Coinciding with the explosive growth of cryptocurrencies and blockchain technology, the notion of a “smart contract,” or a programmable agreement, has entered the lexicon of numerous enterprises interested in applying blockchain technology. But what exactly is a smart contract and why should lawyers care? What are some potential use cases and, more importantly, are smart contracts legally binding in the same sense as a traditional contract?
First conceptualized by cryptographer and legal philosopher Nick Szabo in 1996, smart contracts are described as “a set of promises, specified in digital form, including protocols within which the parties perform on these promises.”[1] According to Szabo, smart contracts are contractual clauses embedded in hardware and software, in a manner that would ensure a breach of contract to be prohibitively expensive to the breaching party.[2] The easiest example of a primitive smart contract is the vending machine, which can be thought of as an automated contract between a consumer and vendor.[3] A customer deposits cash or swipes his card into the machine, fulfilling his end of the contract. The machine automatically checks for contract performance (payment for the full price of the item), and dispenses the item, fulfilling the vendor’s side of the contract. Furthermore, vending machines are very hard to break into, and only contain small amounts of cash. Thieves attempting to break into vending machines would probably have to expend significant effort and resources for a paltry cash reward, thereby dissuading them from doing so. Thus, we have contractual clauses, embedded in hardware and software, protocols for performing the contract, and minimal rewards or excessive costs in the event of a breach of contract. By reducing costs for the vendor, minimizing the possibility of a breach, and ensuring greater availability, the smart contract is a significant improvement over the traditional contract.
By examining the underlying goals of contracts and contract law, the advantages of a smart contract become clear. Szabo distills contractual goals into four main areas: observability, verifiability, privity, and enforceability.[4] Observability refers to the ability of parties to observe or prove to each other the proper performance or ability to carry out contractual terms.[5] Verifiability is the ability of each party to prove contractual breach or performance to an arbiter or neutral third party.[6] Privity is “the principle that knowledge and control over the contents and performance of a contract should be distributed among parties only as much as is necessary for the performance of that contract.”[7] Essentially, privity states that third parties, excluding designated arbiters and mediators, should have no control over contract performance. This helps ensure the security and privacy of the transacting parties. Enforceability is the mechanism of contract enforcement, as well as reducing the need for such enforcement.[8]
Meeting these goals generally requires the use of trusted third parties—accountants to observe, arbiters to verify breach or performance, and the judicial system to enforce.[9] However, privity requires that use of third parties to be minimalized as much as possible. Therefore, while increasing verifiability or observability will help ensure greater enforceability, some amount of privity is necessarily lost when hiring accountants or mediators.[10] Smart contracts aim to maximize the efficacy of trusted third parties, while increasing enforceability and privity.[11] By making a contract self-executing through digital protocols, the need to verify and observe is drastically lessened.[12] Furthermore, if a breach is disallowed or is prohibitively expensive, enforceability is increased, as the incentive to breach has decreased.[13] When the need for trusted third parties, such as mediators or arbitrators is reduced, confidentiality and privity are preserved.[14]
With the advent of blockchain technology, smart contracts can now be implemented across multiple industries and enterprises.[15] The core philosophy behind blockchain technology is the capability of parties to come to a consensus about the state of a given system.[16] Parties who have no reason to trust each other are incentivized to cooperate and agree without the need for a trusted third party. Hence, even parties who mistrust or hate each other can transact in a “trustless” manner.[17] For example, bitcoin runs on a decentralized cryptographically secured network, which acts as a ledger system that records and verifies all transactions, rejecting illegitimate ones.[18] Network participants come to a consensus about the state of bitcoin’s ledger, thereby eliminating the need for a trusted third party to maintain the ledger.[19] The protocol, or rules delineated by the bitcoin algorithm, prevent actions not in accordance with the network consensus.[20] Therefore, the ledger cannot be arbitrarily changed by any one party and can be thought of as immutable and secure from fraud or censorship by one party.[21]
By deploying smart contracts on a blockchain, parties can write and customize their own programmable self-enforcing agreement.[22] Ethereum, a globally distributed and powerful blockchain, is specifically designed to enable smart contract use.[23] Ethereum uses its own programming language, Solidity, and the Ethereum Virtual Machine (“EVM”) to run and store smart contracts.[24] Once on a public blockchain like Ethereum, the contract is protected from censorship, downtime, fraud and third-party interference.[25] The contract and the underlying code is viewable to all parties involved, and easily monitored for proper performance. As a result, counterparty and middleman risk is reduced, as breaching a contract written on an immutable blockchain is difficult and expensive.[26] Specialized conditions can be added to each contract to enable an action when an input is satisfied.[27] For example, functions such as dividend payments to shareholders can be automated to pay out on a certain date, calculated by the amount of free cash flow available, and specified to the percentages written in the contract.[28]
While the most obvious use case for a smart contract is in the financial sector, particularly between large enterprises, many other industries can also use smart contracts. The Chamber of Digital Commerce lists twelve uses, ranging from cancer research to securities.[29] For example, dividend payments, stock splits and proxy voting can all be automated via a smart contract.[30] Settlement times for securities ownership and chain of custody can be reduced if a smart contract can cryptographically verify custody of an asset.[31] Smart contracts can also enable a faster and better flow of information between cancer researchers while protecting the privacy of patient medical records.[32] Data can be shared between the researcher, the clinical review board, and other institutions, thus ensuring compliance of privacy regulations, better and easier monitoring by review boards and increased collaboration between institutions.[33] Smart contracts may even be used between individuals and potentially from machine to machine.[34]
While smart contracts may be a wonderful resource, certain thorny issues remain. One such issue is bad or faulty code, which can enable a bad actor to exploit a contract. A notable example was the decentralized autonomous organization (“DAO”) hack.[35] A flaw in the contract led to a hacker siphoning off a significant amount of cryptocurrency.[36] Another issue is the legal status of a smart contract. Is a smart contract legally binding? While some may assert that “code is law,” courts may disagree and invalidate a smart contract agreement.[37] Many factors must be considered when evaluating the legality of a smart contract, such as the nature and scope of the agreement, and if valid consideration was given, among other factors. While it remains unclear exactly how a court will interpret a smart contract agreement, precedent seems to dictate that courts are open to validating smart contracts in certain circumstances.[38] Smart contracts can play an integral role across many different industries, revolutionizing the way we transact and share information. Attorneys knowledgeable in smart contract formation will have a key role in designing and drafting the most efficient and secure smart contracts. The legal industry should be mindful of the potentially disruptive implications of this technology and consider the ways in which smart contracts can improve the efficiency and productivity of the legal profession.
[1] Nick Szabo, Smart Contracts: Building Blocks for Digital Markets (1996), http://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/CDROM/Literature /LOTwinterschool2006/szabo.best.vwh.net/smart_contracts_2.html.
[2] Id.
[3] Id.
[4] Id.
[5] Id.
[6] Szabo, supra note 1.
[7] Id.
[8] Id.
[9] Id.
[10] Id.
[11]Szabo, supra note 1.
[12] Id.
[13] Id.
[14] Id.
[15] Michael Gord, Smart Contracts Described by Nick Szabo 20 Years Ago Now Becoming Reality, Bitcoin Magazine (Apr. 26, 2016), https://bitcoinmagazine.com/articles/smart-contracts-described-by-nick-szabo-years-ago-now-becoming-reality-1461693751/.
[16] Andreas M. Antonopolous, The Internet of Money 10-12 (2016).
[17] Id.
[18] Satoshi Nakamoto, Bitcoin: a Peer-to-Peer Electronic Cash System (2008), http://bitcoin.org/bitcoin.pdf.
[19] Id.
[20] Id.
[21] Id.
[22] See Buterin et al., A Next-Generation Smart Contract and Decentralized Application Platform, https://github.com/ethereum/wiki/wiki/%5BEnglish%5D-White-Paper.
[23] Ethereum: Blockchain App Platform, https://www.ethereum.org/ (last visited Apr. 13, 2018).
[24] See Buterin supra note 22.
[25] Id.
[26] Id.
[27] Id.
[28] Smart Contracts and Deloitte, Smart Contracts: 12 Use Cases for Business & Beyond, Chamber of Digital Commerce, 3 (2016), https://bloq.com/assets/smart-contracts-white-paper.pdf.
[29] Id.
[30] See Smart Contracts and Deloitte supra note 28 at 19.
[31] Id.
[32] See Smart Contracts and Deloitte supra note 28 at 37.
[33] Id.
[34] See Smart Contracts and Deloitte supra note 28 at 3.
[35] David Siegel, Understanding The DAO Attack, Coindesk (June 25, 2016), https://www.coindesk.com/understanding-dao-hack-journalists/.
[36] Id.
[37] Can smart contracts be legally binding contracts? An R3 and Norton Rose Fulbright White Paper, Norton Rose Fulbright & R3, 27 (2017), http://www.nortonrosefulbright.com/files/r3-and-norton-rose-fulbright-white-paper-full-report-144581.pdf.
[38] Id.
