Blockchain for Lawyers: Smart Contracts

Monday, August 28, 2017 - 17:38

New technology has changed the capabilities of documents once done with paper and pen

 

What if you and your counterparty possessed 100 percent certainty that every word and every signature in every contract you’ve negotiated were perfectly accurate? What if every payment obligation could be automatically enforced without human involvement? What if you could stack contractual duties in condition-precedent dominoes so that you automatically paid a supplier fee only after valid confirmation of goods delivery?

This is no fantasy. It’s the world offered by smart contracts today.

 

What Is Blockchain Technology?

These legal vehicles operate within the blockchain arena. You may be familiar with bitcoin, the famous (or infamous) digital currency routinely making headlines as the payment of choice for innovators, ransomware fiends, dark-web marketplaces and cutting-edge legal exchanges. Bitcoin works via its underlying blockchain technology.

While bitcoin and blockchain technology were developed in tandem, blockchains have a multitude of uses beyond cryptocurrency. People are using blockchain applications for securities management, livestock sales, inventory controls and information exchanges. More important for lawyers, blockchain technology offers the ability to digitally encode a contract and then utilize the encoded contract terms to provide automatic functionality – from confirmation of delivery to payment to certificate issuance.

Think of the blockchain as a ledger. Ledgers have been used for millennia to track transactions. The breakthrough for this new technology is that you can take this ledger and distribute it widely, so that all of the key players in a transaction have a perfect copy of it, and any updates are captured uniformly across the entire distribution chain. Practically speaking, this means that when a buyer and a supplier execute a supply contract, all of the data can be shared and validated on both parties’ systems. This allows them to align the contract throughout the term on a whole range of issues, such as product prices, forecasts, monthly minimum purchase volumes, annual volume discounts and rebates, index-based and raw materials price increases, delivery, and payments.

The data is subject to a mathematical protocol that reveals any errors or inappropriate data manipulation. Practically speaking, this means that a bad actor would need to control at least 51 percent of the computing power across the distributed network rather than simply compromise a critical component. The structure instills confidence in the data’s integrity and ensures that the counterparties possess the exact same data.

To understand this distributed ledger, you need to understand five elements.

 

1. Start with the Ledger and the Consensus Engine. First, each counterparty establishes a point of presence (often called a “node”) on a software server. Each node uses a common consensus engine for algorithms, which means that all of the counterparties are aligned in using the same method to calculate the mathematical representations of the contract content. Also, this common engine ensures that each node will be able to update the distributed ledger with future changes. For instance, let’s say the parties agree on an amendment that extends the term of the supply agreement. Each party’s ledger updates with a perfect and identical version of this amendment.

 

2. Build a Smart Contract. What makes all of this possible is the method of building a smart contract. You think of a typical contract as a word processing file or a piece of paper. In blockchain parlance, this typical contract is called a “wet contract.” When you build a smart contract, you integrate the text of the wet contract into smart contract coding. This enables automated actions without human involvement. For example, let’s say in the wet contract the supplier promises to deliver 100 products on January 1, followed by the customer sending payment of $10,000 within one day of receiving the products. Once you’ve built a smart contract, the supplier and customer could indicate that they will both rely on the supplier’s shipping agent’s database as a valid source for confirming the product delivery date. And once that date is indicated in the database, the smart contract recognizes that fact and orders $10,000 to be wired from the customer’s account. All of this can occur without any customer or supplier employees involved. Of course, prudent companies will also include quality assurance, error recognition and cybersecurity mechanisms (all with human involvement) to oversee the overall process.

 

3. Affix a Digital Signature. Each smart contract is built with an encryption infrastructure to make it easy for the parties to skip the traditional wet contract signature. Using this infrastructure, the contract is labelled with a software code called a “public key” that each counterparty is aware of. Using this key to identify the contract a party wants to sign, the party then offers up its own software code (known as a “private key”) identifying that party and allowing them to digitally “sign” the contract using a mathematical algorithm. The advantage is that execution can be instantaneously recorded across the distributed ledger, so you never have to search for the fully signed version. (If you want to obtain a basic understanding of how this process works, I highly recommend “The Code Book,” by Simon Singh, which explains the underlying mechanics in a friendly manner that’s approachable and doesn’t require a mathematical background.)

 

4. Broadcast It Out. Once you upload the smart contract, it’s sent to all of the nodes for all of the counterparties, and the nodes follow an additional mathematical process to achieve consensus that the smart contract is valid and acceptable as part of the distributed ledger.

 

5. Bundle the Blocks. This is where the “block” in blockchain technology comes in. The smart contracts are grouped into blocks, and each block is immutably linked. Every block references the previous block computationally via a “hash.” This process ensures that no part of any block (including any given smart contract) can be altered without mathematically cascading that change to all of the other blocks and making it obvious that the data has been tampered with. Further, making this change on any one node will fail because the other nodes in the system possess the correct blockchain and will prevent the tampered node from spreading or acting on a bogus transaction. As a result, you can have a high degree of confidence in the data integrity of your contracts, essentially making them immutable while also being easily accessible.

 

Challenges

The path to smart-contract nirvana has obstacles. Cryptographic systems are vulnerable if you use weak encryption or don’t manage your keys well. Keys can be compromised. You may rely on APIs (application protocol interfaces, as used when the supplier and customer mentioned above automatically validate product delivery in the carrier’s database), but the data you pull in from third-party databases may be corrupted or otherwise unreliable. The permissions for the shared ledger you use are ostensibly for the correct counterparties, which means you need strong incident management procedures to handle any situation where a party is compromised.

Technology providers make all of this possible for most counterparties, who typically lack the internal expertise to administer a distributed ledger. As a result, each counterparty needs to at least build strong supplier oversight expertise and systems, as well as maintain sufficient insurance coverage for provider failures. These challenges will not prevent successful smart contracting, but they will be ever-present issues to manage well in a sophisticated blockchain program.

The future is bright for the world of smart contracts. They offer a chance for lawyers to move up the value chain and think holistically about how we can best trigger functionality across payment and delivery systems to ease friction in commerce. In doing so, lawyers become even more valuable by effectively projecting a business agreement beyond the contours of a simple file. We can now create transactions that follow up automatically to facilitate commerce, reduce ambiguity and enhance the likelihood of success for the contractual goals of our clients.