An Explanation of the Use of Smart Contracts
Meme stocks, Non-Fungible Tokens (NFTs) and cryptocurrencies have dominated news outlets for much of the past two years with many news reports on the impact these phenomena have generated. The Federal Reserve has recognized the importance of these technological developments by attempting to set up a new real time payment system known as FedNow and is studying the possibility of a US dollar cryptocurrency. These developments do not seem at first to be of much concern to most lawyers, but beyond the headlines, there have been major technological developments in the legal field. An underreported major innovation that has even greater potential for legal practitioners than the above concepts is the rise of smart contracts. Smart contracts are binding legal contracts that incorporate to some degree computer code that determines if various contractual terms have been met, and if the parameters for performance of contractual terms are met, then reciprocation occurs immediately without human input. Smart contracts offer an effective way for parties to enter into a legally binding contract while keeping legal costs and time delays down. Smart contracts are particularly useful for decentralized finance (DeFi). Decentralized Finance is the concept of providing financial services on a decentralized basis to lower costs and democratize access to financial products and services. Large institutions such as banks, exchanges and central clearinghouses historically have acted as gatekeepers to financial services with restrictions on access to financial services and time delays in processing payments, such as the validation of checks. DeFi applications with smart contracts will allow real time payment for goods and services on platforms theoretically open to a much wider universe of consumers than historically was the case. Smart contracts that rely on Distributed Ledger Technology (DLT), a form of technology used by different cryptocurrencies including Bitcoin, are particularly useful for reducing the threat of fraudulent transactions, guaranteeing contract performance, and ensuring that transactions are recorded and viewable. DLT is a form of a closed network of computers that validate transactions by coming to a consensus regarding the validity of the transaction with subsequent transactions building on earlier transactions to reduce the threat of fraud and cyber hacking.
These developments raise numerous legal issues for lawyers. Smart Contracts differ in the amount and type of computer code used with certain computer languages easier to understand in terms of natural human language. Therefore, the complexity of interpreting smart contracts will vary and may involve employing expert coders to give a reasonable interpretation of the intent and effect of the computer code. Another difficulty concerns modifying smart contracts or to implementing contractual remedies, particularly for smart contracts using DLT. Since DLT networks rely on consensus to verify transactions, all subsequent transactions build on earlier transactions to prevent fraudulent transactions. However, changing or vitiating a transaction by a court order would be quite complex. Smart contracts can therefore be seen as forming part of a broad spectrum of automation where customers’ usage of important services such as debit transactions or smartphone provider services involves agreement to complex boilerplate contracts that are bilateral in theory but operate much more unilaterally in nature. An additional complication is that although smart contracts are primarily used for business-to-business payments, the extension of smart contracts to consumer parties, particularly through DeFi applications, will complicate the growing body of law in this area as many jurisdictions have greater protections for consumers entering into contracts than businesses. A further vexing question is that of jurisdiction. DLT relies on a network of computers that can be based anywhere in the world and therefore the question becomes where the smart contract was formed and what law should therefore apply. The rise of DeFi applications using smart contracts raises the possibility of a conflict of laws concerning which country has jurisdiction given the decentralized nature underpinning DLT and the number of potentially involved parties. Many different jurisdictions could justifiably claim a relevant and sufficient nexus to assert jurisdiction. This concern could be reduced by the fact that the US and many other countries are signatories to the United Nations Convention on Contracts for International Sale of Goods and could use the Convention as a template to resolve issues arising from jurisdiction concerning smart contracts, though a number of jurisdictions such as the United Kingdom are not party to the Convention.
Smart Contracts are important both as a major change in how contracts, the bread and butter of the legal profession, are performed and as a representation of the changes that automation is bringing to the legal profession. The legal profession needs to be ready for major innovations in how commerce is conducted. Some jurisdictions are even mandating basic technological literacy requirements; for instance, New York State’s Continuing Legal Education Board is considering making a cybersecurity, privacy and data protection continuing legal education credit mandatory. Therefore, legal practitioners need to be aware of how technology will impact their practice and how important technological literacy is for modern lawyers.
By Jonathan Windsor