed to purchase stock of a company if that company reports a certain level of financial performance, say profits in excess of 200 million, if this occurs, the contract will be executed to buy the stock automatically with money being transferred to purchase a stock. The information regarding company performance should come from a reliable agreed upon third-party source that is coded into the contract. “Third-party information services provider[s]”[18] are known as “oracles” and provide a digital signature that is kept on the ledger.[19]

1*LiTJq8p1gTlvbzzbNj2MIg.pngA detailed diagram from Blockgeeks

Want to know more about smart contracts generally? Have a listen to The Ledger podcast on smart contracts. 

Taking people out of contracts

In a smart contract on a blockchain, at least theoretically, performance is guaranteed. Therefore lawyers will have less of a role in creating of contracts, as there will be less of an incentive to have a traditional contract that is enforceable in a court of law. This sentiment has been echoed by some in the industry who see smart contracts as a potential disruption to the workforce.[20]

This raises questions as to what role lawyers will play and to what extent smart contracts are pushing up against the traditional role of global legal practices in handling commercial transactions. It is these questions that I will address in this and my next post.

Firms working on mergers and acquisitions are likely to face pressures from this technology.[21] Allen’s has stated that their business model is being threatened because it relies upon exploiting a lack of trust[22] and that the work they do, “we design governance structures, we draft and negotiate contracts, and … we litigate”[23] only exists to provide security to contracting parties.[24]

Exploring opportunities of smart contracts

One possibility for law firms is to integrate smart contracts into their existing practice and offer it as a solution to clients. Lawyers could potentially engage in a consultancy role, brainstorming with clients to create smart contract solutions for their organisations.

The diagram below by the Actus Team poses questions that can help businesses when making a decision to use smart contracts. These questions could be used a starting point for conversation between firms and clients.

 

1*yw-bjHQSKbAzUt1pv61gfg

Source: https://blog.auctus.org/smart-contracts-ideal-uses-cases-930a9ca6a02f

It has also been argued, “Lawyers are still useful, if not required (particularly in the case of complex transactions), to draft the content which is ultimately translated into computer code.”[25]

Lawyers and law firms could serve as facilitators and interpreters of smart contracts, helping organisations to navigate this technology. There is evidence that this is already occurring specifically in the financial services area where smart contracts are being enthusiastically adopted.[26] However, it should be acknowledged that law firms have to compete with global consultancy firms and large accounting firms that want to provide similar services.[27] In my opinion it would be advantageous for lawyers to become more familiar with the technical side of smart contracts and it has been suggested that lawyers “may need to gain a basic proficiency in coding”.[28] The prospect of which was balked at by most of my fellow students in The Global Lawyer, many of whom had not heard of blockchain or smart contracts. This response indicates the need for a culture shift within the legal sector, emphasising a broader and multidisciplinary view of the profession as opposed to simply being an expert in ‘the law’. If the tasks that were previously profitable become obsolete, it will be up to lawyers and law firms to monetise this new technology before they themselves become an anachronism.

This blog post so far has provided an optimistic outlook on the adoption and relevancy of smart contracts. There are in fact many limitations hampering the success of the technology.

 Will smart contracts become the norm?

 Yes and no. It is unlikely that smart contracts will wholesale replace traditional contracts because in a lot of ways they offer something very specific that is not compatible with all the different ways that contracts are used by legal practices.

As discussed above smart contracts are considered to be self-enforcing but most transactions cannot occur solely within the blockchain. As soon as a transaction exits the realm of the blockchain, for example contracts for goods and services, there has to be additional layers of technology and processes to make sure these things actually happen in the ‘real world’.[29] The question for lawyers is then, is it actually helpful or feasible for this contract to be part of a chain of transactions within a blockchain?

The answer really depends on what the aims of the contract are. Smart contracts have potential to bring supply chain transparency; for example, in the diamond industry where smart contracts could allow companies to track a diamond’s chain of ownership from its initial discovery.[30] However, where the contracts specify outcomes that require subjective human judgement to determine whether they have been fulfilled, then the blockchain may not be an appropriate solution. This could be a judgement of quality or effort that cannot easily be determined by an “oracle”, [31] such as a best efforts clause in distributorship agreement. It is the “rigid, inflexible and absolute”[32] language of smart contracts that is a key critique of blockchain as a panacea for all business and regulatory issues.

The technology and financial services sectors will likely see widespread adoption of smart contracts as the objects of the contract exist in digital form and the contracts can be executed solely on the blockchain.[33]

Security Concerns

 Security concerns have often been raised as another disadvantage of the system. This is particularly an issue in public blockchains with headlines often discussing thefts of Ether or Bitcoin[34] as there is a possibility of ‘51% attacks’ where a majority of miners can exploit the consensus process to validate transactions that should not be going through.[35] This will be less of an issue for global legal practices, as business will likely look to adopt permissioned ledgers as opposed to public ledges.[36] Permissioned ledgers being ledgers “where its participants are preselected or subject to gated entry on satisfaction of certain requirements”[37] making those kinds of attacks less likely.[38] Permissioned ledgers do not usually use miners to validate transactions[39] and any thefts will be traceable. They also go against the decentralised nature of blockchain but that’s a whole other blog post, one that I am not quite ready to write![40] However, permissioned ledgers by no means guarantee security and like any technology that purports to offer security to information or assets, it is subject to attack.[41]

Legal practices may need to evaluate potential security risks and partner with technology firms in order to ensure that information and currency is as secure as possible.

I hope this post has given you an introduction to the value and problems of blockchain adoption in legal practices. As well as a sense of how they are relevant to future legal practices. My last post will raise issues around the legality of smart contracts, a topic that lawyers will no doubt be advising clients on more in the near future.

 

This post was amended on 25 January 2017.

[1] Nick Szabo, Smart Contracts: Building Blocks for Digital Markets (1996), [5] <http://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/CDROM/Literature/LOTwinterschool2006/szabo.best.vwh.net/smart_contracts_2.html>.

[2] Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System (October 2008), <https://bitcoin.org/bitcoin.pdf&gt;.

[3] Alexander Savelyev (2017) ‘Contract Law 2.0: ‘Smart’ Contracts as the Beginning of the End of Classic Contract Law’ 26(2) Information & Communications Technology Law 116.

[4] Szabo, above n 1, [6].

[5] Savelyev, above n 3.

[6] Ibid.

[7] Reggie O’Shields, ‘Smart Contracts: Legal Agreements for the Blockchain’ (2017) 21 North Carolina Banking Institute Journal 177, 179.

[8] Savelyev, above n 3.

[9] Ibid 124.

[10] Ibid.

[11] Ibid.

[12] Ibid.

[13] Norton Rose Fulbright, ‘Can Smart Contracts be Legally Binding?’ (Working Paper, November 21 2016) <http://www.nortonrosefulbright.com/files/r3-and-norton-rose-fulbright-white-paper-full-report-144581.pdf>.

[14] Norton Rose Fulbright, Unlocking the Blockchain: A Global Legal and Regulatory Guide (July 2016) <http://www.nortonrosefulbright.com/files/unlocking-the-blockchain-chapter-1-141574.pdf>.

[15] Jenny Cieplak and Simon Leefatt, ‘Smart Contracts: A Smart Way to Automate Performance’ (2017) 1(2) The Georgetown Law Technology Review 417.

[16] Ibid 424.

[17] Ibid.

[18] Ibid 423.

[19] Ibid.

[20] James Eyers, ‘Blockchain “Smart Contracts” To Disrupt Lawyers’ (Financial Review, 30 May 2016) <http://www.afr.com/technology/blockchain-smart-contracts-to-disrupt-lawyers-20160529-gp6f5e>.

[21] James Eyers and Misa Han, ‘Lawyers Prepare for “Driverless M&A” as Smart Contract Era Dawns’ (Financial Review, 19 June 2016) <http://www.afr.com/technology/lawyers-prepare-for-driverless-ma-as-ssmart-contract-era-dawns-20160616-gpknyz&gt;.

[22] Ibid.

[23] Ibid [6].

[24] Ibid.

[25] Mark Giancaspro ‘Is a ‘Smart Contract’ Really a Smart Idea? Insights from a Legal Perspective’ (2017) 33 Computer Law & Security Review 825.

[26] Eyers and Han, above n 21.

[27] See for example, https://www2.deloitte.com/au/en/pages/financial-services/solutions/blockchain.html and https://www.mckinsey.com/industries/high-tech/our-insights/getting-serious-about-blockchain

[28] Brydon Wang, ‘Blockchain and the Law’ (2016) 19(1) Internet Law Bulletin 246, 250.

[29] Norton Rose Fulbright, Smart Contracts: Coding the Fine Print (March, 2016) < http://www.nortonrosefulbright.com/files/smart-contracts-coding-the-fine-print-excerpt-137900.pdf>; Peter Brogden, ‘Smart Contracts and Web 3.0: The Evolution of Law?’ (2017) 31(June/July) Computers and Law 15. Available for viewing at https://www.linkedin.com/pulse/smart-contracts-web-30-evolution-law-peter-brogden

[30] Barbara Lewis, De Beers Turns to Blockchain to Guarantee Diamond Purity (Jan 16 2018) Reuters <https://www.reuters.com/article/us-anglo-debeers-blockchain/de-beers-turns-to-blockchain-to-guarantee-diamond-purity-idUSKBN1F51HV>.

[31] Norton Rose Fulbright, Smart Contracts: Coding the Fine Print, above n 29, 12.

[32] Brogden, above n 29, 18.

[33] See for example, https://www.finextra.com/blogposting/13656/blockchain-and-derivatives-reimagining-the-industry

[34] See https://www.gizmodo.com.au/2017/07/37-million-in-ether-stolen-as-people-refuse-to-learn-their-lesson-about-cryptocurrencies/.

[35] Norton Rose Fulbright, Unlocking the Blockchain: A Global Legal and Regulatory Guide, above n 14.

[36] Ibid.

[37] Ibid 20.

[38] Ibid.

[39] Deva Annamalai, Blockchain – What is Permissioned vs Permissionless? (10 January 2017) Core Dump <https://bornonjuly4.me/2017/01/10/blockchain-what-is-permissioned-vs-permissionless/>.

[40] See https://www.reddit.com/r/Bitcoin/comments/3ew27l/permissioned_ledgers_and_closed_centralized/

[41] Norton Rose Fulbright, Unlocking the Blockchain: A Global Legal and Regulatory Guide, above n 14.

 

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