Smart contracts are self-executing agreements written in code on the blockchain. Parties contract digitally using distributed ledger technology. This article offers a layperson’s, non-technical summary of the underlying technology and consideration of certain legal implications for smart-contracting and contract management.
The blockchain is a series of so-called “blocks”: permanent files of record or transaction data. The blocks are referenced by hash pointers to form a chain sequence and the chain grows in a linear fashion over time as blocks are added sequentially using cryptography.
Picture a set of colorful plastic toddler blocks that can be connected to form various lengths of literal blockchains. These chains cannot be pulled apart, however, and blocks may not be swapped out. The chain, sequence and content of each block is permanent. Additional blocks may be added in accordance with the underlying rubric or coding of the chain. Any additional blocks are viewable by each person or entity that has access to the original chain via the blockchain platform.
Further, the blockchain may be distributed as a shared private or public database across platforms and locations. Consider a spreadsheet accessible by various parties that may view or add cells, but not revise or delete existing cells. For this distributed ledger technology, there is no centralized database to be hacked and the blocks are accessible according to permissions and visible in real time to all parties who have access to the blockchain platform.
In the blockchain, the blocks may not be removed, substituted, copied or altered. Therefore, the blockchain is considered to be inherently authenticated, secure and immutable.
The blockchain may be used to implement self-performing contracts. Considering again the toddler’s plastic block chain, the code may be written such that if the third block is red, the fourth must be purple, but if the third block is green (or simply not red), the fourth must be yellow, and so forth. The parties agree to certain terms and outcomes to be accomplished by the contract. Using this example, the blockchain is well-suited to simple and repetitive contracts, like a series of purchases and payments. The contract is located on a single blockchain, which is accessible from anywhere that has access to the applicable network. The final terms are deployed to the blockchain and distributed throughout the underlying platform to all parties. Therefore, the contract may be executed at the same time from various locations and effectiveness can be immediate.
Further, the blockchain may be used to negotiate contract terms. The draft terms are deployed to the blockchain and distributed throughout the platform. Coding facilitates the review of contract draft terms and the sequential revision of contract documents by parties in multiple locations at the same time. Using the spreadsheet example, draft terms can be instantly viewable by all parties and the draft terms and the other party’s responses and counter-terms can all be immediately logged and viewed. This allows multiple parties to negotiate and draft contracts digitally.
Contract Performance and Enforcement
The smart contract code contained in the blocks renders the contract a set of self-executing and self-enforcing protocols. If A happens, then B occurs. If A does not happen, then C occurs.
As autonomous and automated processes, smart contracts lend themselves well to agreements with clear conditions, simple terms, and repetitive transactions. These contracts may be fairly complex in terms of scope, volume and types of terms and conditions, and number of parties, but the terms must be susceptible to conversion to self-performing code.
For example, consider a sales contract. A seller of construction materials located in North America contracts with a buyer in South America. Using the blockchain, the parties could enter into the same contract at the same time. The contract protocols would provide for self-execution of the contract: the shipment of materials; the shift in risk of loss and insurability; the receipt of materials; and payment for materials. Payment can be effected digitally via the blockchain using cryptocurrency; payment and receipt would be instantaneous. If the materials are not shipped, payment is not made.
Trusted Intermediary Agreements
As an immutable and secure technology, the blockchain can be used to complete transactions typically requiring a trustee or other centralized authority to authenticate the parties, verify that certain contract terms have been met, and execute certain contract terms, such as transfer of ownership or payment.
For example, an escrow agreement can be formed and implemented on the blockchain by linking blocks of defined conditions to the release of certain payments. Independent verification of the satisfaction of the conditions is not required because the fulfillment of each condition is memorialized or effected by the blockchain. Independent disbursement of funds is not necessary because immediate transfers of cryptocurrency can be effected by the blockchain.
In this manner, smart contracts can facilitate certain types of contracts without an intermediary or trustee, at a faster pace, and at lower transactional costs than those associated with traditional trusted intermediary contracts.
The blockchain forms a permanent, trackable record of both the contract terms and the successful performance or failure of the contract terms. All parties have access to the blockchain — as a decentralized and distributed technology — to confirm that contract terms have been met and monitor contract performance directly.
Therefore, no separate recordkeeping or management process may be required. Blocks are accessible at any time and from any location in their permanent form. No separate method of authentication should be required. This could greatly reduce the cost of contract management, while enhancing and simplifying the administration of a vendor management program.
As described above, the blockchain is well suited to contract terms that can be reduced to self-executing smart contract code. This requires the parties to use terms that are clearly defined, have measurable performance metrics or objectives, include concrete steps or conditions, and provide for a series of pre-determined outcomes and results.
For example, the smart escrow contract described above provides that the occurrence of specified triggers automatically and autonomously effect certain pre-determined triggered results. These escrow terms are self-executing and do not require human intervention to verify the occurrence of the triggers or effect the triggered results.
Consider, for example, a software license. Conceivably, terms governing the development of customizations according to specifications, delivery and/or installation of the software, testing and acceptance, and payments could all be memorialized, verified, and executed by smart contract code.
Traditional but more complex terms may not, however, be susceptible to realization on the blockchain. For example, the software licensee will require certain indemnities for intellectual property infringement and data breach. Determination of whether or not intellectual property infringement has occurred or claims trigger liability are not easily reduced to code. Similarly, apportionment of blame and liability for data breach may require external legal analysis. Disclaimers of warranties, limitations of liability, indemnities, force majeure, arbitration or other conflict-resolution clauses, and other so-called “boilerplate” legal terms all pose the same difficulty in this context.
In order to use the blockchain for smart contracts, the dependencies and contingencies must be expected or reasonably foreseeable, objectively measurable, and capable of concrete and automatic resolution. The protocols may be less effective for unlikely or ambiguous events or outcomes or events that require an independent legal determination to be enforced.
The efficacy of smart contracting thus depends not just on technical coding and system capabilities. The ability of the parties to foresee and define a set of terms, events, and outcomes is critical to the reduction of the contract to self-executing code. Further, the type or content of the term will impact how or whether or not the term may be suitable for the blockchain.
In the near future, use of the blockchain for smart contracts is likely to proliferate for agreements that are conducive to the technology. For more complex transactions, it will be interesting to see if these contracts will be excluded from the blockchain, effected using a hybrid approach of smart contracts and traditional contracts, or if the technology will ultimately be developed to implement these sorts of terms directly or impact the content of contract terms themselves by developing an alternative set of terms susceptible to reduction to self-executing code.
***** Paige M. Boshell is a partner at Bradley Arant Boult Cummings LLP in Birmingham, AL. She is an IAPP Fellow of Information Privacy, Certified Information Privacy Professional/US, and Certified Information Privacy Manager. She leads the firm’s Cybersecurity and Privacy, Digital Services and Electronic Contracting, and Cybersecurity and Financial Privacy teams. She can be reached at email@example.com.
The views expressed in the article are those of the authors and not necessarily the views of their clients or other attorneys in their firm.