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Smart Contracts: What lawyers really need to know

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As the interest around smart contracts grows, the debate around it grows too. Some say that smart contracts are the technology of the future that will dramatically reduce the need for lawyers – others say that this is a fledgling technology that will take many years to become workable within a legal setting.

What is a Smart Contract?

Smart contracts and blockchain are complex and if you want a full length technical explanation there are plenty of articles available including this one.

From a lawyer’s perspective, here are the key things you need to understand:

Smart contracts are auto-executable contracts built on a distributed ledger, or blockchain.

‘IF – THEN’ logic is used to make the contracts auto-executable based on key milestones. For example, IF a housing contract is signed by both parties THEN a deposit is automatically taken from the renter’s account.

The distributed ledger element means that information is available to all parties and cannot be overwritten. In terms of smart contracts, this means that once contractual agreement has been reached the smart contract execution cannot be changed or stopped.

Currently, all payments within a smart contract would have to be made in cryptocurrency as this is the only current available for automatic payments on a blockchain.

The final point to note is that the term ‘smart contract’ is potentially misleading as it is often assumed to mean a legally binding contract. Contract here means a transactional agreement but not necessarily a legal one. For example, supply chain management is seen as a key potential area for smart contracts, with all of the suppliers on one blockchain and parts being automatically requested as they are used. This could theoretically be legally agreed via an offline (standard) contract and then delivered via a smart contract system.

Why Do Technologists Think This Will be So Revolutionary?

Blockchain enthusiasts see this as an opportunity to remove middlemen such as lawyers, brokers and bankers in transactions. Legal tech companies would develop template contracts that individuals could purchase, fill in and execute themselves – theoretically with no other parties involved.

It’s also claimed that it should remove the need for disputes or litigation around failure to fulfil a contract. As long as the contract is set up correctly it will be automatically fulfilled as milestones are reached.

Another perceived advantage is that the explicitness required by a smart contract leads to a greater accuracy, transparency and theoretically trust. For example, smart contracts will auto-execute a payment on a specific number of days post-milestone – eliminating waiting for and chasing for payments. This auto-execution is also supposed to give a greater trust as both parties know that the contract will be executed regardless of outside factors.

What Do Lawyers See as the Pitfalls?

One of the first disadvantages is that all payments must currently be made via cryptocurrency. As cryptocurrencies are notoriously volatile, it is unlikely that many individuals would be happy to complete significant or long-term financial contracts using it. Without auto-executed payments, smart contracts lose many of their suggested benefits and until banks are willing to execute smart contracts using national currencies, this will hamper smart contract adoption.

Lawyers in Australia have noted that contractual principles such as frustration, duress, undue influence, unconscionable dealings or force majeure could mean that a contract is not legally valid but would continually to be automatically executed by a smart contract system. There are likely to be similar issues in other jurisdictions.

Another issue is that there is no way for a smart contract to know if offline conditions do not match online conditions. For example, an individual could sign a 6-month rental contract and then arrive at the house the next day to find they have been scammed by a fake landlord. As the contract has been signed it will continue to auto-execute for the 6-month term with full payments taken. If the payments are being made in cryptocurrency they may be impossible to trace or recover.

Finally, if a mistake has been made either by the contractual parties or by the developers it is impossible to fix once the contract has been executed. This raises complications for real-life contracts – for example if a contract proves more difficult to deliver than expected and both parties agree to waive a late delivery financial penalty. If the smart contract was not created with this option, then they will need to go outside of the original contract to do this. Equally, as this $40,000 hack shows, vulnerability in the code can lead to financial losses that contractual parties are unable to protect themselves from.

What’s the Future for Smart Contracts?

In order to deal with coming changes, some US States in particular have already begun to put legislation around smart contracts. However, both technologists and lawyers have argued that these laws are dangerously vague and “a recipe for confusion down the road”.

Despite the hype, in realistic terms this is a technology that is at the pilot stage for the legal industry. It will take some time before appropriate legislation has been placed around it and it becomes commercially or legally viable.  

By Sabina Horgan – Sabina is VP of Market Development at Thread Legal, a case management system built with Office 365 technology.

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