Blockchain and The Legal Sector: Smart Contracts
Introduction
As legal technology continues to permeate the legal sector, blockchain technology has emerged as one of the new innovations supporting the streamlining and enhancement of legal services. There is an array of practice areas in the legal sector where blockchain has the potential to be a transformative force. In this article, we explore the use of blockchain through smart contracts.
Smart Contracts
A smart contract is a computer protocol designed to digitally facilitate the negotiation or performance of a contract. The fundamental principle behind it is the idea that credible transactions can be executed without direct oversight of a third party. A smart contract takes the form of computer code written on Distributed Ledger Technology which is programmed to execute a particular set of actions upon completion of a given criteria. An example of a smart contract in its simplest form is the vending machine, which is programmed to transfer the ownership of a particular good (e.g. chocolate bar) to an individual in exchange for a sum of money. Through physical sealing of the chocolate bar, the vending machine has control over the “property” and can thus enforce the “contract”. “Property” is transferred to any individual with sufficient money who engages in a transaction with it.
A smart contract is thus autonomous and self-sufficient given that it executes the contract from end to end by itself. To better illustrate this aspect of smart contracts, we consider the situation where an individual rents an apartment from a landlord. The individual can engage in this transaction by paying in cryptocurrency. Thereafter, the individual receives a receipt stored in the virtual contract. The landlord gives the digital entry key to the individual by a given time and date, failing which, the blockchain automatically releases a refund. If the landlord sends the digital entry key before the specified rental date, it is withheld by the code, only to be released together with the rental fee when the specified rental date arrives. The smart contract is thus founded on the If-Then premise:
- If the individual sends the requisite amount in cryptocurrency, then he or she will receive the digital entry key (or at least receive a refund).
- If the landlord sends the digital entry key, then he or she will receive the rental fee.
At the crux of it, smart contracts allow individuals and organisations to circumvent the issue of trust, or the lack thereof inherent to transactions. Traditionally, intermediaries are engaged to enable distrusting parties to contract safely. Individuals and organisations employ brokers or agents to represent and protect their interest in any given transaction or contract. With smart contracts, however, the need for many of these intermediary services are negated. The blockchain itself assumes the role of the trusted third party and in theory, is able to serve as mediator where conflicts arise.
Hybrid Models
Nevertheless, the adoption of self-executing smart contracts is not without its challenges. For simpler contract types — contracts with well-defined provisions, limited variation and more generally characterised by the reduced need for intermediation, the application of smart contracts can occur without great difficulties. However, as the adage goes: *the devil is in the details”. Indeed, for more complex contracts, the application of smart contracts is much less straightforward. It is within this context that the concept of hybrid smart contract models also dubbed as “smarter contracts” have been developed. The hybrid model is an extension of the purist model of smart contracts which allows for human intervention. In a hybrid model, individual key elements of a given complex contract are transformed into data points which feed into smart contract mechanisms with broader consequences beyond simple transactions such as payment. For example, the input recorded at these smart contract data points, instead of outputting a decision pertaining to a particular clause or provision of a contract, could instead trigger a message to an external third party to make a decision. Hybrid models thus retain the role of humans in the execution of a contract. The difference between pure play smart contracts and hybrid models of smart contracts is well represented through the analogy of fully autonomous cars and semi-autonomous cars. While the former renders the role of a human driver obsolete, the latter still relies on human judgement, requiring the human driver to assume control at certain key moments.
The adoption of such hybrid models for more complex contract segments has proliferated in recent years. For example, various blockchain-based Flight Delay Insurance products have been developed by companies including AXA, Chubb and Ergo, each with a set of boilerplate General Conditions in natural language which has precedence over the automated smart contract mechanisms. This set up the facilitates off-chain appeals, allowing the insured to recover off-ledger through the General Conditions.
Real World Examples
The leading blockchain-based smart contract platform is Ethereum, which runs more than 2700 smart contracts. Ethereum has been largely successful as It has the second largest market share amongst all cryptocurrencies and large corporations such as Microsoft and Amazon Web Services offer Ethereum based services. The main challenge Ethereum faces is that of scalability; Ethereum’s core development team is working to change the consensus method powering the network from proof-of-work to proof-of-stake in order to tackle this. The transition to the latter consensus mechanism has however drawn criticism for its compromise on security, which Ethereum co-founder Vitalik Buterin has described as a fair trade-off for improved scalability. Besides Ethereum, there are various other blockchain-based smart contract platforms available. Dubbed as the “Chinese Ethereum”, NEO is very similar to Ethereum in terms of its functions but crucially differs in terms of the consensus mechanism it deploys. NEO uses dBFT (decentralized Byzantium Fault Tolerant) which is much more efficient than the proof-of-work mechanism used by Ethereum, thus allowing the NEO platform to support a significantly larger volume of transactions per second.
Practicality
As smart contracts continue to make inroads into various areas of legal practice, debate on whether lawyers will eventually be replaced by this technology has heated up. To argue that smart contracts will render lawyers obsolete is however premature. As alluded to previously in the discussion on hybrid models, smart contracts suffer from the “Oracle Problem”; It is neither possible nor desirable for human reasoning to be completely eliminated from the equation.
A smart contract is by definition, a long-form natural language contract translated into executable code. Crucially, the need to determine the legally binding principles relevant to the transaction at hand remains and this is precisely what lawyers are trained and hired to do. The ability to state things in punctilious terms and to anticipate potential counter-arguments are key components of a lawyer’s work. While smart contracts seek to automate the enforcement of traditional contracts, the technology by itself will not be able to serve as a substitute to the human judgement and reasoning provided by lawyers at the contract drafting stage.
Segueing into the issue of custom contract drafting, the drafting of contracts for simple routine legal transactions is often not the principal focus of a lawyer’s job scope. Rather, highly customised contract drafting accounts for the more significant portion of their job scope. As discussed earlier, the application of smart contracts is more likely to take off where transactions are of a more default or customary nature. In practice, however, a large proportion of the transactions for which professional legal advice and service are required are of a highly specific nature. For example, founder and partner relationships in business are highly unique. The drafting of an agreement between the two parties will require an intimate contextual understanding of the business; It would be foolish to assume that a one-size-fits-all template founder-partner agreement would be appropriate for all businesses.
Along the same vein, it will be a great challenge attempting to code the inherent subjective determinations embedded in legal contracts. Beyond the role of contracts in ensuring the legal enforceability of obligations between multiple parties, contracts more broadly speaking regulate the relationship between multiple parties. These relationships are often not static, they evolve over time and contracts are often designed in a manner so as to accommodate such changes. It is herein where the subjective determinations of traditional contracts such as “reasonableness” provide this degree of flexibility. With smart contracts, however, incorporating such nuances and subtleties will definitely pose a challenge, especially considering that they are structurally built on the If-Then premise.
Future
As with various other revolutionary technologies and their impact on traditional professions, the potential for Distributed Ledger Technology (DLT) to transform the legal profession should not be viewed binarily as a matter of whether lawyers will be replaced or not. As the word transform suggests, a more pertinent question to ask would be how the job scope of a lawyer will evolve with this technology. Ultimately, Smart contracts would primarily reduce the amount of human administration but not necessarily the amount of human oversight or judgment required to protect parties engaging in a transaction. As DLT develops, the number of use cases for smart contracts in the legal industry will multiply. Thus, it will become increasingly difficult for law firms to remain relevant and competitive if they fail to leverage this technology. What would this mean for the lawyers of tomorrow? It may seem a stretch to expect all lawyers of the future to code well enough to convert traditional contracts into executable codes. Would IT departments become more prominent within law firms as a result? It is often difficult to fathom the impact revolutionary technologies may deliver without thinking in exponential terms. While we may not have definitive answers to these questions, moving forward we can expect lawyers and programmers to share a more symbiotic working relationship as blockchain technology continues to reshape the legal industry’s landscape.
