Smart Contracts: Pros and Cons of the New Shiny Thing

The IPKat has briefly written about  smart contracts in the context of emerging blockchain technologies. To reiterate, a smart contract is a software-defined contract (licence?) embodied in a computer algorithm that automatically self-executes once triggered by an occurrence of a certain event. In other words, negotiation, verification and performance are effectively removed from the contracting process.   High level parallels may be drawn between smart contracts and shrink wrap agreements, which are also non-negotiated deals that come into effect when triggered by a certain event, namely use of a licensed work.

Nearly two decades ago, Lawrence Lessig, in his article for Harvard Magazine, considered code acting as a regulator (“Code is Law”), where “code, or architecture, sets the terms on which life in cyberspace is experienced”. In other words, software not only aids in transaction decision-making, but serves as an enforcer of certain rules thereto. “Code is Law” has found its way into digital rights management mechanisms and governmental regulatory schemes, such as No Fly List in the U.S.

However, blockchain and machine learning technologies have demonstrated certain limitations of regulation by code, see here and here, which elevates reliance on code to a whole new level: software not only acts as an enforcer, but also as a rule drafter (“Law is Code”). Smart contracts may be deemed as an assistive technology to blockchain. They are built into a blockchain and help to ensure that transactional applications maintain legal constraints and yet do not hinder the full automation and business processes constructed upon it.

Advocates praise smart contracts for their superior transparency and the security associated with blockchain technology itself and significant reduction in transactions costs, the biggest of which being her majesty TIME. An important benefit of smart contracts is the reduction of language vagueness and ambiguity, as their provisions are drafted in rigid and formal language capable of being understood by a machine. Applications of smart contract are seemingly endless, including escrow service, property (including IP) transfers, digital rights management, supply chain management, and capital market trading.

However, inherent legal challenges are no less evident. We discuss them below.

Technological Utopianism?

Crucial issues for lawyers trying to dissect the phenomenon of smart contracts rest first and foremost on enforceability. Who are the parties? How is liability determined? Are we dealing with contract law, tort law or something sui generis?

Smart contracts may be regarded as written contracts drafted in a computer language, but their enforceability in accordance with contract law principles is far from certain.  Contract law rests on the free will of at least two parties to (not)enter into an agreement to establish a set of rules that represent the will of these parties. Furthermore, contract law incorporates certain legal safeguards that protect the principle of free will (including mutual consent, capacity, undue influence, and misrepresentation) and may render a contract invalid or unenforceable if such principle is violated. A smart contract will be enforced regardless of whether or not it qualifies as a valid contract under the law.

This Kat exercises aesthetic neutrality
when it comes to chains

Even simple transactions require parties to fully understand their obligations in order to be legally bound. Smart contracts seem to chip away at this basic premise of contract law: legal provisions transposed into a smart contract carry an inherent guarantee of execution as anticipated, regardless of the will of the parties. When the transaction is more complex, involving multiple players (humans or machines), multi-component assets and diverse jurisdictions, computer code “smartness” may easily turn into plain “dumbness”.

This Kat is not aware of any case law related to enforcement of smart contracts, but one of the most notable smart contract failures has been widely discussed in the cryptocurrency world.

Distributed Autonomous Organization (DAO) is “the most complex form of a smart contract, where the bylaws of the decentralized organization are embedded into the code of the smart contract, using complex token governance rules”. In June 2016, the DOA with $150 million in crowdfunding was launched on the Ethereum blockchain and was supposed to collect investor money and invest it in various projects managed through smart contracts. The DOA was hacked almost immediately after its launch and $50 million in ether was diverted to a hacker’s pocket. Subsequently, this hack has been restored through Ethereum blockchain forking. Forking seems to also appear in legal interpretation of liability issues that might arise under such scenario.

Commodities Futures Trading Commission (CFTC) Commissioner Brian Quintez argues that liability of the developers of smart contract code is an “appropriate question” and the determination of such liability should be based on the ability of code developers to “reasonably foresee, at the time they created the code, that it would likely be used by U.S. persons in a manner violative of CFTC regulations.” According to Quintez, where code was specifically designed to enable the precise type of activity regulated by the CFTC, and no effort was made to preclude its availability to U.S. persons, a strong case could be made that the code developers aided and abetted violations of CFTC regulations.

Others have suggested  stretching tort law to address liability for “mistakes in coding”, see here and here.  An even perhaps more radical suggestion  has been proposed by Prof. Angela Walch, who analogises software developers to fiduciaries,  and users of a blockchain to “entrustors” of the fiduciaries in public blockchains. It reminds this Kat of a decision to rely on copyright law for the protection of software, which has yielded mixed results…

Image Credits: Refinery29.com/Rockie Nolan and MasterTheCrypto