Live Contracts — Bringing Justice through Blockchain

In the past two decades we have seen computer power revolutionize virtually every aspect of the world as we knew it. While almost all business sectors have benefitted from this, the legal sector has remained largely untouched. It is, in fact, astonishing to see how small the impact of technology has been on the legal sector, especially when compared to for example the neighbouring financial sector. Technological advancements haven’t even made a ripple in the quiet pond of western legal practice.

Yes, we’ve seen the introduction of computer assisted document assembly and AI driven search of contracts and clause recognition, but that’s still trying to make a horse run faster rather than inventing a better mode of transportation. With the introduction of Ethereum’s Smart Contracts a first solution for computable contracting was introduced. However, the effect of Smart Contracts on the legal sector remains negatable. In its quest for full automation of contracts, Ethereum failed to address some practical but very important drawbacks.

With our Live Contracts platform we took a different approach. As a lean startup we skipped the theoretical debate and moved straight towards applying the ideas in practice. Our solution proposes to automate any agreement or law in a way that is understandable for both people and computers.

The importance of contracts and law

The principal function of both laws and contracts is to provide certainty where there is an absence of trust. In order for both to function properly, any participant in the system must be confident that a given rule (law or contract) can be enforced.

Both law and contract formalise a set of rules and apply those rules to a number of participants. In this respect a contract and a law are the same. The difference lies in the range of applicability of the rules: a number of contracting parties or the residents of a whole country.

For ages we have been working with natural language to formalise these rules. This is not without reason. An important feature of natural language rules is its capacity to cover real world scenarios that have not, or could have not, been conceived beforehand. This allows contractual parties or citizens subject to a law to interact with each other knowing that any situation that might arise will be dealt with in an equitable manner. These participants neither have to agree to an extremely complex set of rules beforehand nor do they have to rely on such a thing as “trust”.

But natural language agreements have their limitations.

Limitations of natural language agreements

An inherent aspect of natural language is its ambiguity. There are areas in which this serves an important purpose (e.g. poetry, literature, humor) but in a legal perspective ambiguity forms a serious problem. Linguistics may offer a tool to derail a well intended rule. As a result, the enforcement of rules is less concerned with the idea behind it and more with the way in which they are formulated.

Take for example the 2006 contract dispute between Canadian companies, Rogers Communications and Bell Aliant. The contract stated: “This agreement shall be effective from the date it is made and shall continue in force for a period of five (5) years from the date it is made, and thereafter for successive five (5) year terms, unless and until terminated by one year prior notice in writing by either party.”

Rogers intended the contract to run for five years and automatically renew for another five years. The contract would not renew if Bell Aliant or Rogers cancelled with a 12 month notice. However because of the way the sentence was formulated, Bell Aliant argued they could terminate the contract at any time, even after just one year. This resulted in a court case which was based purely on the linguistic meaning of a comma. The case was won by Bell Aliant by citing the rules of punctuation.

Hence, rules codified in a natural language can easily be exploited or misused purely based on linguistics. Because interpretation is necessary, legalising any agreement calls for slow, tortuous reading that needs a constant check and recheck of definitions, cross-references and exceptions. Lawyer brains, the computational mechanism of traditional contract interpretation, are expensive and subject to cognitive limitations.

Smart Contracts are also defined in an expressive language, making them equally prone to this problem. A small error like the misplacement of a comma or bracket, may lead to the contract as a whole being exploited. This means that Smart Contracts also require slow, tortuous reading by someone that both understands the language and implication of each rule.

Enabling computable contracting and law through Live Contracts

Since the beginning of the millennium various companies started working on contract automation, clause recognition and machine intelligence to process contracts. The results of these approaches have been very limited since significant effort has been put in understanding natural language and finding a way to apply that to an unspecified situation. To do this accurately would require an artificial general intelligence.

With Live Contracts, LegalThings moved away from natural language and makes it possible to model agreements in such a way that they are easily understandable for both computers and humans. Breaking down an agreement or law in these understandable pieces has the added benefit that some parts (those considered simple and safe enough) can be executed by computers that have no or very basic AI. Other parts can be left to human interpretation.

We are doing this by modelling laws and contracts as deterministic finite state machines (FSM), a cornerstone in the field of automata theory. Organisations like NASA use FSM models to render highly complex systems more comprehensibly, such as for example the system used to launch a space shuttle.

The FSM has less computational power than other models of computation such as the Turing machine. This makes them easy to understand for humans and far less prone to errors, which highly reduces the risk of intentional or unintentional exploits caused by linguistics. This has been proven in the 2015 dissertation of Mark D. Flood and Oliver R. Goodenough.

A trail of proof

The intention of any agreement is that all parties will uphold the rules it defines. However, in reality this is often not the case. To address this, agreements need to have a contingency plan. This may be insufficient to actually uphold the rules.

As discussed, the rules of any contract or law are often intentionally ambiguous so as to cover unforeseen scenarios. This leaves room for parties to disagree about how the agreement should apply to the current situation. In such cases, an arbiter is required to make a decision.

Before the arbiter can make a decision, he needs to make up his mind about the course of events and all facts relevant to the case. To do so, all parties present a version of the course of events and facts and provide evidence to support their version.

As they want to highlight their point of view, the presentation of each party is highly biased. It is the difficult task of the arbiter to take these biased and often conflicting stories and construct a coherent and unbiased view of the past. This is a task the arbiter is performing beside his work in deciding how to apply the agreement to the given situation.

Live Contracts remove the need for an arbiter to construct an unbiased picture of the course of events and facts, so he can focus all his attention on his verdict. This is due to the fact that, in order for a live contract to work, all events must be logged on the blockchain. The immutable nature of the blockchain makes it impossible to backdate, forge or hide events, leaving the arbiter a simple view of what actually happened.

This means that in case of a dispute, the arbiter is always presented with an unbiased and complete view of the past and only requires to make a decision about the disputed interpretation of the agreement.

Mitigating fraud through the blockchain

Societies that frown upon fraud and nepotism, place a high value on documented proof. The general consensus is, the bigger the paper trail the harder it is to falsify and the more people are involved, the less nepotism can occur. Additionally, it is unknown in advance which cases are going to be presented to an arbiter. Therefore, paperwork for all cases need to be created and maintained. Keeping a paper trail not only makes it harder to falsify proof, but also functions as proof of work. This concept is what we call “bureaucracy”.

Bureaucracy is intentionally and purposely inefficient. An efficient system would negate the important properties of bureaucracy and likely give rise to nepotism and fraud. Similarly, the blockchain features an immutable paper trail and proof of work. It can be used to replace bureaucracy and thereby pave the way for a more efficient system, without compromising the protection bureaucracy offers.

Example Labour agreement

In an FSM any arrangement, rule, or law is represented by a set of states. You may visualize this as a flowchart. The FSM describes all the possible states and transitions between them. A labour contract consists of several clauses, like salary, non-compete clause or vacation days, each presented by their own FSM. Upon signing such a contract, it becomes ‘live’ and all FMSs are set to an initial state. Any action done by one of the parties may trigger a state change.

Let’s use the non-compete clause as an example. It states that the employee is not allowed to work for a competitor or start a business competing with the employer. If this clause is broken, the employee is subjected to a $10,000 fine. An employer and employee have signed the labour contract. At some point, the employee chooses to leave the company. While most parts of the contract end (e.g. salary payment) the non-compete clause remains active until 2 years after the end of the employment relationship and therefore remains ‘live’.

In our example, the employee starts a new company. At first, this new company seems to offer different services than the employer’s. After a while, however, the employer notes that a striking amount of his customers switch to the former employee’s new business. This is because the former employee’s new business, in effect, has started to offer the exact same services as the employer against a better price. The employer therefore believes the non-compete clause has been violated. He initiates a state change by committing this event to the blockchain.

Fig. 1 representation of a non-compete clause in a Live Contract as a flowchart

Various automated actions are activated by this state change, such as the summoning of the former employee to cease his violation or an instruction to the IT department to secure the telephone and laptop of the former employee for further investigation. Also, the former employee is given the option to confess, in which case the fine is immediately due. Alternatively the employer may cancel the procedure. In both cases, there was no dispute, so lawyers didn’t need to be involved.

The employee may also choose to dispute the breach. This will change the state of the non-compete clause to “conflict”, which must be settled by judges and lawyers.

Why can’t Smart Contracts solve this?

In order for a Smart Contract to function, you need to first place something under its control. For example money or an ownership title. A Smart Contract can only make decisions regarding assets it controls. A Smart Contract that controls nothing can be ignored by any party.

The responsibility for those assets lie with the Smart Contract itself and not with the parties involved. Legally this means that the assets are kept in escrow and are no longer available to parties until the Smart Contract is executed.

This seems like a sensible way in which to ensure adherence to the contract for both parties, but in reality it is usually very impractical. Consider the previous example of the non-compete clause, where a $10,000 penalty is due for each violation.

Fig. 2 A non-compete clause in a Smart Contract

When using a Smart Contract, the employee must immediately deposit 30 Ether (roughly $10,000) upon acceptance of the contract. An average non-compete clause lasts until 2 years after termination of the employment contract, which would mean that the employee has to wait for 2 years before he gets back his down payment. Without interest.

Without the deposit, the employer would need to obtain the $10,000 fine by other means. In this case, the Smart Contract would only hold the state, but doesn’t help any party in presenting the case and providing proof in order to enforce it. It has become pointless.

Conclusion: Live Contracts close the gap with reality

The above-mentioned features of Live Contracts provide immediate usability in today’s world without requiring legislation to be modified or existing systems to be replaced. Smart Contracts were a first start to replace old paper contracts but they will never reach this status. With Live Contracts we close the gap between the certainty of the blockchain and the reality of the millions of contracts created each day.

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