Smart Contracts: What lawyers really need to know

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

Whatis a Smart Contract?

Smart contracts and blockchain are complexand if you want a full length technical explanation there are plenty ofarticles available includingthis one.

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

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

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

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

Currently, all payments within a smartcontract would have to be made in cryptocurrency as this is the only currentavailable 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 alegally binding contract. Contract here means a transactional agreement but notnecessarily a legal one. For example, supply chain management is seen as a keypotential area for smart contracts, with all of the suppliers on one blockchainand parts being automatically requested as they are used. This couldtheoretically be legally agreed via an offline (standard) contract and thendelivered via a smart contract system.

WhyDo Technologists Think This Will be So Revolutionary?

Blockchain enthusiasts see this as anopportunity to remove middlemen such as lawyers, brokers and bankers intransactions. Legal tech companies would develop template contracts thatindividuals could purchase, fill in and execute themselves – theoretically withno other parties involved.

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

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

WhatDo Lawyers See as the Pitfalls?

One of the first disadvantages is that allpayments must currently be made via cryptocurrency. As cryptocurrencies arenotoriously volatile, it is unlikely that many individuals would be happy tocomplete significant or long-term financial contracts using it. Withoutauto-executed payments, smart contracts lose many of their suggested benefitsand until banks are willing to execute smart contracts using nationalcurrencies, this will hamper smart contract adoption.

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

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

Finally, if a mistake has been made eitherby the contractual parties or by the developers it is impossible to fix oncethe contract has been executed. This raises complications for real-lifecontracts – for example if a contract proves more difficult to deliver thanexpected and both parties agree to waive a late delivery financial penalty. Ifthe smart contract was not created with this option, then they will need to gooutside of the original contract to do this. Equally, asthis $40,000 hack shows, vulnerability in the code can lead to financiallosses that contractual parties are unable to protect themselves from.

What’sthe Future for Smart Contracts?

In order to deal with coming changes, someUS States in particular have already begun to put legislation around smartcontracts. However, both technologists and lawyers have argued that these lawsare dangerously vague and “arecipe for confusion down the road”.

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

By Sabina Horgan – Sabina is VP of MarketDevelopment at Thread Legal, a casemanagement system built with Office 365 technology.