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O'Toole, Kelly and Hahn Discuss Why Smart Contracts Need Smart Corporate Lawyers

February 7, 2018

With the development of advanced distributed ledger technology and coding comes the potential for deployment of “smart contracts.” These programs autonomously effectuate and enforce contractual rights and obligations without the need for further human intervention. Strictly speaking, a “smart contract” need not be a legal agreement at all; fundamentally, it is computer code that automates performance of an already existing contract. Yet many smart contracts — such as the “Ricardian Contract” and other “smart legal agreements” — may constitute self-effectuating contracts in software, potentially in a format that could be both machine-readable and intelligible to the parties and their counsel. Given the promise that blockchain technology holds for making certain types of transactions more efficient, economical, reliable and transparent, smart contracts have been the subject of substantial development efforts by financial institutions and technology firms.

As various forms of smart contracts begin to manage and transact substantial digital resources (e.g., cryptocurrencies and potentially fiat currencies, corporate securities and other financial assets), users of this technology must mitigate its risks. Chief among these is the operational accuracy and security of the code. According to a paper published by the Association for Computing Machinery in 2016, coding bugs and other vulnerabilities were identified in nearly half of all smart contracts written on the Ethereum blockchain, potentially putting at risk $30 million worth of the virtual currency Ether. A review of Ethereum smart contracts conducted by Peter Vessenes, the co-founder of the Bitcoin Foundation, revealed at least 100 errors per 1,000 lines of code. The high error rate, in part, may be attributed to the fact that writing smart contract code remains highly complex. Researchers at the University of Maryland’s cryptocurrency lab observe that “even for very simple smart contracts (e.g., a 'Rock, Paper, Scissors' game), designing and implementing them correctly was highly non-trivial.”

The June 2016 hack of “The DAO” best illustrates the downside risk. The DAO was a “decentralized autonomous organization” deployed as a smart contract on the Ethereum blockchain. An attacker stole approximately $50 million worth of the organization’s virtual currency by exploiting a vulnerability in its code. Hackers have stolen a total of more than $1 billion worth of various virtual currencies, with potentially the largest theft of nearly $500 million worth of cryptocurrency occurring just last month. Put simply, “there is no such thing as flawless software; there are always errors or ‘bugs’ that negatively affect the performance of the software or make it vulnerable to attacks by hackers.” Even the humble vending machine, the “original” smart contract, can malfunction or be manipulated. As financial institutions, technology companies and other firms utilize smart contracts for a rising number of transactions of increasing value, the operational and security risks will only intensify.

Thus, rather than reducing the role of corporate lawyers, smart contracts may expand their responsibilities; electronic discovery’s transformation of business litigators’ practices provides a possible analogy. Just as today’s litigators work closely with e-discovery vendors, tomorrow’s transactional counsel may work alongside smart-contract programmers to develop and encode accurate and secure smart contracts. Others have made similar predictions: the Harvard Business Review recently suggested that smart contracts may require law firms “to develop new expertise in software and blockchain programming,” while a recent Governance, Risk & Compliance Technology Centre publication stated that “smart contracts should be authored by both the lawyer and the developer” given the “paramount” role lawyers play in contract drafting. Computational legal projects and other legal engineering ventures focused on drafting legal documents in software code already are under way.

How can corporate lawyers deliver value to their clients in the context of smart contracts?

  • Advising and Negotiating Deals. Before any smart contract code is deployed on a blockchain, parties considering a potential transaction generally still need their counsel to: advise them regarding the deal process, timing and structure; assist them with negotiations (particularly as to the noncommercial aspects and legal provisions of the agreement); apprise them of the deal’s various legal and regulatory implications; and guide them through compliance with those requirements. The lawyer’s traditional advisory role largely should not change and may even expand because parties “would most likely want to specify a more detailed range of contingencies and outcomes ahead of time before committing themselves to abide by the decisions of a software-driven contract.” In a similar fashion, corporate counsel in the future may prepare reusable “form” smart contracts and coding templates for standardized documentation of routine transactions.
  • Selecting Contract Form. The nature and complexity of a transaction will impact whether, how, and to what extent an agreement can or should be memorialized or performed by smart contract. There is no single type of smart contract, nor is a smart contract entirely appropriate or possible for every agreement. For example, contracts may have “non-operational clauses” (such as “best efforts” and “good faith”) that do not translate easily (if at all) to executable code. These provisions (or the contract as a whole) may need to be written in natural language and not (or in addition to) computer code. Even if non-operational clauses could be written completely in code, negotiating parties may not be able to agree on the precise programming language. Corporate lawyers and clients also may prefer traditional non-operational clauses after weighing the benefits of deterministic code against the possible loss of linguistic expansiveness and expressiveness. Additionally, a blockchain-based smart contract may be inadvisable if a party’s performance would not be effectuated on the blockchain or if the transaction involves off-chain digital assets (of course, parties might work around these issues by involving an external intermediary). Deal counsel can assist clients in determining if a smart contract would be preferable in place of or as a supplement to a natural language contract, and, if so, in selecting which of the various forms of smart contract would be best for the particular transaction involved.
  • Translating Contract Terms. No matter the form of smart contract, it will to some extent comprise software code — e.g., to automate performance of an already existing agreement, or both to express the parties’ legal agreement and to encode its performance. Smart contracts are generally written in high-level programming languages and then reduced to byte code, a machine-readable set of instructions that may be difficult for humans to understand. At both levels of coding, the parties’ intent can get lost in translation, resulting in mistakes or vulnerabilities. One of the primary reasons for coding errors in smart contracts is that the software developer may not have the economic perspective or legal knowledge necessary for accurate programming. A capable transactional lawyer can bridge this gap, identifying and correcting business errors commonly encoded in smart contracts. Working alongside software developers, deal counsel can: identify legal prose and business concepts in operational clauses to be expressed in computer code; translate those words and concepts suitably into automatable smart contract code; verify that the code performs as intended (first in a testing environment); and, finally, help revise the code as necessary to address any errors.
  • Facilitating Performance. Smart contracts may require intermediation by or with external parties or services. For example, a particular smart contract might not be fully automatable and self-executing; it might execute instead upon the happening of an external event or might need to interact with an external party to effectuate performance. Law firms could serve as “oracles” — trusted parties that facilitate contract execution by serving as an intermediary between the smart contract and the outside world. Legal oracles might, for instance: supply data to trigger smart-contract execution; retrieve data from the blockchain and deliver it to a third party to cause off-chain performance; assist with resolution of unforeseen “corner cases” in smart-contract states; and halt the contract’s execution upon the happening of some external event (e.g., a court order or bankruptcy stay).
  • Arbitrating Disputes. Smart contracts may involve non-operational clauses relating to the parties’ broader legal relationship that may be difficult to express in conditional logic. For instance, where an agreement (or applicable law) requires a party to act in “good faith” or in a “commercially reasonable manner,” the meaning and application of such provisions may be subject to dispute. Corporate law firms could provide escrow-like services for multi-signature transactions, acting as a trusted, neutral third-party to provide the second signature in a “2-of-3” multi-signature transaction where the parties have a dispute. A law firm could also serve as a mediator to facilitate a mutual resolution of a dispute regarding the parties’ compliance with non-operational clauses or perhaps the implied covenant of good faith and fair dealing, or act as an arbitrator to resolve a smart-contract dispute between the parties in a binding manner based on applicable law.

Given the operational and security risks involved and the substantial digital asset values transacted, the rise of distributed ledger technology and smart contracts will create new opportunities and responsibilities for transactional lawyers. Smart contracts need smart lawyers. Far from displacing lawyers from their traditional role in negotiating and drafting agreements, smart contracts may very well require lawyers to work even more closely with their clients to address risks and contingencies in a detailed, prescriptive fashion. Lawyers will also need to work with software developers to ensure that smart contracts are secure and accurate. If smart contracts ever do become “the foundation of our economy — possibly even our technological infrastructure,” it will be in no small part because lawyers helped the technology realize its full potential.

This article was originally published on February 7, 2018 by Law360.