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Smart Contracts Are Coming: Are We Ready?

By February 13, 2017 No Comments

Originally published in the February 2017 issue of the King County Bar Association Bar Bulletin.  Reprinted with permission of the King County Bar Association.

Imagine this: A buyer buys, obtains title for, and takes possession of a used vehicle without ever meeting the seller or dealer or even leaving his home. He finds a car he would like to purchase and makes an offer for the car by sending the seller a contract — or rather, a smart contract. The seller accepts the smart contract, and at the moment of acceptance, the following actions occur automatically:

(1) Information regarding the car such as ownership, liens, VIN, mileage, maintenance history, and other pertinent information is instantly verified to ensure that the vehicle is exactly as advertised.

(2) Once all of the car’s information is properly verified, the buyer’s payment is withdrawn from his account and deposited into the seller’s account, while simultaneously, the vehicle’s title and registration are updated with the buyer’s name as the owner, and the car’s computer system replaces the seller’s credentials with the buyer’s credentials allowing only the buyer to unlock and operate the car.

(3) The vehicle then drives itself to the buyer’s driveway.

Although the scenario above1 may seem futuristic and perhaps even like science fiction, such an automatic transaction will soon be possible with a full-fledged Internet of Things (IoT)2 by using a smart contract on a mature and secure blockchain.3 The benefits of a smart contract, like that of any new technology — increasing efficiency and predictability while decreasing costs and time — will alter legal practice.

This article provides a basic introduction to IoT, blockchain and smart contracts, not in their current state, but as they could be with further development, and discusses the potential effects of smart contracts on legal practice.

Basic Introduction to IoT, Blockchain and Smart Contracts

Smart contracts are not the types of contracts that form-filling/clause-selection software generates. Such generated contracts, like any other traditional contract, are written in natural language. A smart contract, on the other hand, uses computer programming languages to express the agreement between parties.

Because a smart contract is simply a piece of computer code, it can be programmed to do more than just document each party’s agreements, which is the intended, and only, feature of a traditional written contract. For instance, a smart contract can be programmed to verify a party’s representations (such as verifying the ownership of the car) and enforce a party’s obligations (such as withdrawing funds and transferring title). Thus, a smart contract — “the use of computer code to articulate, verify, and enforce an agreement between parties”4 — may be used to substitute for or supplement a traditional contract.

The idea of a smart contract, developed two decades ago,5 remained a theory until recently. There were two major technical hurdles to overcome.6 First, a smart contract needs to have access to and control of each party’s assets and information about the assets in order to verify the assets and enforce the transaction. In the car purchase example above, the smart contract must be able to verify information about the car, transfer the payment from the buyer to the seller, and update the car title.

Second, a smart contract needs a computer that is secure and trusted by all parties involved to run its code and enforce the terms of the contract without the need for human involvement or the ability for human interference. Both of these hurdles are being overcome with IoT and blockchain technology.

The IoT addresses the first hurdle by bringing every object online, thereby making them accessible and controllable by a piece of computer code, such as a smart contract. New iterations of common objects — from door locks to household appliances — are embedded with sensors, electronics and software that allow these items to collect information and communicate with other items connected to the Internet.

In a full-fledged IoT world, a car’s tire pressure, maintenance history, accident history and all other information could be automatically collected by the car and stored online. Likewise, databases containing information regarding title and registration can be uploaded online. The place where these databases reside online could be a blockchain,7 as further discussed below.

Once databases of relevant information and assets are either stored online or connected to the Internet, a smart contract can be programmed to access the available information and assets to verify the conditions necessary to initiate a transfer of assets, and, once these are verified, automatically transfer assets and information between parties to an agreement.

The blockchain technology8 addresses the second hurdle by providing a trusted computer — or rather a network of computers that can be trusted collectively — to execute the smart contract. A blockchain is a cryptographically secure digital ledger9 of transactions that are shared in a pseudo-
anonymous, peer-to-peer computer network in a decentralized manner.

A ledger is essentially a database (a spreadsheet) that can store any information including names, account numbers and account balances. Currently, when a buyer pays a seller using a check or credit card, the parties rely on centralized, trusted third entities (such as a bank, via an employee) to facilitate the transfer of funds and record that transfer on the respective account ledger.

On a blockchain, the buyer would transfer assets directly to the seller,10 and the blockchain would automatically record that transaction. That record is stored on all computers within the network; this decentralization allows data to be independently viewed and verified by anyone on that network. Once a transaction is recorded, it cannot be altered.

Furthermore, assets on a blockchain are uniquely identified and cannot be “double-spent.” Thus, a buyer cannot use the same asset to pay multiple sellers, and the seller cannot sell his asset to two different people. Due to its redundancy, transparency and immutability, a blockchain is essentially tamper proof, making it a trustworthy and sufficiently secure11 medium through which to verify and fulfill the terms of a smart contract.

The Smart Contract’s Effect on Legal Practice

BlockGeeks, an online hub that provides information about blockchain technology, boldly titles its beginner’s guide to smart contracts as “Smart Contracts: The Blockchain Technology That Will Replace Lawyers.”12 Smart contracts are unlikely to replace the need for lawyers,13 but once widely utilized, smart contracts will certainly change legal practice. For transactional attorneys, areas that will be mostly affected by smart contracts include due diligence,14 contract drafting and review, and alternative dispute resolution.

Today, transactions often involve due diligence reviews to verify the value of the asset being purchased or the capacity of a contractual party to perform its obligations. In a car purchase, the buyer needs to verify the seller’s title and the car’s condition, and the seller would need to verify that the buyer has enough funds. When the parties forsake due diligence, the parties simply assume the risk of the transaction.

When information such as the Uniform Commercial Code filing and land title record,15 or a party’s financials, are available online (though encrypted and only accessible to authorized users and applications), due diligence, audits and title searches will be obsolete.16 The smart contract would instantly verify such information and if verification fails, the transaction would not take place.

Attorneys will need to become proficient enough in computer programming languages to either partner with a computer programmer or independently draft and review smart contracts for clients.17 While sophisticated clients can read a natural language contract to verify that the contract the attorney drafted reflects the client’s intention, without computer programming language skills, a client will have to rely solely on his computer programmer/attorney to ensure that the smart contract does not contain any loopholes or unintended actions.18

Even if attorneys do not become proficient computer programmers, they will need a working knowledge of the complexity of blockchains and smart contracts so they can advise clients on the shortfalls, risks, benefits and best practices in using blockchains and smart contracts in their businesses.19 Further, certain contracts, or parts of them, remain ill-suited for automatic, smart contract implementations. These contracts involve human performance,20 which cannot be automated or forced (as one would hope). Therefore, attorneys will need to be able to bridge the gap between parts of a transaction that are suited for computer language and parts that are best represented in natural language.

Even though our common law system aims to be as predictable as possible, its application is inherently unpredictable because it is subject to interpretation and judgment, which may result in corruption, but may also achieve equitable outcomes. However, as computer software, the smart contract is rigid. When disputes arise, as they often will even if currently unforeseeable by advocates of smart contracts, smart contract users will seek advice from an attorney to determine if they have recourse to right any wrongs they may have suffered. Because transactions on the blockchain are outside jurisdictional boundaries, the parties may not be able to avail themselves of the court system. Thus, an alternative dispute resolution method will likely need to be adapted to address blockchain disputes.21

With both major technical hurdles being addressed by the growing IoT phenomenon and the ever-improving blockchain technologies, smart contracts have a good foundation to thrive on. There are, of course, legal hurdles that smart contracts advocates still struggle with, including public policy, regulatory and jurisdictional issues.

Government agencies are notoriously slow at adopting new technology and standards. The aspiration of conducting all business and governmental activities using blockchains is still far from reality. Even when new technology is accepted, adoption often begins sporadically and haphazardly, which causes inconsistency and confusion.

Like all new technology, smart contracts need time to fully evolve, mature, and be uniformly adopted. During this time, attorneys need to consider how smart contracts could affect their practices and prepare to adapt accordingly. When blockchains and smart contracts start to become mainstream, attorneys should be ahead of the game. 

Vi Duong works as of counsel with Stacey L. Romberg, Attorney at Law, and with Analytics Pros, Inc., as an in-house attorney. Duong has experience in counseling businesses on various business and corporate law issues. For more information on other areas of Duong’s practice, please visit Stacey L. Romberg’s website at https://staceyromberg.com/.

1 Dewey, Joe and Amuial, Shawn, “What Is a Smart Contract,” Bloomberg Law, Big Law Business (2015): https://bol.bna.com/what-is-a-smart-contract/
(last visited December 29, 2016).

2 See Burrus, Daniel, “The Internet of Things Is Far Bigger than Anyone Realizes,” WIRED (2014): https://www.wired.com/insights/2014/11/the-
internet-of-things-bigger/ (last visited December 29, 2016).

3 See Kelly, Jamima, “Banks Adopting Blockchain ‘Dramatically Faster’ than Expected,” IBM, Reuters (2016): http://www.reuters.com/article/us-tech-blockchain-ibm-idUSKCN11Y28D (last visited December 29, 2016).

4 The term “smart contract” as used in this article focuses on the use of computer code to substitute or supplement traditional contracts. However, the term “smart contract” as used in the blockchain community refers to any computer code that operates on a blockchain. See Josh Stark, “Making Sense of Smart Contracts,” CoinDesk (2016): http://www.coindesk.com/making-sense-smart-contracts/ (last visited December 29, 2016).

5 Gord, Michael, “Smart Contracts Described by Nick Szabo 20 Years Ago Now Becoming Reality,” Bitcoin Magazine (2016): https://bitcoinmagazine.com/articles/smart-contracts-described-by-nick-szabo-years-ago-now-becoming-reality-1461693751 (last visited December 29, 2016). See Nick Szabo, “Formalizing and Securing Relationships on Public Networks. First Monday,” (1997): http://firstmonday.org/ojs/index.php/fm/article/view/548/469 (last visited December 29, 2016).

6 Stark, Josh, “How Close Are Smart Contracts to Impacting Real-World Law?” CoinDesk (2016): http://www.coindesk.com/blockchain-smarts-contracts-real-world-law/ (last visited December 29, 2016).

7 Blockchains can store any information, including land titles. Dale, Brady, “Three Small Economies Where Land Title Could Use Blockchain to Leapfrog the US,” Observer (2016): http://observer.com/2016/10/benben-factom-bitfury-ghana-georgia-
honduras/ (last visited December 29, 2016).

8 Blockchain technology is the underpinning of cryptocurrencies such as Bitcoin.

9 Initially, blockchains were developed as public blockchains. However, recently several companies have developed private blockchains. Parker, Luke, “Private versus Public Blockchains: Is there room for both to prevail?” Magnr Blog (2016): https://magnr.com/blog/technology/private-vs-public-blockchains-bitcoin/ (last visited December 29, 2016).

10 In the Internet of Things world when any item can have a unique digital identifier and be controlled by computer code, such items can become assets that can be transferred via the blockchain.

11 Contra Kuchler, Hanna, “Cyber attacks raise questions about blockchain security,” Financial Times (2016): https://www.ft.com/content/05b5efa4-7382-11e6-bf48-b372cdb1043a (last visited December 29, 2016). See also Penny Crosman, “Does Blockchain Tech Solve Security Problems or Cause New Ones?” American Banker (2016): http://www.americanbanker.com/news/bank-technology/does-blockchain-tech-solve-security-problems-or-cause-new-ones-1090801-1.html (last visited December 29, 2016).

12 BlockGeeks: http://blockgeeks.com/guides/smart-contracts/ (last visited December 29, 2016).

13 Howlett, Richard, “A Lawyer’s Perspective: Can Smart Contracts Exist Outside the Legal Structure?” Bitcoin Magazine (2016): https://bitcoinmagazine.com/articles/a-lawyer-s-perspective-can-smart-contracts-
exist-outside-the-legal-structure-1468263134 (last visited December 29, 2016); Weinberger, Evan, “‘Smart Contracts’ Won’t Eliminate Need for Lawyers,” Law360 (2015): http://www.law360.com/articles/637833/smart-contracts-won-t-eliminate-need-for-lawyers (last visited December 29, 2016).

14 Miller, Brent, “Smart Contracts and the Role of Lawyers (Part 3) – About Lawyering Transactions on Blockchains,” BigLawKM (2016): http://biglawkm.com/2016/10/25/smart-contracts-and-the-role-of-lawyers-part-3-about-lawyering-transactions-on-blockchains/.

15 Marvin, Rob, “Blockchain in 2017: The Year of Smart Contracts,” PC Magazine (2016): http://www.pcmag.com/article/350088/blockchain-in-2017-the-year-of-smart-contracts (last visited December 29, 2016).

16 See Miller, supra, note 14.

17 See Gautham, “Are Hackers the Future Lawyers? Maybe They Are!” NewsBTC (2016): http://www.newsbtc.com/2016/06/26/hackers-future-
lawyers-maybe/ (last visited December 29, 2016).

18 For an example of a recent loophole that was exploited on a blockchain, see Hinkes, Drew, “A Legal Analysis of the DAO Exploit and Possible Investor Rights,” Bitcoin Magazine (2016): https://bitcoinmagazine.com/articles/a-legal-analysis-of-the-dao-exploit-and-possible-investor-rights-1466524659 (last visited December 29, 2016).

19 Dewey, Joe and Amuial, Shawn, “Blockchain Technology Will Transform the Practice of Law,” Bloomberg Law, Big Law Business (2015): https://bol.bna.com/blockchain-technology-will-transform-the-practice-of-law/ (last visited December 29, 2016).

20 See Stark, supra, note 6.

21 See Bacon, et al., “Arbitrating blockchain disputes—will smart contracts require smart dispute resolution?” LexisNexis (2016): http://blogs.lexisnexis.co.uk/dr/arbitrating-blockchain-disputes-will-smart-contracts-require-smart-dispute-resolution/ (last visited December 29, 2016).

This post is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting with an attorney.

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