2021: The Year of the Smart Contract – Can the Law Keep Up?

 

While recent headlines may be focused on the meteoric rise of Bitcoin, another disruptive technology derived from the famed cryptocurrency may have even more profound implications for the future: blockchain-based “smart contracts.” A wide variety of companies are already experimenting with the ability of smart contracts to automatically transfer assets among parties over secure computer networks. With their promise to increase efficiencies and reduce costs by cutting out traditional intermediaries, such as escrow agents and banks, the future of smart contracts looks bright indeed. However, a question still remains of whether the law will be able to keep up with this innovation.

As smart contracts become more commonplace, the risk of failing to enact new laws to define parties’ rights and obligations in conducting blockchain-based asset transfers grows exponentially Click to Tweet

Traditional legal frameworks, such as contract or property law, act as road maps for private parties seeking to create and enforce legal rights. However, unlike human beings’ ability to adapt quickly to dramatic innovations in technology, legal frameworks are less flexible. Our laws, and the legal rights that emanate from them, are based on hundreds of years of trial and error. While they may have been well-suited for the 20th century, smart contracts have the potential to conflate these frameworks and leave parties in a type of legal “no man’s land.”

The failure to regulate technological innovation can have disastrous effects on society. Parties must have a reasonable expectation of how the law will treat private agreements before legal disputes arise. As smart contracts become more commonplace, the risk of failing to enact new laws to define parties’ rights and obligations in conducting blockchain-based asset transfers grows exponentially. Lawmakers need to do more than merely observe this technological “trend” – they need to get ahead of it.

What is a blockchain-based “smart contract”?

Blockchain is a form of distributed ledger technology (DLT) that records transactions in electronic format using cryptographic signatures and keys and then “distributes” copies of the ledger on a decentralized, peer-to-peer network of computers. A majority of these computers, referred to as “nodes,” must approve the transaction for it to be added to the ledger. The ledger expands as it incorporates approved transactions, which are grouped into “blocks.” These blocks are then kept in order, with each new block being connected by a cryptographic algorithm, or “hash,” to the previous block. The end result is that an approved transaction cannot be altered by feasible means because the blocks are linked together in a long sequence, or “blockchain,” an exact copy of which is stored on each computer on the network.

Blockchain is a disruptive technology because it can securely record asset rights without the need for a central authority to verify the information. This is the central concept behind the decentralized finance (DeFi) movement. There is no need for an original or “master copy,” as each computer on the network can trust that its copy of the ledger matches that found on any other computer. Consensus is how the network participants can trust blockchain-based information. Because a bad actor would need to exceed the computing power of the entire network, altering or falsifying a record of a transaction is an extremely remote possibility – if not impossible. This “trustless” system allows for greater security and transparency among network participates and ensures the accuracy of the ledger.

A smart contract is a computer program that uses blockchain to document or execute the terms of an agreement. Parties can create “security tokens” on blockchain platforms that digitally represent the rights to real-world assets such as stocks, gold, real property – pretty much anything. Smart contracts can then be programmed to transfer these “tokenized” assets automatically and instantaneously upon the occurrence – or nonoccurrence – of an agreed-upon event.

Using a computer to facilitate an instantaneous transaction is nothing new. A classic example is a vending machine that automatically provides goods to the vendee in exchange for payment to the vendor. However, it wasn’t until the advent of blockchain that parties could begin to rely on the security and inalterability of electronic records necessary to transact big ticket items – think billions of dollars rather than candy bars and bubble gum.

Why are smart contracts significant?

Traditionally, parties have relied on intermediaries, such as escrow agents, banks, or governments, to ensure the performance of a contract (or that a party didn’t simply run off with your cash). Smart contracts eliminate the role of intermediaries because they are both self-executing and self-enforcing. The entire transaction is dictated by computer code alone. By cutting out the “middleman,” transaction fees are dramatically reduced, while transaction speed is dramatically increased. Parties can now make a wide variety of agreements without fear that the agreement will be dishonored.

Blockchain-based smart contracts are quickly becoming a common method of transacting #DigitalAssets Click to Tweet

Blockchain-based smart contracts are quickly becoming a common method of transacting. Since 2018, private parties have increasingly used smart contracts to tokenize assets and execute the terms of commercial loans and securities lending transactions, such as “repo” swaps of U.S. Treasury bonds. In the near future, smart contracts may be used in an even greater variety of transactions involving international trade finance, derivatives markets, mortgages, and auto leasing. With their ability to instantaneously execute and settle transactions, smart contracts have the potential to increase the liquidity of traditional credit markets, as well as creating entirely new ones in intraday lending.  The possibilities for creating new deal types and methods of transacting business are endless.

The self-enforcing feature of smart contracts may also have significant consequences for the Internet of Things. Take for instance a car lease stored on blockchain, where the financing company is entitled to automatically disable, or even seize, the vehicle if the lessee defaults on a payment. Once autonomous vehicles hit the road, one can imagine a delinquent lessee returning to the parking lot only to find his vehicle has literally driven itself back to the bank. Smart contracts may ultimately spell the end of the “repo man,” as well as a number of other professions.

How does current law treat smart contracts?

Traditional legal frameworks act as road maps for parties to create legal interests and rights when entering into an agreement. However, they are often subject to different – and sometimes conflicting – requirements. When a transaction shares the characteristics of different legal frameworks, disputes between parties can arise.

Smart contracts have the ability to capture and transfer assets from one party to another. As such, they can conflate contract law with other legal frameworks, such as property, secured transactions and entity law. For instance, contracts are typically private agreements in which the rights of third parties are unaffected. As such, the terms of a contract may be kept confidential. A smart contract, however, can put assets out of the reach of third parties that claim an interest in them. Property law has the ability to affect third parties’ rights. However, property rights require the giving of notice to be enforceable against third parties, such as by recording a deed or mortgage at the county clerk’s office.

How does current law treat smart contracts? #blockchain #digitalassets Click to Tweet

A smart contract may also share the characteristics of a secured transaction governed by Article 9 of the Uniform Commercial Code (UCC). Imagine a smart contract where a creditor extends a loan to a debtor and takes as collateral a “secured interest” in the debtor’s personal property, such as a vehicle, patent or valuable artwork. This same smart contract may also contain a self-enforcing protocol that uses blockchain to automatically capture and transfer the collateral to the creditor if the debtor fails to repay the loan on a certain date. In this scenario, the creditor would engage in a sort of “digital self-help” by seizing the collateral without court intervention, similar to the rights of a secured creditor under UCC Article 9. As with property law, a creditor must provide notice to others by filing a financing statement with a state office to “perfect” its security interest. However, unlike property law, which typically allows one to abandon or even destroy owned property, a secured creditor is required to dispose of the collateral in a “commercially reasonable manner,” such as be selling it for value at public auction.

Smart contracts could also provide protections only available under entity law. Unlike a security interest, which prioritizes competing claims between creditors, entity law can completely shield assets from creditors’ claims. By incorporating and respecting corporate formalities, business assets of a corporation are placed beyond the reach of the creditors of the corporation’s owners. This ability is unique to entity law, and arguably its most important feature. However, a smart contract may have the same effect without requiring incorporation.

Given the overlap of these legal frameworks, smart contracts may be prone to litigation. Disputes over the nature of an agreement are not uncommon. Our courts are inundated with lawsuits requiring judges to decipher the “true” intentions of parties and enforce contractual obligations. What makes smart contracts problematic from a legal standpoint is that parties agree beforehand to both the execution and enforcement of the agreement using nothing more than computer code. If a dispute arises, there may be no way for a party to seek court intervention to resolve the dispute before the assets have changed hands. As a result, a court may be left in the more challenging position of trying to undo enforcement of the agreement.

Why is regulation necessary?

History has shown that a failure to regulate technological innovation that affects traditional legal frameworks can create systemic risks to the legal system. One needs only to look back to the global financial crisis of 2007-2008 to find an example.

During the early 2000s, the mortgage-backed securities market grew exponentially as large financial institutions bundled and sold millions of mortgages to investors. The industry relied heavily on the Mortgage Electronic Registration System (MERS), an electronic database for mortgages, servicing rights and ownership interests, which promised to reduce costs and increase efficiencies. When homeowners began defaulting in record numbers, mortgage investors sought to exercise their foreclosure rights under the mortgages. However, in many instances, courts delayed or even denied enforcement of these rights when MERS records made it difficult to decipher who owned the rights to a mortgage. The majority of these problems were eventually resolved, but not until after costly and time-consuming litigation. By then, the real estate market had crashed and billions of dollars in asset value were lost.

As smart contracts become more commonplace, parties must have confidence that they are creating intended legal interests and rights. As such, new regulations must be enacted to account for how blockchain and tokenization intersect with traditional legal frameworks – or perhaps create new ones. This process has already begun at the state level, where states like Arizona and Tennessee have enacted laws to define smart contracts and recognize electronic signatures secured by blockchain technology as valid and enforceable. Wyoming has gone even further, amending its state commercial code to specifically define and classify digital assets, and to establish requirements for the perfection of a security interest in a tokenized asset. However, these states remain the exception, not the rule.

Blockchain-based smart contracts have the potential to revolutionize business transactions and open the door to entirely new markets. But regulatory adoption cannot be outpaced by technological innovation. Much more is needed from lawmakers, including those at the federal level. Otherwise, the term “disruptive technology” may take on a whole new meaning.


 

 

Steven Knipfelberg is an associate in the New Jersey office of Duane Morris LLP. He focuses his practice on complex commercial and business litigation and secured creditor litigation, with an emphasis on representing national and regional financial institutions. He is experienced in loan default actions, real and personal property foreclosures, defending consumer claims including FDCPA, TILA, consumer fraud and other federal and state consumer claims, and judgment enforcement in New Jersey and New York.

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