05 July 2022 - Article
Blockchain technology offers a decentralized consensus mechanism using networked servers that facilitate peer-to-peer transactions without the need for a centralized authority to maintain the information generated by the transactions. Each transaction is validated and combined in a group of validated transactions, to create a new “block” in an existing chain of transactions, hence the name “blockchain.” Once a transaction has been added to the chain, it cannot be altered or removed. There has been a huge growth in blockchain technology and in blockchain-based applications, especially in finance giving rise to so called “smart contracts”. Blockchain based “smart contracts” will improve many aspects of financial transactions. While blockchain can be expected to intersect with many, or even most, aspects of the law, areas of anticipated significant intersection include:
- Legal recognition of smart contracts: To what extent do smart contracts represent something new from the perspective of existing legal frameworks, if at all? If they are new, how do we best afford them legal recognition? If they are not new, how do we best incorporate them into existing frameworks?
- Legal value of a blockchain-based proof: To what extent does data stored on a blockchain have evidentiary value, if any?
- Blockchain creation of assets: To what extent does blockchain technology allow for the creation of new types of assets, if any?
- Decentralized autonomous organizations (DAOs): To what extent are DAOs a new form of organization that requires its own legal definition and treatment?
- Blockchain transfers of value: To what extent do transfers of assets on a blockchain represent transfers for value or legal consideration, if any?
A solid legal and regulatory framework is a prerequisite for a healthy and value-producing blockchain industry and basis for entrepreneurs, developers and others to innovate. It appears at this juncture that many situations can be handled through existing frameworks, though there will be instances where blockchain-specific clarifications will be necessary. The issue of the legal recognition of smart contracts is a case in point. Smart contracts are merely the expression in code of a commercial arrangement between counterparties (usually with the intention of automating the carrying out of the arrangement). In that sense, they are no different than traditional paper or oral contracts and, as a result, most participants did not see a need for a new wholly smart contract law. However, given the brevity of the code typically used, there are many terms and conditions of the arrangements that are left unstated, perhaps on the assumptions that existing legal frameworks are sufficient to “fill in” the unstated terms and conditions. The validity of this assumption is untested and likely to be found flawed in many instances. It may well be that enabling widespread adoption of smart contracts, at least in a commercial contest, will require a statutory framework to fill in those missing terms and conditions similar to the manner in which Article 2 of the uniform Commercial Code does so for the sale of goods. In the absence of such a framework, it may be prudent for parties to a smart contract to incorporate in the applicable code a reference to a standardized set of terms and conditions, perhaps posted in another blockchain or on a website. Such standardized terms and conditions could also contemplate annexes recorded in a blockchain which would cover specialized situations or the “off-chain” relationships among the counterparties.
As digital assets are represented by blockchain-based tokens, such assets will require a clear understanding and categorization so that legal principles can be appropriately applied. In many cases, it should be possible to map the tokens to existing financial, currency, consumer or investor protection frameworks. Of course, this would not always be straightforward; certain tokens, particularly those with a hybrid function, may need unique clarifications. Leaving aside those cases, however, even within existing frameworks, there are many questions to be addressed, such as:
- Contract interpretation rules change: Where there is more reliance on standardized automated contracts, should interpretative rules be refined? For example, allowing parole evidence more easily may enable smart contracts to, in practice, more clearly reflect intent of the parties. However, it may also undermine the efficiency and certainty characteristics that are hallmarks of smart contracts.
- Legal recognition in various jurisdictions: How will the jurisdiction in which a smart contract is formed be determined? In this regard, the extent to which governing law and forum selection clauses should be given effect present particular challenges. For a contract formed online, identifying Nexus for jurisdiction purposes and where offer and acceptance occur may require special focus.
- Evidentiary value of blockchain data: In particular, will the “immutability” of the data receive judicial recognition? Will parties need to prove in each case that data has not been changed?
Assuring a client that a smart contract does what it purports to do is challenging for an attorney who is not familiar with the unique legal and mechanical issues these contracts present or with basic smart contract coding. Certain attorneys, especially in areas where test cases have been prevalent, such as swaps and derivatives, will need to become comfortable communicating with and speaking the language of contract code-writers or programmers. To facilitate this new requirement , Withers Partner, M. Ridgway Barker and Joseph Bambara together with a team of industry professionals have written a book which can prepare attorneys and businesses to understand and incorporate emerging technology trends: the Blockchain, Artificial Intelligence (AI) and the Internet of Things (IoT). This book is available for purchase here.