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Embracing Blockchain and Smart Contracts in Today’s Legal Environment

Embracing Blockchain and Smart Contracts in Today’s Legal Environment

Blockchain technology is often associated with digital currencies, notably bitcoin, which has gained widespread use for purchasing goods and services online. However, the blockchain protocol is also useful in other applications, notably smart contracts, to provide a secure means of securing agreements and transferring funds between parties. The technology behind blockchain-based smart contracts does not require third party oversight, making this a convenient, cost-effective mechanism for supply chains, banks, and contracts. 

The How’s and Why’s of Blockchain

Blockchain technology was initially developed for bitcoin but is an open-source platform that is free to use and customizable to suit other functions.  Blockchain functions on a decentralized or peer-to-peer digital ledger, where data is globally stored on many servers at once. Each node or participant in the network stores a copy of the data and communicates with one another. 

The blockchain technology functions in this order when a transaction occurs:

  1. The transaction is verified by a network of computers, or nodes, numbering as high as the thousands or millions, located worldwide. The function of these nodes is to approve the transaction.  
  2. Upon verifying accuracy, the information is stored as a block with data on the date, time, amount, and digital signatures of the involved parties.
  3. The block is assigned a unique cryptographic code with the most recent block added to the chain. 

Enter Smart Contracts

Upon realizing the value of decentralized ledgers, legal scholar and cryptographer, Nick Szabo tied in the concept of smart contracts to blockchain in 1994. As in digital currency, contract data is converted to computer code, which is then stored, replicated, and supervised in the same decentralized manner. 

Ethereum, another type of cryptocurrency, facilitated the development of the smart contract. The Ethereum protocol powers the code to execute the transaction. The contract is essentially a program running on the Ethereum blockchain. 

Vitalik Buterin, a cryptocurrency programmer, best describes how a smart contract works with the blockchain protocol. The underlying asset or payment is transferred into a program that uses code to determine who receives the asset or if it should be refunded. A decentralized ledger stores and replicates the document, effectively securing it.  He goes on to compare the transaction to that of a vending machine. The logic programmed into the machine grants the buyer the purchased item upon receipt of the money, much like the code in a smart contract works between parties. 

Smart Contracts and the Law

As all other contracts, smart contracts are agreements between parties that are legally enforced. However, unlike traditional written agreements, smart contracts are more precise and explicit. No longer is there room for interpretation of vague wording that leads to disputes and claims. Instead, data specifics must be agreed upon, which may include matching time zones and other variables.

In their report, the Smart Contracts Alliance states how a smart contract’s elements satisfy contractual law in the U.S.  These consist of an offer, consent, and consideration. 

  1. Offer
    Smart contracts meet these criteria since they are deployed on a distributed ledger with other participants to interact and execute the code. A party sending the terms of a proposed smart contract to another party constitutes the offer.
  2. Acceptance
    Acceptance of a smart contract is indicated by digital signatures using private keys.
  3. Consideration
    A legally binding contract stipulates an exchange either at the time of the signing or a promise in the future. 

Some concerns still need clarification for smart contract execution and legal recognition. These include the extent to which smart contracts are legally recognized and how blockchain data is recognized as evidence. 

The state of Illinois is one of the first states to clarify any legal issues by enacting the Blockchain Technology Act (BTA), effective January 1, 2020.  This act clarifies that a smart contract cannot be denied any use in legal settings only because blockchain is used to create, store, or verify the contract, record, or signatures. Other states have also enacted similar regulations. 

Benefits of Smart Contracts

Smart contracts provide several advantages to both the client and the law firm. 

  • They are more easily retrieved since all that is needed is a digital key. 
  • Smart contracts are impossible to hack since the blocks of data are encrypted. Though the data is stored on redundant systems, only the owner can view and use the data. This is done through the use of a smart key that is only known to the owner. Unless someone gives this key out, the information is not accessible by unauthorized people.
  • Smart contracts reject transactional errors, making them more accurate by nature. They are guaranteed to execute if they are free from errors. The exchange of funds can be carried out through the contract as well. 
  • While traditional contracts are time-consuming to write, smart contracts conducted online take a fraction of the time. Their execution takes less time since the verification and processing of information is instantaneous. 

Will Lawyers Still be Needed?

That is not to say that lawyers are no longer needed. While smart contracts provide the above benefits, legal professionals will continue to be involved. 

  • Lawyers are still necessary for subjective determinations that are usually indicated with the terms “reasonable,” “good faith,” and “best efforts.” Smart contracts cannot be written using this terminology. 
  • Smart contracts experience errors if the data input is incorrect. The contract will not automate if this is the case.
  • Complex contracts are difficult, if not impossible, to establish in smart contracts. Legal professionals must still be recruited for such agreements. 
  • Legal professionals are joining forces as a community to develop specifications for smart legal contracts. 

 Blockchain and Smart Contract Applications

There are several areas where blockchain and smart contract applications are in use today. 

  • Financial
    These smart contracts are used in trade clearing and settlement, coupon payments, insurance claim processing, and micro-insurance. They perform error checking, calculate payments, and trade settlement amounts. 
  • Health Care
    In electronic medical records, smart contracts can be used to access and transfer records with signature approvals. Patients using mobile devices to track their health receive virtual rewards for milestones. 
  • Media
    Smart contracts are used for royalty distributions to artists according to the stipulations of the agreement. Blockchain provides evidence of rights management and can track the distribution of an artist’s material. 
  • Informational
    Private companies can share records and distribute shareholder communications such as corporate filings. 
  • Criminal Cases
    The National Law Review describes how criminal cases could greatly benefit from blockchain technology since records are generally document-heavy and complex. Any changes in legal status are documented immediately, allowing all involved parties to keep abreast of case statuses. 
  • Notarizations
    There are several start-up companies already using blockchain technology for notary services. These services use the technology to provide proof of document existence anytime. 
  • Real Estate
    Passing ownership rights can be done without intermediaries in just a few clicks using a smart contract. 

Anatomy of a Smart Contract Transaction

From start to finish, a smart contract transaction consists of four main steps.

  1. The pre-defined contract terms are established.
    In this phase, the terms are established by all parties, including payment amount and type of currency.
  2. The event is triggered.
    The event triggers the contract’s execution. This action can be an initiated transaction or received information. 
  3. Execution and transfer of value are determined.
    The terms of the smart contract are automatically executed as determined by the contract’s pre-agreed terms.
  4. Final settlement of the contract.
    In the case of digital assets such as cryptocurrency, accounts settle automatically. For all other assets, changes to the account will occur as per the settlement instructions.

Challenges and Risks Facing Smart Contract Use

While smart contracts are hailed for the above advantages, there are many challenges and risks that are inherent in their use. 

In 2016, hackers exploited a vulnerability in the Ethereum platform on which smart contracts are processed. The losses amounted to $150 million to the decentralized pool that funded and governed the platform. However, the flaw was in the smart contract itself that enabled hackers to trigger a vulnerability with repeated “send funds” requests. While this was a rare, one-time occurrence, this breach demonstrates that imperfect coding could essentially expose the platform to intrusive threats. 

Despite the above-reported breach, according to Gartner, smart contracts will be used by more than 25% of global organizations by 2022. 

Before considering smart contract solutions, organizations should pose the following questions to creators and vendors of this technology.

  • Can the contract be undertaken in traditional legally binding methods before considering the smart contract route? If not, the contract should have been tried and tested before being used. 
  • Is the smart contract in use by others with successful results?
  • Will the smart contract creator take responsibility for any problems with the contract? If not, there is a significant risk to the organization.
  • Are there mathematical proof of correction tools within the contract?
  • Are there avenues for canceling out of the contract within the software, and who can initiate them? 

Gartner recommends that when choosing smart contracts, to ensure that the code has been thoroughly tested to avoid exposure to risks. 

While smart contracts can never replace the legal professionals’ services and experiences, they are having a tremendous and positive impact overall in many areas. Despite any risks, Gartner strongly supports using the contract technology and recommends that organizations deploy them in simple contract agreements.

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About the author

Allen Rodriguez Allen Rodriguez is a legal product development strategist who has been serving the legal industry for over 21 years. Over the course of his career, Allen has built a reputation for creating innovative legal services products as well as developing highly effective law firm business and marketing strategies. Allen is a valued speaker on the topics of law marketing, legal services product development, and future of law issues.

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