Smart Contracts

Contracting for Smart Contracts

“Smart contracts,” self-executing computer scripts, enable machines that are equipped with virtual wallets to conduct financial transactions with other machines, without the need for third-party brokers.  Many have argued that these smart contracts are the wave of the future and will result in an entirely new type of commercial activity.  With that said, while smart contracts could transform some traditional industries when applied to complex transactions involving multiple parties and jurisdictions, smart contracts may cause the very uncertainty they were designed to prevent.

What Are Smart Contracts?

Smart contracts are instructions converted into computer code to facilitate, execute, and enforce commercial agreements between parties.  To develop a smart Contract, a computer programmer converts terms and conditions of a traditional contract into a computer code and uploads the script to the blockchain, producing a decentralized contract that does not rely on a third party for record-keeping or enforcement.

Smart contracts were first introduced by Nick Szabo in 1997, a computer scientist and legal theorist. Taking inspiration from the system of automatic vending machines, Szabo defined smart contracts as contractual clauses embedded into hardware and software.  Thus, a vending machine with drinks that invites a passerby to insert a dollar to purchase a drink constitutes an offer. Inserting that dollar constitutes acceptance and the dollar and soda, respectively, are consideration. Szabo envisioned smart contracts as representing a fundamental shift in the world away from paper and towards digital systems, due to a reduction of the transaction costs.

Although conceptualized in 1997, it wasn’t until the end of 2008 and the introduction of the Bitcoin as a new way to transfer ownership rights that coders began the implementation of contractual provisions written in computer code, designed to self-execute and self-enforce at the occurrence of a condition.  To summarize, smart contracts are software scripts that:

  1. Execute on blockchains to perform a digital activity (the terms of a negotiated contract)
  2. Are triggered by the occurrence of a conditional statement. These contractual promises (that execute X if Y occurs) are processed automatically on the blockchain and without human interactions.

Smart contracts promise many advantages, especially with respect to relatively simple transactions. As mentioned above, smart contracts are managed automatically on the blockchain and exclude intermediaries, which would potentially reduce processing and other transaction costs. Because the documents are recorded on the blockchain, encrypted, and duplicated many times over when distributed among other computers on the peer-to-peer network, the process is secure when the documents are accurately archived.  Because smart contracts are translated into computer code, theoretically they reduce the risk of human error, ambiguity, uncertainty, vagueness, and prospects of a dispute.

Machine-to-Machine Commerce

Last year, EMotorWerks, a California startup, in partnership with MotionWerk, launched a pilot of a distributed, peer-to-peer charging marketplace for electric vehicles (EV) called Share&Charge. The platform enables drivers to pay other drivers for the use of residential EV chargers that otherwise are unused most of the time.  In practice, a driver of an EV logs into the network, locates an open charger in someone’s driveway a few blocks away, and plugs the EV there for a quick charge.  EMotorWerks anticipates that the homeowners, by participating in the marketplace and making their EV charges available to others, may profit up to $1,000 a year.  EMotorWerks believes that, if successful, this concept could drastically expand the population of readily available EV chargers, which could effectively reduce “range anxiety” and promote EV ownership.  Following the implementation of Share&Charge in California, MotionWerk launched similar programs across Europe.

The Share&Charge platform relies on the blockchain technology and, significantly for lawyers who might see this as their natural domain, smart contracts.  The blockchain assures that the homeowner is paid for the service and, through a digital smart contract, that the entire transaction is fulfilled.

Share&Charge is just one example of smart contracts running on the blockchain that parties have recently launched.  Other smart contract projects are found in industries such as banking, finance, energy, supply chain, music, healthcare and insurance.  In the majority of cases, machines equipped in virtual wallets and without human interference conduct transactions among themselves, opening the door to so-called machine-to-machine commerce.  A set of commercial interactions performed by a growing number of smart devices—including computers, phones, or EMotorWerks’ smart chargers, as described above—operate in an autonomous fashion process to transfer rights and record these transfers on the blockchain.

The machine-to-machine commerce is conducted on the blockchain that, at its core, is a platform that stores and verifies the history of transactions between participating “users.”  These “users” can be machines (e.g., an electric vehicle, charging station, or refrigerator) that conduct transactions by following directions embedded in smart contracts.

Smart Contracts and State Legislation

Blockchains and smart contracts have gradually become subjects of interest by state lawmakers.  In March 2017, Arizona enacted legislation, House Bill 2417, validating smart contracts, with respect to transactions relating to the sale of goods, leases, and documents of title, governed respectively under UCC Articles 2, 2A and 7.  The statute defines the “blockchain technology” as a “distributed, decentralized, shared and replicated ledger, which may be public or private, permissioned or permissionless, or driven by tokenized crypto economics or tokenless” and a “smart contract” as an “event driven program, […] that runs on a distributed, decentralized, shared and replicated ledger, that can take custody over and instruct transfer of assets on that ledger.”  Importantly, the statute grants to a person who uses the blockchain technology the ability to secure information and have the same rights of ownership as a person who uses traditional means.

Following Arizona’s example, Tennessee, Nevada, Delaware, Ohio, and Wyoming enacted similar laws, which echo a general understanding that smart contracts are enforceable.

Some cast doubts whether the new statutes enacted by various states are necessary to make smart contracts valid and enforceable.  In fact, a growing number of industry experts believe that the existing federal framework already “supports the formation and enforceability of smart contracts under state law.” Particularly, the Chamber of Digital Commerce argues that the Electronic Signatures in Global and National Commerce Act (ESIGN Act) and the Uniform Electronic Transaction Act (UETA) “provide sufficient legal basis for smart contracts executing terms of a legal contract.  Lastly, they state that “[a]dditional state legislation, inconsistently drafted, will confuse the marketplace and potentially hinder innovation.

Indeed, from the standpoint of the underlying technology, blockchains are not much different than other platforms that operate on the peer-to-peer architecture and have already been sharing files among the “nodes.”  Furthermore, the federal laws are drafted broadly enough to capture all new software inventions without the need for a new set of regulations every time a new technology is conceived.  It is, therefore, doubtful if new laws are needed to regulate concepts that have already been fully operational and successful, including commercially.  Over-regulation and over-fragmentation of laws might cause uncertainty around contract formation or other concepts crucial for commercial transactions.

Regulating smart contracts in one jurisdiction but not the other creates even more questions.  What if one party to a smart contract is domiciled, headquartered, or conducts business from a jurisdiction that regulates smart contracts, and the other is not; or if all jurisdictions involved regulate smart contracts, but define certain concepts inconsistently?  And although federal law is likely to preempt the inconsistent local laws, the startups, developers and entrepreneurs would benefit from the body of law that is well-established and adequately interpreted by the judiciary.  Indeed, as of today, smart contract programmers must pay close attention to the law of the forum in which they are operating, since a one-size smart contract designed to fit all jurisdictions is not likely to be contractually binding.

Smart Contracts and Growing Complexity of Machine-to-Machine Commerce

As the complexity of underlying transactions continues to grow, so will the complexity of the underlying source code of smart contracts which, subsequently, may increase the likelihood of bugs and errors, which makes it difficult to predict both the legal and technological consequences.

As of 2018, smart contracts conduct simple transactions that typically transfer ownership rights to assets in response to conditional statements to do X if Y occurs.  These relatively simple transfers are unlikely to raise legal issues.  But with time and the rapidly growing complexity of blockchain platforms, the complexity of smart contracts, as well as the associated risks, is also likely to increase.  Indeed, the smart contracts of today can be written in high-level, object-oriented languages that allow for far greater intricacy that goes beyond “if/then” statements.  For instance, Solidity, a popular programming language for implementing smart contracts, supports inheritance, classes, libraries, or complex user-defined types.  Therefore, it is safe to assume that the smart contracts of tomorrow will grow beyond simple conditions to conduct compound, or even subjective, balancing tests, in order to determine what is “reasonable” in light of particular circumstances or even incorporate artificial intelligence and machine learning to make judgment calls based upon vast quantities of data and patterns drawn from such data.

Despite these highly optimistic claims, a smart contract is still software that is written by humans, which, like any other software, may contain syntax, error handling, or functionality bugs. Indeed, the likelihood of writing a bad smart contract that contains a bug increases with the complexity of the underlying transaction that the smart contracts are managing.  It is, therefore, crucial for smart contract programmers to apply best-practices in smart contract software development, including code review, audits, and testing.

Smart Contracts and Increased Regulation of Privacy

Transparency, one of the most eminent qualities of the blockchain, may incidentally run against the person’s right to privacy, exposing companies behind the blockchain to financial penalties resulting from violations of global data privacy laws.  Indeed, it is the ability to review and scrutinize all transactions on the blockchains by their users which makes the technology attractive.

Nevertheless, smart contracts drafters should be mindful not to disclose (without securing adequate consents or other legitimate bases), any “personal identifiable information,” as defined by state laws or any “personal data,” as defined by foreign laws such as the GDPR or the LGPD, if the blockchain deals with or in any other way “processes” data of European, Brazilian or California residents.  The smart contracts drafters should write scripts while keeping in mind “purpose limitation,” “data minimization” or “accuracy” among other privacy principles; whereas blockchain developers design and develop their platforms while incorporating appropriate “technical and organizational measures to ensure a level of security appropriate to the risk.”  This difficult to quantify balancing test or the means to accommodate the rights of so-called “data subjects” (e.g., the right to be forgotten) adds yet another level of complexity and contributes to the uncertainty that companies face when contemplating the use of immutable blockchains.

Summary

Although smart contracts are still to be more broadly utilized, the recent implementations, including by EMotorWerks, indicate that innovators are seeking ways to streamline and simplify underlying transactions while reducing the associated costs.  It is important for developers, entrepreneurs, but also particularly legal counsel, to recognize potential risks that such implementation might carry, as well as to identify the disruptive impacts that blockchains and smart contracts might have on their industries.  Lastly, all parties involved should track the efforts of legislatures and authorities that signaled their interest in regulating the implementation of these technologies.

This article should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own lawyer on any specific legal questions you may have concerning your situation.

About Michael Baumert

Michael Baumert
Michael Baumert is an associate in Barnes & Thornburg’s Chicago office who focuses his practice on technology-driven transactions, sourcing, and cloud computing.

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