United States: Five Things To Know About Smart Contracts

Computer scientist and legal scholar Nick Szabo first proposed the idea of "smart contracts" in 1996. Szabo published his initial paper on the topic in a publication called Extropy, a journal of transhumanism, a movement seeking to enhance human intellect and physiology by means of sophisticated technologies. At the time, the idea was nothing if not futuristic.

Fast forward 22 years, and even if the actual use of smart legal contracts remains largely in the future, the idea of them has gone mainstream. What follows is our list of the top five things you need to know about this quickly evolving area.

1. Their Name Is Somewhat Confusing

When lawyers speak of contracts, they generally mean agreements that are intended to be legally enforceable. In contrast, when most people use the term "smart contract" they're not referring to a contract in the legal sense, but instead to computer coding that may effectuate specified results based on "if, then" logic.

Advocates of smart legal contracts envision a day when coding will automatically exercise real-world remedies if one of the parties to a smart contract fails to perform.. For example, if an automotive borrower were to fail to make a car payment, coding within the smart loan agreement could automatically trigger a computer controlling the relevant car to prevent the borrower from driving it, or could cause the car to drive autonomously to the lender's garage.

Even then, whether coding itself could ever satisfy the requirements of a legally binding contract is up for debate.

2. They Are Works in Progress, But Hopes Are High

Smart contracts also aren't particularly smart. For one thing, the "if, then" logic of their coding typically relies on an external source of information, a so-called "oracle," to state whether a certain event has occurred and a prescribed remedy should thus ensue. In most cases, connections between the coding and the oracles are works in progress. Likewise, connections between smart contracts and the means to exercise real-world remedies for nonperformance are still being built.

Smart contracts' relatively early stage of development has not dimmed hopes that they will ultimately play a large, even central, role in much commerce. Some proponents have claimed that they will revolutionize business arrangements by offering a more efficient alternative to conventional contracts, dramatically lessening enforcement costs while limiting the government's role in contract enforcement.

3. Major Projects Are Percolating

Work on smart contracts has begun in earnest. For example, a smart-contracts consortium, the Accord Project, has begun work to develop "techno-legal standards" and open-source software tools for smart contracts. And a syndicated loan industry group, the Loan Syndications and Trading Association, has released a detailed white paper exploring how smart contracts might allow parties to transact more efficiently and securely.

The International Swaps and Derivatives Association, the derivatives-industry trade association, has begun work to identify legal and documentation issues that may arise from smart-contract technology. And certain smart-contract functionality is now offered on Ethereum, an open-source, blockchain-based distributed platform.

4. They Will Likely Rely on Distributed-Ledger Technology

Smart contracts are distinct from distributed-ledger technology, such as the blockchain system, but are often discussed in the context of that technology, which permits the sharing of synchronized digital data geographically over multiple sites without any central administrator. Distributed-ledger technology is expected to facilitate the use of smart contracts by permitting the relevant coding to be embedded in the shared ledger while preventing either party from altering that coding.

5. Regulation May Be on the Way

While certain proponents of smart contracts may wish to limit governmental involvement in the realm of private contracts, it nonetheless seems likely that smart contracts will engender their own regulation. From a legal perspective, much of the novelty of smart contracts is the automatic nature of the exercise of remedies for breach. Legislators and regulators may well wish to limit the remedies that may be agreed in advance or exercised without human intervention.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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