Smart Contracts Can't Escape Contract Law

For a primer on Blockchain Technology and Smart Contracts take a look at my previous entry "The Future is Looking a Little Smarter with Smart Contracts."

Edited by Brett Williams

Smart Contracts, backed by the decentralized power of blockchain technology, have amazing potential to revolutionize our economy. Beyond streamlining the contracting process, they also promise to democratize it.

Traditionally third-party institutions like insurance companies, banks, or the governments provide the “oil” by which the modern economic engine runs smoothly. Only through these institutions could you get the security and assurances necessary to incentivize people to take business and financial risk. The downside to these institutions was their size and centralized nature made doing business costly, not just in fees and bureaucratic red tape, but costs associated with corruption and exploitation. Smart contract technology threatens to upend that, cutting out the middleman with the mechanical automation of the blockchain, and thereby reducing the cost of doing business.

But some experts have gone so far as to declare that smart contracts may exist outside or totally replace the institution of contract law. Legal scholars are debating where exactly smart contracts and contract law intersect. On a philosophical level questions such as “What is a contract?” and “What constitutes an agreement?” are important to determine how the law changes with new technology. Unfortunately this line of thinking isn’t conducive to a practical application of the law and new technology. While taking smart contracts out of the courts and decentralizing the power to enforce them in the blockchain is a laudable goal philosophically, it isn’t realistic or desirable.

Vulnerabilities in Smart Contracts

In 2016 an innovative group of developers created the decentralized autonomous organization (DAO) on the Etherium (ETH) blockchain. Their vision was revolutionary: a stateless venture capital fund without a conventional management structure or board of directors completely funded by a record breaking crowdfunding campaign totaling over ETH 10.7 million ($120 Million). Essentially the company would run, according to its code, a series of smart contracts between its members on the blockchain which would automate everything from corporate voting to wallet transfers.

Within a few months the DAO was “attacked” by enterprising users who discovered significant vulnerabilities in the code. This user was able to sequester around ETH 3.6 million ($50 million) of the fund. Because of the static nature of the code there was no way to remedy the situation without resorting to a full hard-fork which would split off from the original blockchain and create a totally new one.

The proposed fork split the Etherium community ideologically. Proponents of the fork were worried about the public perception of cryptocurrency and smart contracts after the perceived theft of such a massive amount of wealth. Opponents to the fork argued that the “Code is Law” and that all executions and transactions on the blockchain were “final and immutable.” Their concern was that, by voting to hard fork the Etherium community was essentially validating an invalid transaction (moving the money from the sequestered account back into the accounts of the DAO members). While this may be an overly idealistic viewpoint, the argument has merit. Blockchain technology promises an immutable and decentralized ledger; it is not supposed to be edited at the whim of the mob. Besides, who in the community would be the arbiter of which on-chain code executions were thefts and which were valid? Despite these concerns the hard fork was approved, although only by 85% of the Etherium miners. This fork resulted in a split between Etherium and what we now know as “Etherium Classic” (ETC) which is still maintained and supported by those who believed the “code is law.”

What is important to note is that according to the programming the “attack” wasn’t an error or a theft. It was a valid action according to the code on the blockchain. This highlights the most glaring and problematic flaw with smart contracts: their autonomous and mechanical nature lacks the intelligence and agility to identify and resolve errors or conflicts in a reasonable manner. Computers lack the ability to understand the meaning behind the code– they cannot decipher between what the parties intended and what the code directs. In essence, computers cannot differentiate between a theft and a valid transaction. Under the DAO no one intended that a member could steal funds from other members, but the code allowed it.

The question remains: If the DAO not been such a public enterprise, would the Etherium community agreed to a hard fork? Maybe not. Going forward it is impractical to believe that every time a smart contract is exploited in a non-ethical manner the community will agree to such drastic remedies, nor would that type of mob-mentality reaction be beneficial to the perception of blockchain technology in general. Unfortunately, the very characteristics of smart contracts that make them a valuable financial tool (autonomous, mechanical, decentralized) create the vulnerabilities that undermine that value (exploitable, immutable, perfunctory).

Remedy in Contract Law

The exploitation of the DAO contracts presents an interesting line of questions concerning enforceability: do we enforce the written code, the intent of the contracting parties, or something in between? Smart contracts are executed according to their code, but their mechanical nature leaves a lot of unanswered questions. What if a smart contract executes, but the results do not reflect the intention of the parties? What if the code contains an error or an exploit by accident? What if the exploit was put there on purpose by one party without the knowledge of the other? Fortunately, a lot of these question have been considered and answered before – in contract law. Unfortunately, the answers are, as with most legal answers, “it depends.”

The institution of contract law combines legal philosophy, ethics, and economic reality into a codified set of rules. The law is rigid in its application, but flexible in its content. Contracting parties are able to include a number of clauses in their contract that describe the agreement between them. For example, clauses can deal with what terms are to be enforced (merger and integration), determine the laws and the court that will govern the agreement (law and forum), or even spell out the exact penalties for breaching the contract (liquidated damages). In the event of a breach the court considers every contract on a case-by-case basis. Courts weigh a number of factors including its form (oral or written), the offer, the intent of the parties (“meeting of the minds”), the manner and content of acceptance, the consideration (the benefit/reason for entering into the contract), the party’s capacity to contract, and the legality of the contract’s objective.

Despite what some experts may claim, legal oversight of smart contracts is desirable, not only for increasing the effectiveness of smart contracts, but transforming them into a more viable tool for commercial contracting. The law balances justice and fairness, treating each contract differently, but with the intention of upholding a tradition of stare decisis (previous precedent). The result is a system that gives contracting its economic value: fairness and consistency. This fairness and consistency is valuable to society, and is why contracting is the prevalent form of enforceable agreement in our economy. When you provide fairness and consistency of result you limit the amount of contingencies that must be planned for and you reduce the costs of doing business.

Ultimately, despite the insistence of some developers to push smart contracts outside the oversight of the law, they may have no choice in the matter. A party that has suffered damages because of a contract, whether smart or otherwise, may have no other choice but to seek remedy in the law. In reality it’s a legal catch-22: any enforceable agreement is a contract under the law, and any agreement that isn’t a valid contract isn’t enforceable. No matter how many times you say “our agreement isn’t a contract” during the contracting process, if the agreement has the form and substance of a contract the courts will enforce it. The developers of smart contract technology would be fighting an uphill battle and may be hindering the popular implementation of blockchain technology as an economic tool if their ideological viewpoint that smart contracts should operate outside the law influenced their projects. Until the point where the programming language is infallible and so universal as to avert any future conflict, there just isn’t a reasonable justification to do so.

Smart Contracting under the Law

Whether by choice, or by force of law, smart contract technology cannot escape legal oversight, but that is not necessarily a bad thing.  As described above legal oversight provides security and consistency of outcome, two important concepts that promise to make smart contracting a popular financial tool.  The important question now is how do developers working with blockchain technology continue to innovate but with an eye towards a product that meets the basic legal requirements.

The first conversation I have with any developer in smart contract technology involves a reference to LegalZoom. This is because, despite the amount of good work LegalZoom does to democratize the practice of law, it has been the target of many state bar complaints and investigations for the “Unlicensed Practice of Law.” In almost all jurisdictions it is a punishable offense to practice law without being licensed to do so in that jurisdiction. That goes for lawyers who are licensed in one state, but practice in another and non-attorneys who provide legal representation or advice.

LegalZoom carefully treads the line between “practicing law” and providing a legal document service with ample disclaimers and well thought-out data input systems. As a result they have beaten or settled many of the complaints filed against them. Other such legal services have not been so lucky and the penalties can be pretty stiff. These laws differ from state to state, which means what constitutes the Unlicensed Practice of Law in one state may not constitute such an offense in another. If you are not a not a properly licensed lawyer it is important that you fully understand the laws in your jurisdiction to avoid costly complaints.

This discussion is important because there are at least two hypothetical uses of smart contract technology. The first will be for everyday contracting of simple economic transactions– a simple bill-of-sale. This type of transaction doesn’t require the sophisticated protections of a major business deal, but may still benefit from the transactional security of an automatic economic transfer. These kind of transactions could be accomplished through a “fill-in-the-blank” style service/app (akin to LegalZoom style services), but only with the appropriate legal disclaimers. The second usage will be for large scale business contracts or supply side transactions (think: internet of things) that will benefit from the automatic transfer of funds, but still require the complicated contract terms of a traditional written contract. These contracts will almost certainly have to be reviewed and drafted in part by an attorney and so a service/app without sufficient attorney input may be illegal and unethical.

The second conversation I have with the developer will usually concern what their technology does and what the contract will look like “on paper.” Looking forward, the practical “writing” of smart contracts within the institution of contract law may be simple and the only limit would be the technology utilized. In order to draft a more complicated smart contract that implements some of the protections described above, two discussions need to take place: first, what constitutes the terms of a smart contract, and second how do we memorialize that language in a sufficient and legal manner?

The code of the smart contract is the most important part of the smart contract and under contemporary programming technology it is possible to leave comments in the code language. Hypothetically an attorney/programmer team could write the automatically executing portions of the code and then write in the necessary contract terms either in between the lines of related code, or segregated to a comment section. An attorney could include a digital signature line, a merger and integration clause, along with a clause reflecting the intent of the parties to the contract. There is no reason that such code in its entirety, whether printed out or accessed from the blockchain, cannot constitute the whole agreement and subsequently accepted as a contract in the court of law.

Every situation is different, and as this technology evolves, so will the law. Anyone interested in utilizing smart contract technology should consider these two conversations as a starting point for their product.  Once you have a basic understanding of what you are building and where it is going you need to contact an attorney for a more in depth conversation.

This article is not intended to be legal or trading advice and is for informational purposes only. If you would like to discuss this or any other topic further feel free to comment or message me.