The Blockchain & Smart Contracts – Are They Legal?

The Hutch Report

Earlier this year there was a lot of press about whether or not Donald Trump asked FBI Director James Comey not to fire Michael Flynn, who was forced to resign in February. According to James Comey’s testimony before congress Trump said, “I hope you can see your way clear to letting this go, to letting Flynn go. He is a good guy. I hope you can let this go.”

One of the keys to that statement from a legal point of view lies in that word “hope.” It is a common word, employable as both a noun and a verb, and it boasts an extraordinary breadth. We may say, “I hope to catch the 6:42 a.m.,” or “I hope the kids don’t catch a cold.”  So where do the hopes that Comey cited, in his own words and in his reports of others’ speech, belong?

This example is not meant to refer to contractual law, but it is intended to present the important part that language plays in law, and lawyers can be very clever about how they use their words and frame their sentences. So what does this have to do with smart contracts and the blockchain? Probably everything because the law is made of words and the interpretation of those words.   Coders and Lawyers don’t speak the same language so if a certain language is coded into a smart contract that is not coherent with legalise, that contract could be tested.

So what is a smart contract?

Smart contract is a term used to describe computer program code that is capable of facilitating, executing, and enforcing the negotiation or performance of an agreement (i.e. contract) using blockchain technology. The entire process is automated can act as a complement, or substitute, for legal contracts, where the terms of the smart contract are recorded in a computer language as a set of instructions.

As explained by Ethereum Founder, Vitalik Buterin, at the DC Blockchain Summit 2016:

Suppose you rent an apartment from me. You can do this through the blockchain by paying in cryptocurrency. You get a receipt which is held in our virtual contract; I give you the digital entry key which comes to you by a specified date. If the key doesn’t come on time, the blockchain releases a refund. If I send the key before the rental date, the function holds it releasing both the fee and key to you and me respectively when the date arrives. The system works on the If-Then premise and is witnessed by hundreds of people, so you can expect a faultless delivery. If I give you the key, I’m sure to be paid. If you send a certain amount in bitcoins, you receive the key. The document is automatically cancelled after the time, and the code cannot be interfered by either of us without the other knowing, since all participants are simultaneously alerted.

A Smart Contract Example

Here is the code for a basic smart contract that was written on the Ethereum blockchain. Contracts can be encoded on any blockchain, but Ethereum is mostly used since it gives unlimited processing capability.

On March 10, 2017, Yale Law School put together a panel for a discussion on the Blockchain: Smart Contracts which included Scott O’Malia, Chief Executive Officer, International Swaps and Derivatives Association who explained that these contracts are all fine when everything is working but when there is a conflict that arises then you need to fall back on traditional legal documents, which are based on many different legal statutes.

Buterin proposed some ideas that appeared in an FT Alphaville article:

Buterin envisages the use cases as follows:

  • Using smart contracts for events that are potentially highly subjective
  • Arbitration in decentralized crowdsourcing and on-demand economy applications
  • Storage or distribution of funds (eg. one use case is a will where you do not want to force the recipient to set up a private key or learn about ethereum unless they actually need to)
  • As an emergency backstop measure to get funds out of a smart contract if they are stuck for a long time

Scott O’Malia took issue with Buterin’s idea that any conflicts that arose could be arbitrated by decentralized crowdsourcing. O’Malia said, “Too much has gone into all of this to really just turn it over to a coder’s dream world.” “There are established standards and codes.”

There is an assumption that the blockchain and smart contracts will replace many legal participants but this is, for the moment, far from the truth. There are already governing bodies, including that of O’Malia’s, that are already looking at solving the problems of how to take legal agreements and turning them into executable code and what the standards around that will be, which documents do you work with first, how to establish common domain standards, protocols etc. The legal community sees the value in smart contracts as being a tool to capture evidence, however they are seen as being valuable for executing only certain points and forms of contracts and therefore limited in their scope.

The idea that programmers and coders will essentially plug a bunch of these smart contracts into the blockchain and do away with a large part of the legal system is not very realistic. A current problem is the fact that contracts and all legal documents are written by people. Computer code is also written by people. It becomes a technological problem when you don’t have a lawyer who has the ability to code, or vice versa. Therefore it will be necessary for lawyers to learn how to code or coders to be trained as lawyers. There is no current effort to accomplish this.

The blockchain is a decentralized entity. It doesn’t recognize borders. How would a smart contract between geographical locations, that abide by different legal systems, be managed? It will take time to fix these things.

There are still very clear advantages to smart contracts. When something needs to be verified you have the cost of verification. This requires an audit which requires resources and can be very costly. The blockchain has the ability to track attributes and data integrity at a very low cost.

In spite of all these issues, the hype cycle often assumes that technology will radically change things overnight, yet they rarely do. Software has bugs and needs to adapt, and although that is not a reason to not adopt the technology it does often take more time than anybody expects. The first email was sent in 1971 and needed 25 years before there was widespread adoption. Now it is an afterthought.

Laws are complex and probably many times more complex than they need to be yet that is how the system has evolved. Technologies like the blockchain and cryptography will hopefully help to simplify many parts of it yet it is hard to imagine how this industry can be easily disrupted.

At the first sign of trouble the place you are most likely to run to is the lawyer’s office!