Smart Legal Contracts: Explanation & Enforceability
First, let me tell you a few things about myself. My name is Brett Cenkus, I’m a business attorney, a corporate attorney, and we’ll talk a little bit about what that is specifically because it plays into smart contracts. My practice is mainly around mergers and acquisitions and capital raising, startups, partner/founder structuring and a little bit of dispute work and I’ve got a growing technology practice.
Back around to today’s topic—smart contracts or smart legal contracts. A smart legal contract is not necessarily a term you’ll hear a lot of, but I use it today to distinguish from smart contract code. Both these things are sometimes referred to as “smart contracts” and that’s confusing. Smart contract code is the executable code that sits on top of a blockchain and it’s essentially a program running and interacting with the information on a blockchain. It’s code. Now, a smart legal contract is a particular application of that type of code. So, that code can be used to form an organization, what’s called a decentralized autonomous organization. It can be used to run an application or it can be used, in our case, to actually facilitate a binding legal agreement—a legal contract. By a legal contract, I mean an enforceable, binding agreement between two or more parties. Smart legal contracts are what we’re talking about today, they’re a type of contract that exists in the real-world put onto the blockchain in codified or code form.
Now one of the things, lets talk about kind of specifically what they are, in 1996 Nick Szabo coined the term smart contract and he was envisioning, the example he gave back then was a vending machine. He explained a vending machine is essentially a type of electronic contract. The “offer” in legal terms to a passerby is to put money in and get something in return, food or beverage. The “acceptance” is putting the money in—offer and acceptance are two elements of a legally binding contract—and then the delivery, right, is the performance of the contract. That really is all the elements of an electronic contract. Very, very simple, but he proposed, why couldn’t you take something like that and put it in sort of software type of form – a form of smart contract. Why do we need that in a piece of paper?
Well here we are 22 years later and we’ve got the blockchain, which has a lot of potential to disrupt a lot of industries, and people are starting to play around with the application of these smart legal contracts. A better example that maybe you’re hearing a lot about right now: smart contracts are expected to disrupt a lot of industries, particularly intermediaries in industries or people whose role is just to sit in the middle of a transaction.
A great use case is replacing an escrow agent. Right now if you want to buy my watch, you call me, you say “I’ll give you a hundred bucks.” I say, “sure send the money” and you say, “well no, send the watch.” And I’ll say “uh-hmm you know we’ve got a problem here.” I don’t trust you; you don’t trust me. I’m assuming we don’t know each other, not that you’re a very good friend of mine and then we’ve got a bigger problem if I don’t trust you. But, in that instance there are a couple different things we could do. We could put together a binding contract. We could hire an escrow agent and that escrow agent would serve as a middleperson, and I would send the watch to the escrow agent, you would send the money. The escrow agent would get both and then distribute them. Well that’s expensive and it’s time-consuming or can be expensive.
Smart contracts could serve a really useful purpose in this context. You could deposit your money to the smart contract, which in this case would be some type of cryptocurrency, you know Ether or Bitcoin or something like that. I would send you my watch, perhaps it would tie—and this is essentially a software program if you, if you will—it could tie into a FedEx data feed to say that the watch was delivered, and then at that point automatically release your money to me. So there’s a way to put that on the blockchain to take away or address the problem of trust or a lack of trust in the relationship.
A lot of people are talking about it. I’ve read many articles that “this is finally the death of the corporate lawyers”, maybe depending on how you look at. It’s good for me, it’s not our death quite yet. And for you, if you’re sort of longingly waiting for it, you’ve got a little while longer to wait.
So, let’s look back at our escrow agreement. You have this very simple agreement, seems to work well, but what happens if the watch arrives and it doesn’t work. Uh oh, this smart contract all of a sudden got dumb, right? We now need to take a look at that situation and decide well what then? And if you don’t send that watch back, we need remedies and mechanisms for going to get it. So there’s always a lot of things that are going to take place, you know kind of offline or at least in the foreseeable future and really there’s a lot of those things, if you think about it.
But, before I get into that, let’s just talk about what people like me do, what business attorneys do, you might also call me a corporate lawyer or a transactional lawyer. There’s maybe a perception among some people that what we do is something like a client calls and we think about the best form. We go to get it and we just fill in a couple blanks, ship it over to a client, end of story and we pocket a lot of money. The vast majority of what I do, any sort of service agreement or customer contract or a merger and acquisition deal that stuff’s all custom work. There’s a lot of time spent with a client thinking about what we should worry about, our risks, what’s important to you. And then I always start with the form, never a blank piece of paper, but it would be exceedingly rare that the particular form wouldn’t get changed a lot and that change is what I get paid to do and it’s 20 years of practicing law and I still learn things every day. So yeah, hopefully you get better and better at your craft but we’re professionals and experts at helping clients figure out how to write a contract to cover the situation, what’s important to our clients. That’s what I do in the world.
Now, back to smart contracts. Will they replace what I do? Again, certainly not in the short-term. Let’s think about a couple of reasons why. Number one is, take a look at LegalZoom. LegalZoom has been around for 15 some odd years, been around for a while, came out in the first dot-com boom and there was talk then that these would replace us. It really hasn’t eaten a whole lot into my practice. For a nondisclosure agreement or something like that, it does the trick, but it really works for very simple transactions or very low-budget transactions, where people can’t afford to do something different. Anything that’s more complex, which again is the vast majority of things that come across my desk or where my client has any amount of budget, they’re going to want to do some custom work and to think about and have something, a bespoke contract. So that’s not going to change. Smart contracts, at least for the foreseeable future, are really going to be for sort of simple use cases. That’s number one.
Number two, just because you have a contract and you’ve got some blanks and it’s easy to fill in doesn’t mean what you put in there is enforceable. So for example, let’s say you go to LegalZoom and you order a promissory note. You lend $10,000 to a friend and you plug in the interest rate, here’s how it’s going to be paid back and here’s my security. The templated contract doesn’t tell you that the things that you put in a contract will be enforceable. For example, what’s the maximum rate you could charge without it being usury, without it being illegal? Can you charge a prepayment penalty? Will the prepayment penalty be treated as interest? If they pay it off quickly, should that be added in to calculate interest for purposes of usury? If you have security, how will that be written up so as to be enforceable? Again, there are plenty of things you could DIY. This isn’t about having to come to me for absolutely everything, but there’s a lot of stuff that is not, including most types of contracts and then specifically things that go in those contracts.
A third big reason that I’m here for a while longer is that there are always arguments around enforceability and the like. Contracts – business contracts – are replete with language that’s squishy and subjective like “reasonable” or “best efforts” or “good faith”. These are not things that can be codified. That’s not a standard that you can have a computer program decide was met and it’s intentional. We build that in because we can’t think of every single situation that we define acceptable performance, so we say “reasonable performance” or that a party is trying in “good faith” to accomplish something. These things are meant to be analyzed after the fact not necessarily by a business lawyer all the time. You don’t want all your contracts to need to be interpreted to determine if they’re enforcible.
So, I’ve got a contract that says you’ll send me that watch if I buy your watch, you’ll send me the watch within a reasonable amount of time after receiving my money, let’s say that’s the deal. Well what’s a reasonable amount of time? Well, just depends, but it’s meant to say if you get sick and it takes you a few more days, I can’t sue you. I mean, it’s meant to be interpreted in the overall context of things and that’s not going to change and people are going to need advice about proper satisfaction of contractual terms.
So, in today’s world LegalZoom has done me a favor in certain ways, which is things that are very routine, I’m not really that interested in taking someone’s money for. Number one, I get paid hourly or even on projects I get, I scope how much time I’m going to put into it. So, if I just really had to grab a form and put in a name and send it, there’s not any real money on it anyway. I would feel badly charging someone something more. I’m happy that the easy legal world is more accessible for my clients. That’s great, you know? It frees a couple dollars up for them to do other things and for me to work on more high-value transactions.
The way this is all going is that it’s no longer about the paper, that’s not where my value is. You can have my forms. I don’t care. In fact Carrington is a big West Coast startup and technology law firm and they’ve got a huge technology practice and their forms for startups are free on their website. You can go and get bylaws and certificate of formation and an option plan. They don’t care, that stuff’s out there. The value they provide is advice – telling you if that’s the right form to use, what needs to change. Any lawyer who’s still guarding their forms like they’re precious and that’s where the value is is missing where this profession is going. That stuff’s all out there and it still doesn’t make me any less useful, but it makes my role different.
Now, there’s talk about these small contracts and whether or not they’re even enforceable. Let’s talk just for a second about whether smart contracts are enforceable. And my answer is yes. As any good lawyer, I’m going to qualify that just a little bit, but yeah there’s no reason not to expect a smart contract, typically, to be enforceable. Now the major elements of a contract are an offer by one party and an acceptance by the other party. There’s also something called consideration, which is kind of a weird esoteric term, but the reason you sometimes see someone selling something for a dollar or ten dollars, you know, they’re transferring a piece of real estate for ten dollars, I mean the real estates got to be worth more than ten dollars, but what’s going on is they’re giving it to the person, but they’re putting “consideration” into the document. Those are the main elements, there’s mutuality of obligation, there’s some other things, and sometimes it has to be in writing, but rarely. So, these are the things that make a contract.
A smart contract is really no different. I mean, the form of it right, whether it’s written, whether it’s a physical piece of paper I’m holding my hand, whether it’s on the computer in the form of a PDF or whether it’s coded on a blockchain, it doesn’t change. There are, in the short term, I think because the use cases for smart contracts are going to be so niche so most examples there could be a piece of the transaction that takes place on the blockchain but other things will have to take place off-chain and there’s are things called oracles that can monitor offchain activity (things like the delivery of packages, arrival of a vehicle in a geofenced area, etc) and report satisfaction of contractual conditions back to the smart contract on-chain.
These smart contracts are going to be part of a broader transaction. Now, we have a contract, offer and acceptance, consideration, so I don’t think that means it renders the smart contract useless because you need a piece of physical paper or PDF or something. It’s going to be needed anyway to kind of put the whole context around the transaction of which the smart contract will be just one piece. So, in that, you’d have some of those elements that today may be a little bit hard for a court who’s looking at this after the fact to decide if was there offer and acceptance on this thing. Now, really soon the law is going to take care of that. There’s going to be changes, I can guarantee it. It’s like e-signatures. For a while there I would hear people writing online and talking the fact that these aren’t enforceable, there’s no law to enforce them. Look, they were. I mean, most courts would have enforced those even before the digital signature legislation and all that. Could there be some risk? I mean, some judge who doesn’t understand it throwing it out? Sure. Or some judge who wants to rule against enforcing that contract for some other reason, equitable reasons, sort of real-world reasons that drive decisions? Yeah that could happen, but generally speaking, if the court gets this thing it’s obvious the parties agreed to do something. It’s just that part of the execution took place on the blockchain, and that’s going to be enforceable. Again, I expect some federal legislation to come out kind of like it did with the digital signatures to just take care of and put the issue to rest once and for all so we don’t all have to debate or worry about weird corner cases, but I wouldn’t be worried about being out on the bleeding edge with clients, I’m not worried today about doing things in the smart contract space. You know, depending on the size of the transaction, right. I mean if my client iss making a ten million dollar investment into someone, well I might just say that might not be the best use case for something very cutting edge, right. You see where I’m going with it, I mean there might be circumstances in which you say it just doesn’t make sense, but generally speaking, they’re enforceable, they will be enforceable, there’s no question. By the time we get to doing things that are more fulsome, like larger transactions and things there’s no question this issue will be covered over.
So, I’m really curious what you think about this. If you have thoughts about trying to use smart contracts, if you’re a lawyer and you’re listening to this, what are you thinking about? One thing that I’m wondering a lot is where this all goes. Do you think that every lawyer is going to need to code? Do you think that the coders are all going to need to be sort of armchair lawyers? Are they just going to be working together and every law firm is going to have a huge IT department? Where do you the world is going with this? Or do you think it’s more hype than then promise?
I think it’s more promise than hype when it comes to smart legal contracts, even though there’s a ton of hype. I just think it remains to be seen how it’s all going to unfold, but I want to hear from you. So drop a comment, send me an email firstname.lastname@example.org. Thanks for tuning in today and appreciate it.