Source: https://corpgov.law.harvard.edu/2018/05/26/an-introduction-to-smart-contracts-and-their-potential-and-inherent-limitations/
Timestamp: 2020-02-22 13:54:47
Document Index: 503256398

Matched Legal Cases: ['§ 2', '§ 2', '§ 2', '§ 7001', '§ 7006', '§ 719']

Posted by Stuart D. Levi and Alex B. Lipton, Skadden, Arps, Slate, Meagher & Flom LLP, on
Comments Off on An Introduction to Smart Contracts and Their Potential and Inherent Limitations Print E-Mail Tweet
Blockchain, Contracts, Cybersecurity, Financial technology, Legal systems, Risk, Risk management
More from: Alex Lipton, Stuart Levi, Skadden
Stuart D. Levi is a partner and Alex B. Lipton is an associate at Skadden, Arps, Slate, Meagher & Flom LLP. This post is based on their Skadden publication.
Before a compiled smart contract actually can be executed on certain blockchains, an additional step is required, namely, the payment of a transaction fee for the contract to be added to the chain and executed upon. In the case of the Ethereum blockchain, smart contracts are executed on the Ethereum Virtual Machine (EVM), and this payment, made through the ether cryptocurrency, is known as “gas.” [1] The more complex the smart contract (based on the transaction steps to be performed), the more gas that must be paid to execute the smart contract. Thus, gas currently acts as an important gate to prevent overly complex or numerous smart contracts from overwhelming the EVM. [2]
New institutions, and new ways to formalize the relationships that make up these institutions, are now made possible by the digital revolution. I call these new contracts “smart,” because they are far more functional than their inanimate paper-based ancestors. No use of artificial intelligence is implied. A smart contract is a set of promises, specified in digital form, including protocols within which the parties perform on these promises. [3]
Smart contracts today also find their origin in Ricardian Contracts, a concept published in 1996 by Ian Grigg and Gary Howland as part of their work on the Ricardo payment system to transfer assets. Grigg saw Ricardian Contracts as a bridge between text contracts and code that had the following parameters: a single document that “is a) a contract offered by an issuer to holders, b) for a valuable right held by holders, and managed by the issuer, c) easily readable by people (like a contract on paper), d) readable by programs (parsable like a database), e) digitally signed, f) carries the keys and server information, and g) allied with a unique and secure identifier.” [4]
A discussion regarding the enforceability of smart contracts must start with the fundamental distinction between an agreement and a “contract.” States generally recognize that although two parties can enter into a variety of “agreements,” a contract means that the agreement is legally binding and enforceable in a court of law. [5] In order to determine enforceability, state courts traditionally look to whether the common law requirements of offer, acceptance and consideration are satisfied. These basic requirements surely can be achieved through ancillary smart contracts. For example, an insurer might develop a flight insurance product that automatically provides the insured with a payout if a flight is delayed by more than two hours. [6] The key terms, such as delineating how the delay is calculated, can be set forth in a text-based contract, with the actual formation of the contract (payment of the premium) and the execution (automatic payout upon a verifiable delay) handled through an ancillary smart contract. Here, the insurer has made a definite offer for a flight insurance product that is accepted by the insured upon payment of the premium as consideration.
Although, today, certain contracts must be in writing, and additional formalities may be required such as those under the Uniform Commercial Code (UCC) and state statutes of frauds, [7] agreements do not always need to be in writing to be held enforceable. [8] Thus, many code-only smart contracts also will be enforceable under state laws governing contracts. Szabo’s example of a vending machine is instructive in this regard. There, while the buyer has many implied rights, a contract was formed without any meaningful written terms other than a price display for each item. Thus, the fact that an agreement is rendered only in code, such as the case with code-only smart contracts, presents no particular barrier to contract formation outside the barriers imposed by the UCC and statutes of frauds. Indeed, a variety of laws and legal constructs have long considered the role of information technology in contract formation.
For example, the Uniform Electronic Transactions Act (UETA) which dates back to 1999 and forms the basis for state law in 47 states, provides that, with limited exceptions, electronic records, which include records created by computer programs, and electronic signatures (i.e., digital signature using public key encryption technology) be given the same legal effect as their written counterparts. [9] UETA even goes so far as recognizing the validity of “electronic agents,” which it defines as “a computer program or an electronic or other automated means used independently to initiate an action or respond to electronic records or performances in whole or in part, without review or action by an individual.” [10] Under UETA, an electronic agent is “capable within the parameters of its programming, of initiating, responding or interacting with other parties or their electronic agents once it has been activated by a party, without further attention of that party,” [11] arguably a prescient acknowledgment of smart contracts.
Similarly, the federal Electronic Signatures Recording Act (E-Sign Act) not only recognizes the validity of electronic signatures and electronic records in interstate commerce, but also provides that a contract or other record relating to a transaction “may not be denied legal effect, validity, or enforceability solely because its formation, creation, or delivery involved the action of one or more electronic agents so long as the action of any such electronic agent is legally attributable to the person to be bound.” [12] The term “electronic agent” means a computer program or an electronic or other automated means used independently to initiate an action or respond to electronic records or performances in whole or in part without review or action by an individual at the time of the action or response.” [13]
Though an understanding of the current legal framework is important to evaluating the enforceability of smart contracts today, those using smart contracts in the future may not need to rely on laws that pre-date the development of blockchain technology. Arizona and Nevada already have amended their respective state versions of UETA to explicitly incorporate blockchains and smart contracts. [14] The fact that these states have adopted decidedly different definitions of those critical terms suggests that as more states follow their lead, there may be increasing pressure to adopt unified definitions to reflect blockchain and smart contract developments.
To some extent, the inability of contracting parties to understand the smart contract code will not be a hindrance to entering into ancillary code agreements. This is because for many basic functions, text templates can be created and used to indicate what parameters need to be entered and how those parameters will be executed. For example, assume a simple smart contract function that extracts a late fee from a counterparty’s wallet if a defined payment is not received by a specified date. The text template could prompt the parties to enter the amount of the expected payment, the due date and the amount of the late fee. However, a party may want to confirm that the underlying code actually will perform the functions specified in the text, and that there are no additional conditions or parameters—especially where the template disclaims any liability arising from the accuracy of the underlying code. This review will require a trusted third party with programming expertise.
Code-only smart contracts used for business-to-consumer transactions could pose an additional set of issues that will need to be addressed. Courts are wary of enforcing agreements where the consumer did not receive adequate notice of the terms of the agreement, [15] and may be hesitant to enforce a smart contract where the consumer was not also provided with an underlying text agreement that included the complete terms.
Finally, as the validity or performance of smart contracts increasingly become adjudicated, courts may need a system of court-appointed experts to help them decipher the meaning and intent of the code. Today, parties routinely use their own experts when technical issues are at the center of a dispute. While both federal courts and many state courts have the authority to appoint their own experts, they rarely exercise that authority. [16] That approach may need to change if the number of standard contract disputes that center on interpreting smart contract code increases.
Smart contracts introduce an additional risk that does not exist in most text-based contractual relationships—the possibility that the contract will be hacked or that the code or protocol simply contains an unintended programming error. Given the relative security of blockchains, these concepts are closely aligned; namely, most “hacks” associated with blockchain technology are really exploitations of an unintended coding error. As with many bugs in computer code, these errors are not glaring, but rather become obvious only once they have been exploited. For example, in 2017 an attacker was able to drain several multi-signature wallets offered by Parity of $31 million in ether. [17] Multi-signature wallets add a layer of security because they require more than one private key to access the wallet. However, in the Parity attack, the attacker was able to exploit a flaw in the Parity code by reinitializing the smart contract and making himself or herself the sole owner of the multi-signature wallets. Parties to a smart contract will need to consider how risk and liability for unintended coding errors and resulting exploitations are allocated between the parties, and possibly with any third party developers or insurers of the smart contract.
1See “What is the ‘Gas’ in Ethereum?” Cryptocompare, November 18, 2016, available here.(go back)
3Nick Szabo, “Smart Contracts: Building Blocks for Digital Market,” 1996, available here.(go back)
4Ian Grigg, “The Ricardian Contract,” available here.(go back)
5See, e.g., “Restatement (Second) of Contracts,” Section 1, American Law Institute, 1981. In the U.S., contract law is ordinarily a function of state law. Although this article outlines general contract law principles that are common across states, we note that state law differences may impact the enforceability of smart contracts in certain states.(go back)
6At least one company, AXA, currently offers such a product. See here.(go back)
7See, e.g., UCC § 2-201.(go back)
8See, e.g., Lumhoo v. Home Depot USA, Inc., 229 F. Supp. 2d 121, 160 (E.D.N.Y. 2002) (holding that the plaintiffs adduced sufficient evidence to support an inference that the parties formed an oral contract for payment by their employer at an overtime rate for any hours worked in excess of eight hours per day).(go back)
9Uniform Electronic Transactions Act (Unif. Law Comm’n 1999)—New York, Illinois and Washington have state-specific laws relating to the validity of electronic transactions.(go back)
10Id. § 2(6).(go back)
11Id. § 2 cmt. 5.(go back)
1215 U.S.C. § 7001(h).(go back)
1315 U.S.C. § 7006(3).(go back)
14See 2017 Ariz. HB 2417 44-7061 and Nev. Rev. Stat. Ann. § 719.090.(go back)
15See, e.g., Nicosia v. Amazon.com, Inc., 834 F.3d 220 (2d Cir. 2016) (reversing the district court’s dismissal for failure to state a claim and holding that reasonable minds could disagree as to whether Amazon provided the consumer with reasonable notice of the mandatory arbitration provision at issue).(go back)
16See Charles Alan Wright & Arthur R. Miller, Federal Practice and Procedure, Section 6304 (3d ed. supp. 2011) (“In fact, the exercise of Rule 706 powers is rare under virtually any circumstances. This is, at least in part, owing to the fact that appointing an expert witness increases the burdens of the judge, increases the costs to the parties, and interferes with the adversarial control over the presentation of evidence.”), and Stephanie Domitrovich, Mara L. Merino & James T. Richardson, State Trial Judge Use of Court Appointed Experts: Survey Results and Comparisons, 50 Jurimetrics J. 371, 373–74 (2010).(go back)
17See Haseeb Qureshi, “A Hacker Stole $31M of Ether—How it Happened, and What it Means for Ethereum,” FreeCodeCamp, (July 20, 2017), available here.(go back)
An Introduction to Smart Contracts and Their Potential and Inherent Limitations 2018-05-26T09:44:01-04:00 2018-05-26T09:44:01-04:00 Harvard Law School Forum on Corporate Governance and Financial Regulation