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  • Writer's pictureMichael Bacina

Smart Contracts and Contract Disputes

Aren’t lawyers supposed to be out of a job by now?

There continues to be a lot of hype around blockchain and smart contracts as the technology moves through the Gartner hype cycle. It has been said that humans overestimate and the short term impact of technology but underestimate the long term impact and smart contracts are no different.

Nick Szabos, who has been called the ‘father of smart contracts’ provided one of the earliest definitions of a smart contract as:

A set of promises, specified in digital form, including protocols within which the parties perform on these promises

He later said:

By using cryptographic and other security mechanisms, we can secure many algorithmically specifiable relationships from breach by principals, and from eavesdropping or malicious interference by third parties, up to considerations of time, user interface, and completeness of the algorithmic specification.

The above quotes are from 1996 and 1997, at the very start of the technological revolution brought on by the World Wide Web. Mr Szabos was well ahead of his time in considering how technology could be applied to replace and improve the slow, expensive and error prone transactions of the time to unlock greater benefits for all parties.

The law has of course, taken a long time to catch up to technology, and just when we were seeing settled positions on clickwrap, browsewrap and internet based contracting, along comes Bitcoin in 2009 and the Blockchain Revolution, building on the power of the internet to promise a new level of efficiency in contracts and automation, where the very intermediaries which have long been required for certain transactions are already being replaced by technology in a way that has never been seen before.

What is a Smart Contract?

Smart Contracts represent the next step in an evolution which started with the humble vending machine, evolved to human readable contracts on digital documents with digital signatures and online click-wrap and browse-wrap contract acceptance, digitally executed agreements and ordinary contracts which used the output of computer programs as part of inputs determining the rights of parties.

When considering modern smart contracts, one should always first recognize that they are not very smart, in the way we understand intelligence (or even a ‘smart’ phone), and they are not usually contracts, being unable in most use cases to satisfy the basic requirements of a contract.

We are, however, stuck with the phrase for now, until something like Programmably Executed Transactions (“PETs”) or “Computerised Automated Transactions” (“CATs”) catch on. Even the co-founder of the second most popular blockchain, Ethereum, recently lamented:

‘I quite regret adopting the term ‘smart contracts’. I should have called them something more boring and technical [like] persistent scripts’.

The term ‘Smart Contract’ in popular use currently describes:

  1. a container of open source computer code;

  2. which is running on the nodes within a decentralised blockchain (which may be permissioned or unpermissioned); and

  3. which usually (but not always) requires the transfer of a cryptographic token to the contract address and the payment of a transaction fee (on the Ethereum blockchain this is known as ‘gas’) in order to remunerate the various nodes on the blockchain to run the code; and

  4. The outcome of the code in the container is compared against the outcome of the same code stored (and run) on all of the nodes in the blockchain; and

  5. If the blockchain nodes collectively reach consensus on the output of the code (typically that 51% of the nodes agree on the output of the smart contract code); then

  6. that output transaction is written into the blockchain record as a (for practical purposes) immutable record of what occured between users of that code.

A key element of smart contract and development from Mr Szabos original thesis is that the code is running on a decentralised blockchain network and no single party on that network can interfere with the running of, or terms of the smart contract code.

The reason for this is, in essence, because of the consensus mechanism which requires that someone take over 51% of the nodes in a blockchain network to hijack the outcome of a smart contract transaction, which would be both prohibitively expensive to do, and in any event almost instantly discovered or discoverable.

The blockchain technology on which Smart Contracts run is a subset of decentralised ledger technology, where a series of distributed computers, usually under the control of parties which don’t know each other, use a consensus algorithm to determine the validity of transactions passing through the blockchain network and prevent double spending of digital currency or cryptographic tokens. You can read more about what a blockchain is here.

What smart contracts are currently being used?

Smart contracts in the blockchain world were popularised by the Ethereum blockchain, which enabled anyone to use simple smart contracts to create their own tokens. Every Initial Coin Offering (ICO), being a project where a group or entity issues cryptographic tokens which the project intends to be used within a subsequent software platform (usually decentralised and blockchain based), has used a smart contract to “mint” their tokens.  Early ICOs involved automatic “minting” as payments were made, others use a single purpose smart contract which would run at the end of the ICO and issue tokens out to those who had contributed.

Outside of these single purpose smart contracts, the platforms and systems developed by these projects, and others, where they rely on decentralised blockchains are knowns as “DApps”, or Decentralised Applications. There are a number of websites which keep track of the popularity of DApps and their usage. Below is a graph showing the rise in use of DApps from the website State of the DApp:

At the time of writing, the total number of DApps is 2,241, with 31,500 daily active users (measured by the number of unique addresses identified in transactions to the DApp Smart Contracts) with 1.4m transactions occurring every 24 hours and involving a total of approximately 5,100 individual smart contracts.

The most popular category of DApps is cryptocurrency exchanges (such as IDEX), with 180 DApps enjoying around 53,000 monthly active users and 800,000 transactions per day in the last 30 days and around 450 smart contracts.

Next is Storage DApps (such as Storj and Filecoin), where data or files are stored, with 38,000 monthly users, 59,000 transactions per day and a low 19 smart contracts. Finance DApps (like ETHLend where loans can be made against crypto security) have 25,000 monthly users, with 90,000 daily transactions and 2,000 smart contracts, Gambling (like DiceBet) is unsurprisingly popular, with 21,000 daily users and 500,000 daily transactions and 1,300 smart contracts and finally Games comes in with 10,000 daily users, 460,000 daily transactions and 1,000 smart contracts.

Compared to the “normal” internet, these numbers are pretty small, but it is worth remembering that ten years after the internet was invented in the 1960s, essentially no one had heard of it. We have just passed the ten year anniversary of the creation of Bitcoin, and the currency and technology behind it have progressed much further, but still have a long way to go in terms of adoption.

The most popular 5 DApps in the 7 days prior to this article being published, by volume of USD transacted were all gambling DApps with over USD$90M lowing through those DApps. It is clear that gaming is a growing and popular area for DApps. Games which operate without any central entity controlling the transactions and interactions, utilising smart contracts are a fascinating experiment sure to assist in the ongoing adoption and growth of smart contracts. One such example, CryptoKitties, was so popular it caused transaction congestion across the entire Ethereum network as users sought to buy cryptographically unique digital and collectible cats.

How are legislatures and courts dealing with Smart Contracts around the World?

A number of US states are passing specific blockchain and smart contract enabling legislation, including a law making blockchain records admissible in Vermont, and in Arizona in April 2018 which made clear that “writing” included blockchain records and both Arizona and Tennessee have passed laws which defined smart contracts as:

An event-driven program, that runs on a distributed, decentralised, shared and replicated ledger and that can take custody over and instruct transfer of assets on that ledger.

Further, the bills state:

No contract relating to a transaction shall be denied legal effect, validity, or enforceability solely because that contract contains a smart contract term.

Wyoming and Delaware passed laws in 2017 specifically recognising the validity of blockchain transactions for specific securities purposes and other US states are moving to adopt their own enabling legislation including New York and Florida.

However, a recent report from the Digital Chamber of Commerce based in Washington, DC pushed back against specific enabling legislation, arguing that the Uniform Electronic Signatures Act and the Electronic Signatures in Global and National Commerce Actalready already ‘recognize, enable and validate the use of electronic signatures and electronic records when using a blockchain’.

One commentator has gone so far as to allege that ‘states that pass smart contract laws have no idea what they are doing’.

In Australia sections 8 and 15C of the Electronic Transactions Act provide that, a transaction is not invalid solely for the reason that it takes place solely in electronic form or as a result of automated electronic messages.

It seems that from the perspective of recognizing that transactions cryptographically signed in relation to a smart contract are binding, or that follow-on contracts potentially created by a smart contract, the legislation in place appears capable of recognizing smart contract code as embodying a contract.

However, the question will always be one of fact, as at the most basic point, a contract must embody an agreement between parties, intended to create legal relations, with identifiable terms of the agreement of which the parties have been put on notice to read and understand prior to entering into the agreement.

There are smart contracts which plainly will not be recognized as having sufficiently certain terms, an example of an early smart contract (which suffered a spectacular failure) was the DAO, which set out as part of it’s published terms of use (which are no longer available online):

The terms of The DAO Creation are set forth in the smart contract code existing on the Eth ereum blockchain at 0xbb9bc244d798123fde783fcc1c72d3bb8c189413. Nothing in this explanation of terms or in any other document or communication may modify or add any additional obligations or guarantees beyond those set forth in The DAO’s code. Any and all explanatory terms or descriptions are merely offered for educational purposes and do not supercede or modify the express terms of The DAO’s code set forth on the blockchain; to the extent you believe there to be any conflict or discrepancy between the descriptions offered here and the functionality of The DAO’s code at 0xbb9bc244d798123fde783fcc1c72d3bb8c189413, The DAO’s code controls and sets forth all terms of The DAO Creation.

Not all smart contracts will be capable of becoming contracts at law, and the term “smart legal contract” is emerging as a category of smart contracts which intend to be treated as legally enforceable contracts, as distinct from other smart contract.

Outside of regulatory enforcement, there are no current reported judicial decisions which address the interpretation or validity of a smart contract, but it appears that the popularity of smart contracts will lead to them being recognized in certain transactions where the formal requirements for a contract exist.

What are some practical examples of smart contract disputes?

The biggest and immediate impact of blockchain technology and smart contracts is the immutable record of transactions, particularly concerning transactions. We have seen situations where one party, located in one country, was in dispute with another party located in a different country concerning the performance of a contract. Ordinarily, the lawyers involved would need to consider not only how the contract was formed, and when and how payment was made, including considering international transfers and the like. But where the payment was made over a blockchain, the record is shared and clear. This may be an incremental improvement in shortening the need for evidence of payment, but repeated globally the efficiency gains are there for the taking.

A considerable amount of time in disputes is spent by lawyers verifying that instructions are correct and assembling evidence, and a time honoured tactic in contract disputes is for a party to put the other side to proof to delay what ultimately is a matter which should be settled. Blockchain cuts through this delay tactic in particular and instantly reduces the workload needed for a party to prepared for enforcement of a breach of contract, and may lead to many disputes never reaching the lawyers in the case of self enforcing smart contracts or records which can’t be disputed.

Similarly there is little scope for dispute over the actual smart contract code constituting an agreement between parties. There may be issues concerning the identification of the parties, law applying to the contract or what was understood by the code (or representations made about what the code would do) but smart contract code itself presently cannot (or is extremely difficult) to change and is open and readable by all.

The main area of contract disputes in relation to smart contracts is likely to be in the field of smart contracts being used for illegal purposes or misrepresentation around the entry into the smart contract. By this we don’t mean contracts for purposes which are obviously illegal, like a smart contract to put a hit out on a person. But rather contracts which might create unforseen incentives (like a prediction market where a bet can be placed on a person dying, which in some ways is analogous to the above illegal contract) or where a smart contract developer or entrepreneur discovers there is interest in people coming together to transact in a way that is traditionally part of a regulated or licensed system.

On the LawTech side, there are some very interesting projects which are enabling lawyers to be a part of the smart contract revolution. The OpenLaw project by Consensus, the Accord Project and Legaler (a client of Piper Alderman) all seek to provide and promote the use of smart contracts in legal practice.

Smart Contract Disputes

While there is a paucity of reported court decisions considering smart contracts, regulators have been forced to address the ‘wild west’ of Initial Coin Offerings which rose to prominence in 2016/2017 and which have dramatically fallen away in the second half of 2018. In particular, enforcement actions by US regulators against two ICOs identifies potentially persuasive precedent which might help guide eventual court decisions.

For when considering who is liable when something goes wrong with a smart contract, the first problem may be simply identifying the parties to the smart contract. Absent a “promoter” or site operator, the authors of the smart contract may well find themselves in the firing line.

In 2017, the US Securities and Exchange Commission (SEC) published a report into the collapse of the DAO which occured in 2016. That report used Mr Szabos definitions of smart contracts and highlighted that:

The automation of certain functions through… “smart contracts”... does not remove conduct from the purview of the U.S. federal securities laws.

Recently the CFTC Commissioner Mr Brian Quitenz gave a speech in which he commented on how that regulator is approaching smart contracts, identifying that there are four categories of users within a smart contract/blockchain ecosystem, including the core developers of the protocol, the ‘miners’ who process transactions and ensure the processing of code in the network, the users of the network, and smart contract developers who write the code being processed by the miners and utilised by users.

Mr Quitenz right identified that the core developers of the protocol upon which the entire blockchain relies have merely invented a code upon which DApps and smart contracts can be run. Plainly they are analogous to a telecommunications carrier who is not held responsible for the words spoken over a phone line. Similarly general users and miners have no knowledge of what is occurring on most of the network.

What is left is two groups who would seem to be at risk of facing liability, being the authors/developers of smart contracts, and the individuals users transacting with smart contracts which are in breach of law. It is not novel for individual users or participants in a transaction to face legal liability to another party for breach, including for monies had and received where a contract is void for illegality, but holding the author of such a contract (who may not have been involved in the breach) liable is novel.Mr Quitenz noted:

The developers of the code could claim that they merely created the protocol and therefore have no control over whether and how users choose to use it once it is part of the public domain. They would place the liability on the individual users, who are the actual creators and counterparties of the event contracts.
...this analysis misses the mark... the appropriate question is whether these code developers could reasonably foresee, at the time they created the code, that it would likely be used by...persons in a manner violative of [law].

While Mr Quitenz speech has been criticised, from 2016 there have been calls from at least one US academic that the core developers and miners on public blockchains should be treated as fiduciaries.

Following Mr Quitenz’s speech, on 8 November 2018 the SEC released an order and announcement that they had reached a settlement with the past operator of a popular cryptocurrency exchange called EtherDelta. EtherDelta operated as:

A centrally administered website, which permitted users to post buy or sell orders in relation to a very wide array of cryptographic tokens (including importantly a great many which the SEC considered to be securities); andWhen a user wished to accept a posted order, the transaction would be settled and cleared by a smart contract.

It has been reported that the SEC’s newly formed cyber crime unit has taken the view that the creation of a decentralised exchange, such as EtherDelta, without any central control will not absolve the original creator of the exchange from responsibility for what the code they wrote is used to transaction, and this view would seem to extend to the authors of smart contracts. Or put another way you can’t imprison a company, but you can imprison the CEO.

Whats next

The law in relation to smart contracts has a lot of development to go through, and if history is any guide there will be issues arising for many years to come. What is clear, is that there is a novel view emerging to hold the authors of a smart contract liable and responsibility for their creation, in a way that has not been previously recognized in the technology space.

This places a clear need on all smart contract developers, who are involved in the development of any smart contracts, to ensure that they have competent legal counsel reviewing their project (if not walking through the code flow-charts as well) and/or that the terms of their engagement (if they are building a smart contract for a project) ensure that their client has competent legal counsel providing advice on the legality of the use of the smart contract and business model. In short, it seems for now lawyers have a greater need to be part of, rather than replaced by, the blockchain revolution.


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