Smart Contract: Is it the new sexy? (and what Roman Egypt has to do with it) - by Levent Aslan

After Ivona's blog about lawtrepreneurs last week, the second ehvLINC blog is here! Written by one of the new faces at ehvLINC Levent Aslan! A practical analysis of smart contracts, from the lawyers point of view. It probably is the future of contracting, but what legal and conceptual difficulties do we have to overcome to get there? Levent gives you some practical insights!

2017 has been the year for Blockchain technology. Its most famous creation, the big daddy of all cryptocurrencies, Bitcoin is breaking record after record. You can hear people sighing “only if I threw some cash at it in 2013”. Initial Coin Offerings (ICOs) are on the rise too, and no matter how risky they are people are willing to bet on them. A quick web search will show you hundreds and hundreds of articles, all dedicated to how Blockchain will change the world as we know it and in what ways this technology will disrupt every industry.

This statement sounds bold, maybe even outrageous for a technology that is only 9 years young; but come to think of it, another technology that is currently an integral part of our lives, the Holy Internet was nowhere to be found till 1990s. With that in mind, key players from different industries are digging in Blockchain to figure out new applications of it. One such application, smart contract is particularly fascinating; vowing to eliminate middleman for all kinds of transactions.

First result of the Google search “smart contract” brings you an article titled “Smart Contracts: The Blockchain Technology That Will Replace Lawyers”. As a law student, I am – as you can imagine – intrigued so to say at least. Does this mean I will be without a job, living on the streets, remembering that dreadful day when I wrote this blog? Maybe, but even with its slow rate of development, law (and lawyers) will eventually adapt to fit into this new era. Till then, let’s take a look at the smart contract and see whether it is as smart as it claims to be.

The origin for smart contract can be found almost everywhere, thanks to a highly developed (?), automated machine that has been here for over 400 years: The vending machine. First designed by the Hero of Alexandria - an engineer from Roman Egypt - vending machines act as the ledger, recording your input (money) and delivering the corresponding good (e.g. chocomel). Smart contract, on the other hand, uses a decentralised ledger (Blockchain). Stored in Blockchain as a piece of code, contract executes itself when its conditions are met.

Let’s use this example from the aforementioned article: “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 its releasing of both the fee and key until the date. 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.”

So on paper, smart contract is visible, traceable, verifiable, secure and self-executing. One may ask “Well, why don’t we start using this magnificent technology right away?”. Indeed, there are already early examples of smart contracts, however certain issues have to be resolved before smart contract becomes the norm. Contract Law definitely will have some say on this topic:

Validity of Contractual Consent

If you are not familiar with coding, a smart contract might be difficult to understand.

Ideally, a contract should be easy-to-understand for a “common person”, someone who doesn’t necessarily possess a legal or computing background. Rights and obligations arising from the contract should be clear, otherwise one party (in a cheesy Hollywood movie fashion) may say “I didn’t sign up for this!”. Validity of contractual consent depends on whether parties have a mutual understanding of essential contract terms, otherwise contract can become voidable due to invalid consent. What is meant here is not the comprehension of the entire legal mumbo-jumbo lawyers love to put in a contract, but rather the terms without which there will be no contract.

A smart contract, with its complex nature, is vulnerable from this perspective. However, smart contracting engines like Agrello and Hawk may eliminate this problem by setting a standard framework with a focus on the accessibility. Time will tell.

Identification & Capacity of the Parties

Blockchain’s main selling point is its decentralised character. There is no authority regulating, gatekeeping or checking the information within the system. In an era where the “Big Brother” is watching, this sounds perfect right? Yes and no. Authorities – even with their flaws and incompetences – do serve an important purpose: Examining the authenticity of information. Your personal/public records (ID, driving license, birth certificate etc.) ensure you are the person you claim to be.

“Let’s rent Mommy’s car out for some Bitcoin,
I need new toys”

Within Blockchain there is no such guarantee. You can never be sure about the identity or the capacity of the counter party (without aforementioned documents at least). From a Contract Law perspective, although there are some exceptions where identity of a party is irrelevant (e.g. contract between an auctioneer and a bidder), in principle parties to a contract should be properly and unambiguously identified. This rule holds extra value for contracts where identity is a fundamental element (contract with an athlete for instance).

Authentic identification is also vital in determining the legal capacity of a party. Without the necessary legal capacity (age, mental capacity, consciousness etc.) a contract is deemed to be voidable and liabilities arising from it will not be held against that party. Proving these points in a smart contract is much harder since everything is digital and parties usually do not interact with one another in real life.

Legal Definition of Smart Contract

Each legal system has a definition of “contract” and what elements it possesses. There are formal (e.g. date, being written) and material (parties’ identity, performance etc.) requirements for different types of contract. Of course, there is logic behind all this legality: Since contracts are binding and usually putting parties under certain obligations, you would want legal security and unambiguity in a contract to eliminate unwanted consequences.

With smart contract there is no certain framework on its elements. So how can one party contest the validity of a smart contract if there is no set list of its definition or requirements need to be fulfilled? Another question may rise in case where smart contract has interjurisdictional aspects (e.g. an American buying a summer house in Italy). Which jurisdiction will be applied when a dispute arises and smart contract needs to be evaluated? One may see the need of integration into local and international legal systems, however this can also affect the decentralised character of smart contract.

Liquidity Issue

As you may have noticed in the smart contract example, your payment is hold within the code until the execution date of performances. This means you lose the liquidity of your money when you sign the contract, even though you receive the return at a later date. Having multiple smart contracts of this nature will not be financially rational since it may cause illiquidity problems.

Privacy & Security of Personal Data

Contrary to popular belief, Blockchain does not offer anonymity but rather pseudonymity. All transactions are transparent, but they are not explicitly connected to real-world individuals or organisations. However, with ever improving technology there is a future possibility of identifying a contracting party from the transparent data. National governments may also demand “backdoors” to private encrypted Blockchain systems for law enforcement purposes (looking at you NSA).

Irreversible Transaction

This can be the Achilles heel. Transactions in smart contract are both immutable and irreversible, meaning once the contract is signed, it is a done-deal, there is no going back. However, a lot of things can happen between the signing and the actual execution: A party may change his mind, required performance may become impossible, aliens may invade Mother Earth… but smart contract will still execute itself. Under Contract Law there are multiple options to renegotiate or terminate the contract. Let’s use the smart contract example for a third time to understand the value of these options.

You paid for the apartment through Blockchain and your counter party immediately sent digital key. So both parties actually completed their performance, right? However, the day before the execution, a neighbouring apartment caught fire and took down your rental with it. Should you still pay for it? In a normal contract both parties would have been relieved from their performances since it is impossible for your counter party to rent his apartment. Smart contract, with its irreversible and immutable nature, will simply execute itself; transfer the money to your counter party’s account and deliver the digital key – which is worth absolutely nothing – to you.

Last Words

As a TED talker (whose name I cannot recall) once said, Blockchain can very well be the technology that will define the 21st century. But before jumping on the hype train for smart contracts, one should bear in mind the multi-layered character of a contract and how it is regulated to ensure mass enforceability. All problems mentioned here are solvable though, so in the meantime law students like me better prepare themselves for the future, otherwise we will become just another victim to automatization.

(Oh and the next time you use a vending machine, remember Hero of Alexandria, the “greatest experimenter of antiquity”. From what I read he was more or less the Elon Musk of his time)