discussion

Volume 37 • Number 10 • October 2018 Banking & Financial Services Policy Report • 5

“Smart Contracts” Are Neither Smart Nor Contracts. Discuss. Judah A. Druck

Hiram Walker has a problem. As a breeder of Angus cattle, he has agreed to purchase a barren cow named Rose 2d of Aberlone for the discounted price of five and a half cents—an absolute steal. But the seller, a farmer named Theodore Sherwood, has reneged on the deal, having discovered that sweet Rose is far from barren, and actually pregnant. Luckily, Hiram is a big proponent of blockchain technology, and need not worry about a failure to deliver. The par- ties’ “smart contract,” listed on a public ledger for all to see, requires that Sherwood tender delivery of the cow within 30 days of agreement, at which time he will automatically receive his five and a half cents worth of bitcoin, or pay a cancelation fee to Hiram adequately compensating him for the breach. Thus, Hiram sits back and relaxes, knowing that he will walk away fully compensated even if that charlatan Sherwood breaches their contract.

Unfortunately for law students, the blockchain did not exist at the time of Sherwood v. Walker,1 a staple of every first-year Contracts course. Instead, the court allowed the recession of the parties’ contract under the doctrine of mutual mistake, thereby leaving Hiram without the great deal he had expected (and argu- ably deserved). The practical lesson, we are taught, is that effective contract formation requires careful due diligence, precise language, and ample contingency planning.

All of these things, of course, require lawyers. But the involvement of lawyers invariably raises costs, increases transactional complexity, and frequently delays ostensibly straightforward agreements. Wouldn’t smart contracts—written on distributed ledgers, with clear, irreversible terms, and automatic execution—remove these needless inefficiencies?

Blockchain proponents seem to think so. A Google search for “smart contract” and “lawyers,” for example, brings up such headlines as “Smart Contracts Are Taking Over Functions of Lawyers,”2 “Smart Contracts: The Blockchain Technology That Will Replace Lawyers,”3 and—with a not-so-subtle hint of optimism—“Hello Blockchain . . . Goodbye Lawyers?”4 State law has similarly begun to recognize the potential impact of the blockchain revolution, with both Arizona5 and Tennessee6 passing legislation recognizing the enforce- ability of smart contracts. Investors have taken notice as well: even after the epic rise and fall of cryptocurrency prices in 2017—led by bitcoin, whose value which peaked at $19,000 and now hovers around $7,000—the prospect of disrupting global industries through smart contracts and other blockchain technology remains the darling of financiers, venture capitalists, and the larger crypto community. A recent special report from The Economist, for example, noted that more than $1.3 bil- lion was invested in blockchain startups during the first half of 2018 alone.7

But can this technology, and its promises of greater economical approaches to contracting, actually deliver? This article assesses the current state of smart contracts, including their usefulness in performing the tasks of lawyers, and limitations in being able to fully disrupt the legal industry. Ultimately, as when discussing any new technology, predicting long-term effects would be fool- hardy, though this article concludes that smart contracts (in their current form) provide few practical benefits, and will do little to remove lawyers from anything but the simplest of transactions.

The Blockchain Smart contracts are predicated on the blockchain,

which in turn was, at least for a time, predicated on cryp- tocurrencies. Cryptocurrencies are digital assets that act like regular currencies—they can be purchased, traded, and exchanged. Rather than relying on bank or gov- ernment control, however, cryptocurrencies are wholly decentralized, allowing anyone to easily transfer funds

Judah Druck, an Associate at Maslon LLP in Minneapolis, MN, represents clients in complex commercial disputes, including tort and product liability, breach of contract, and noncompete and trade secret litigation.

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with few restrictions. Oversight exists solely by virtue of transactions being publicly listed, utilizing a public, uni- versal ledger—the aforementioned blockchain. Before a transaction can occur, it must be verified to ensure that the transfer is valid, which includes confirmation that the funds (say, bitcoins) being transferred are not duplicates or counterfeit. Once the transaction is veri- fied, its details (including source, destination, and date/ time) form a “block,” which is added to the ever-ex- panding blockchain. This process repeats itself each time a transaction takes place.

The need to put one’s trust as a distributed ledger assures its trustworthiness. Any attempt to change trans- action records or edit the underlying code would be futile, as millions of users, each with their own copy of the blockchain, would quickly spot inconsistencies and discard them. Complete transparency and multi-party verification remove (at least theoretically) the concerns typically associated with any financial transaction, and in doing so eliminate the need to put ones trust in a neutral central authority to regulate the marketplace. Unsurprisingly, while blockchain technology was ini- tially unitized solely for facilitating cryptocurrency exchanges, its usefulness and continued development has enabled it to branch out into other industries, with different variations and mechanisms tailored to assure trustless authentication.

Smart Contracts If the blockchain’s decentralization can assure trust-

worthiness in financial transactions, then why wouldn’t it be able to do the same in all transactions, including for goods and services? That was the thinking of Nick Szabo, a computer scientist and cryptographer (and the rumored inventor of bitcoin), who in 1996 theo- rized that “many kinds of contractual clauses . . . can be embedded in the hardware and software we deal with,” and that what he called a “smart contract” could be “far more functional than their inanimate paper-based ancestors.”8 Since then, and particularly in the wake of the aforementioned cryptocurrency craze of 2017, commentators and crypto-enthusiasts have built on Szabo’s thinking, predicting that these digital contracts would soon disrupt industries ranging from healthcare to real estate to governmental voting systems.

So how do they work? Consider the oft-repeated example provided by Szabo himself: a vending machine,

whereby you deposit your currency into the machine, you “execute” the arrangement by making the selec- tion, and the product drops out. There is no concern about the trustworthiness of either party: if you with- held your funds, the machine would not respond and, conversely, your money would be returned to you if your selection was not delivered. The “contract” with the machine is executed automatically, without any intermediaries needed. Smart contracts work the same way, where two or more parties agreed to certain con- ditions—pay a dollar, get a soda—that are memorial- ized on the blockchain, free of tampering and subject to uninterrupted enforcement. When the trigger- ing event occurs—depositing the dollar into a digital escrow account—the blockchain automatically exe- cutes the corresponding action—delivery of soda—at which time the dollar is released. Again, trustworthi- ness is irrelevant, as no third-party observers, arbiters, or enforcers are necessary to execute the conditions of the contract, which occur automatically. If the soda is not delivered on the date specified, then the dollar is returned, along with whatever other penalties the par- ties agreed to insert into the smart contract. Lawyers need not apply.

These hypothetical scenarios illustrate the benefits of smart contracts: they remove dependence on interme- diaries, thereby cutting costs, time, and increasing effi- ciency; they remove the trustworthiness of the opposite party from the equation; they assure complete trans- parency and security, as the blockchain’s public listing removes the fear of theft, misappropriation, or tamper- ing; and they make the entire contractual process move quickly (if not instantaneously), without need to wait for third-parties to chime in, confirm terms, or assure compliance.

The Benefits of Smart Contracts The implications of this crypto-arrangement, so

the lore goes, are wide-ranging. Real-estate provides an obvious example of the potential impact of smart contracts. If I were to rent an apartment, I would typ- ically need to negotiate and agree to certain terms, potentially run them by an attorney, and then exe- cute, hoping that the owner of the apartment delivered the key on the specified move-in date. With a smart contract, I put my monthly rent into the blockchain escrow account, which is released to the owner on the first of the month, in exchange for my access to the

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apartment. If I fail to deposit my rent, the apartment remains locked; if I deposit but the apartment is not released, then the funds are returned to me. All without any brokers in sight.

Similar examples abound. An insurance policy can be automatically executed after submitting car accident information or a medical bill, at which time the block- chain system triggers a clause in your policy remitting payment. Complex supply chains can be streamlined through smart contracts, which would arrange pur- chases of raw materials, track shipments, and adjust purchases volumes based on delivery trends.9 Payroll management, securities transactions, airline travel—all seem ripe for a smart contract reckoning. In this uto- pian vision, consumers would be able to pick from an à la carte buffet of contracts, choose the arrangement that works for them, and execute with minimal cost or hassle.

The Reality of Smart Contracts Or so we are told. An astute reader would recog-

nize that all of the aforementioned examples are simply elaborate “if-then” transactions, with very little room for extenuating circumstances. Consider our vend- ing machine example, where funds are deposited and a selection is made. The automatic execution kicks in and out pops a soda. But now suppose that the machine delivers the incorrect product. Or suppose the soda is damaged in some way. What is the available recourse? As far as the smart contract can tell, the transaction (“if money, then soda”) has been completed—the quality or accuracy of delivery never enters the picture. There is no way for the blockchain to “know” anything about the actual reality in the physical space.

The issue lies in the fact that the benefits of smart contracts come at the price of debilitating inflexibil- ity. Smart contracts are effective only insofar as execu- tion includes perfect performance. When performance falls short, however, the parties are left with only two impractical options: (1) formulate a new smart con- tract reversing the prior transaction—recall that the contract’s inclusion on the blockchain makes even a simple modification to its terms nigh impossible— which raises the prospect that the wrongfully paid party will decline to do so (thereby implicating the trustworthiness the initial smart contract was meant to avoid), or (2) proactively create a smart contract that

requires confirmation from a third party that the cor- rect product was delivered, free of defect, before funds are released—which requires a concession that over- sight may be necessary after all. Either way, the smart contract ends up raising the very concerns its entire formulation was meant to allay.

Worse yet, the rigidity inherent in smart contract prevents parties from including subjective terms and conditions inherent in smart contracts. The entire point of hiring a lawyer to draft and negotiate a contract is to arrange a transaction that comports with the parties’ expectations, which are often amorphous and neces- sitate a degree of flexibility. Consider the number of contracts that include terms like “reasonable,” “at the party’s sole discretion,” “good faith,” or which refer to future discussions and decision (“to be agreed upon,” “at a reasonable time,” etc.). None of these subjective deter- minations are conducive to digital formulations, which take judgment out of the equation. How would the smart contract determine when a “reasonable” amount of time has passed, or when an employer’s action was taken in “good faith”? Unless the parties included unre- alistically specific terms that prepared for an impracti- cally large number of contingencies and outcomes, the blockchain algorithm would ultimately make the deci- sion, and remove the parties’ discretionary intent.

Finally, widespread implementation of smart con- tracts would require a low entry cost, which may not be compatible with the need to meet parties’ specific requirements. As discussed earlier, in a perfect world, a consumer would be able to select a form contract that meets the specific transaction at issue, and proceed with the agreement immediately. But while a contract for a one-off purchase or rental of a property can be simplified to cover a wide range of consumers, more complex transactions, particularly those between finan- cial institutions, require a high level of customization. A simple “if-then” arrangement could not possibly cover all aspects of a complex merger agreement, for example, which may implicate different state and fed- eral laws, regulatory provisions, and detailed financial terms. Unique circumstances and variations necessarily require drafting from experts on the subject—namely, lawyers. This customization carries high, but often nec- essary, costs. The assumption that smart contracts can be employed across all industries without considering the difficulty in drafting their underlying terms paints

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an overly optimistic picture, one that fails to consider the costs of entering into the contract before it is even placed onto the blockchain.

Beneath all of these obstacles lies the fundamental problem with smart contracts: they attempt to digitize a process that is fundamentally predicated on the human condition. The concept of entering into a contract with another person is dependent on a system that allows for interpretation and a certain number of defenses to deal with the ambiguity and gray areas that will always present themselves in the real world. Indeed, the com- mon law that established the pillars of contract law evolved based on people’s real experiences and com- plications, and developed into a system that could pro- vide remedies while taking these realities into account. Blockchain-based contracts, on the other hand, operate on a different plane of existence, where agreements can be distilled into black-or-white scenarios. While that worldview is certainly attractive—who wouldn’t want that kind of certainty?—it fails to account for natural conflicts and complexities. Contracting is simply not a theoretical problem a computer can “solve,” and any attempt to do so—as reflected in the aforementioned difficulties—will remain incompatible with the philos- ophy underlying contract law.

And the Dangers Even ignoring the practical drawbacks of smart con-

tracts, the assumption that the blockchain can assure complete security and trustworthiness is itself a flawed concept. For one, smart contracts are subject to the same hacking risks typically associated with crypto- currency exchanges. This past July, for example, an ini- tial coin offering project called KICKICO lost nearly $8 million, after hackers obtained the private key to the project’s smart contract.10 Similarly, in 2016, an organization called the Decentralized Autonomous Organization had its smart contract hacked at a loss of nearly $50 million.11 Recent studies have highlighted even more security holes underlying current block- chain-based smart contracts.12 Given the anonymity provided by blockchain technology, stolen funds are typically lost forever.

Of course, even if a transaction is successfully com- pleted, the exchanged funds are subject to similar risks of theft. Given the lack of central oversight in the cryptocurrency market, any issues with fraud, theft, or

scamming can often leave victims without recourse. The U.S. Consumer Financial Protection Bureau, for example, has received hundreds of complaints about bitcoin exchanges, and no FDIC-equivalent exists to protect investors.13 These risks, combined with the costs of entering into a fulsome contractual agreement, may prove too daunting for investors and consumers.

Conclusion Mr. Wichelhaus has a problem. He has contracted to

purchase bales of cotton from a Mr. Raffles, with deliv- ery being made by a ship named Peerless. But while Mr. Wichelhaus understood delivery to occur in October, Mr. Raffles believed that delivery would be made in December, aboard a different ship named Peerless. Mr. Wichelhaus now refuses to accept the December ship- ment of cotton, having expected delivery to occur ear- lier in the year. Unfortunately for Mr. Wichelhaus, the parties entered into a smart contract that simply referred to “delivery from the Peerless,” without specifying a spe- cific date or which ship it was referring to. As such, the blockchain algorithm has, on its own, decided that the contract referred to the December Peerless, and that Mr. Wichelhaus must either accept this shipment, which he does not want, or face automatically executed financial penalties as a result of his breach.

Fortunately for Mr. Wichelhaus, Nick Szabo was not writing at the time of Raffles v. Wichelhaus,14 yet another pillar of Contracts law. In reality, the court ruled that the parties’ mutual mistake rendered the contract void, and that Mr. Wichelhaus was therefore not required to pay for the December shipment. Yet, the scenario demonstrates the difficulties of trusting a smart contract to handle ambiguity, which can result in consequences antithetical to the parties’ original intent and expecta- tions. Given the finality of smart contracts—ostensibly one of its strongest characteristics—these results are not easily remedied.

The increased efficacy and cost-cutting promised by smart contract proponents are tempting, and one can easily imagine more and more transactions soon adopting the blockchain’s vending machine model. But those of us working for sophisticated clients with complex purchases, mergers, or sales, will likely find that the distilling contracts into a computer code is a herculean task, one that carries its own immediate and long-term costs. Until blockchain technology can

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adapt to recognize and effectively compensate for real- world complexities and uncertainties, smart contracts will be unable to cause a meaningful disruption in our everyday lives.

Notes 1. 66 Mich. 568, 33 N.W. 919 (Mich. 1887) 2. https://cointelegraph.com/news/smart-contracts-are-taking-over-

functions-of-lawyers-expert-blog. 3. https://blockgeeks.com/guides/smart-contracts/. 4. https://www.cablelabs.com/hello-blockchain-goodbye-lawyers/. 5. https://legiscan.com/AZ/text/HB2417/id/1588180. 6. https://publications.tnsosfiles.com/acts/110/pub/pc0591.pdf.

7. https://www.economist.com/technology-quarterly/2018/08/30/ what-to-make-of-cryptocurrencies-and-blockchains.

8. http://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/ CDROM/Literature/LOTwinterschool2006/szabo.best.vwh.net/ smart_contracts_2.html.

9. https://uk.reuters.com/article/grains-blockchain/u-s-soy-cargo-to-chi- na-traded-using-blockchain-idUKL8N1PG0VJ.

10. https://www.ccn.com/another-ico-hacked-kickico-loses-8-million-af- ter-smart-contract-breach/.

11. https://www.bloomberg.com/features/2017-the-ether-thief/. 12. https://www.technologyreview.com/s/610392/ethereums-smart-

contracts-are-full-of-holes/. 13. https://www.bloomberg.com/news/articles/2017-08-30/bitcoin-

exchange-sees-complaints-soar-as-users-demand-money. 14. [1864] EWHC Exch J19 (April 1864).

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