Article 11 August 2016

Blockchain and Smart Contracts: Game-Changing Technology?

Blockchains and "smart contracts" may revolutionise the mechanisms for storing, tracking, trading and verifying assets and information. But what are they and how do they look like from a legal perspective?

What is a blockchain?

A blockchain is as a distributed database of transactions recorded in a chronological order. Each transaction is recorded on a block by a time-stamp. The blocks are then chained together by using a unique address, called a "hash".

The transactions are secured by verifying the accuracy and validity of the information before adding the block to the chain. The blockchain is permanent and grows with each additional transaction and can be used to confirm the most recent transaction and all of those on the chain.

Blockchains operate across a network of computers, which allows anyone on the network who knows the address of the blockchain to access the information. They are not owned or controlled by anyone, meaning that the people on the network maintain the blockchain themselves without intermediary involvement.

The concept of parties engaging in so-to-speak "trustless" transactions, without depending on a third party, such as a clearing house, but rather on collaboration and clever code, is only one of the many interesting aspects of the blockchain technology.

Blockchains also act as a platform upon which future applications can be built. Interestingly, smart contracts are already here to lead the way.

What are smart contracts?

"Smart contracts" are not necessarily contracts in the legal meaning but, rather, software that can form or execute a part of or an entire contract. These contracts are written in code and enforced automatically by software when specific, pre-programmed conditions are met. In other words, contracting parties agree on certain conditions and outcomes that are encoded into the smart contract.

When the necessary conditions are met, the encoded outcomes occur without the need for third-party enforcement.

Where can blockchains and smart contracts be used?

Transactions and financial services

Blockchain technology and smart contracts create a platform for trade of digital assets, which can virtually be anything of value, for example, information, money, intellectual property and licenses.

It has a potential to fundamentally change the financial services industry, as the technology removes the need of an intermediating party. This will reduce the costs and complexity of transactions, simultaneously increasing their security and efficiency.

The blockchain is evolving to be applied to a broad range of crypto-currencies (currently primarily bitcoin) and other asset classes. The development may disrupt the role of banks, but is also prone to create new financial service opportunities.

Notary and registry services

A blockchain is like a decentralised ledger that cannot be altered by third parties. It therefore has great potential to be used for notarising and certifying documents.

The documents are uploaded to the blockchain with a unique digital identifier and timestamp. They are then verified independently without the need to share the document. Supply chains could also benefit from blockchain-based registries, which could track the whereabouts and changes in the ownership of an asset.

IP management

Managing and securing the revenue of intellectual property might be a whole lot easier in the future. Brand management issues, for example, could be solved by using the blockchain technology and smart contracts to create digital registries to track licenses and changes in ownership and to maintain documentation relating to the intellectual property.

The technology may also offer a means of creating a new, global database for music, films and other content, functioning as a distribution channel and providing an opportunity for creators to secure their receiving of royalties. Blockchain technology is also expected to foster the growth of IoT devices due to the reduction of costs resulting from decentralised storage and use of data. (see our article on IoT)

Decentralised autonomous organisations

There are discussions about using blockchain as decentralised organisations that are akin to corporations without legal personality and that would be run by a set of business rules, enshrined in software code, recorded permanently on a blockchain and transacting through smart contracts. These types of entities, self-governing their actions in accordance with the bylaws in which they were coded, would , for example, enable suppliers to receive greater value from their services as third-party resellers could be replaced by smart agents on a blockchain.

Smart contracts from a legal perspective

It is possible that blockchain technology and smart contracts could create significant changes to existing contract law.

Blockchain technology and smart contracts will undoubtedly have implications on the legal practice, but before forgetting everything you know about contract law, it is worth considering how they fit into the current Finnish contract law.

The Finnish civil law system does not recognise the principle of consideration, where a contract is only valid where both parties promise something of value. We are, therefore, not faced with the same challenges as common law countries in connection to smart contracts. In addition, the absence of formal requirements of contracts has been recognised by the Finnish Contracts Act (228/1929, as amended) for decades.

Real contracts are considered valid in Finnish contract law, and many smart contracts belong to this contract type. The self-executing nature of a smart contract resembles a simple vending machine, in other words, a machine transferring an asset (candy bar), when provided with a certain defined input (the price of the candy bar).

Even though the implications of blockchain technology and smart contracts may not, at least in the near future, be as radical as some claim, we do have some practical challenges ahead.

Error in declaration and unjust enrichment

The self-executing nature of smart contracts may cause problems if the contract turns out to be based on erroneous coding and the contracting party needs to restore the legal status or prevent unjust enrichment. Fortunately, expressions that differ from the parties' intent are not legally binding in Finland and there is no reason why this would not apply to smart contracts as well.

There is, however, no way of escaping the practical challenges of undoing an already executed transaction. Enforcing the return of unjust enrichment when the assets are already distributed may be a heavy burden for the claiming party.

Presentation of evidence

Dispute resolution will need to adjust to the new landscape of contract law, as smart contracts will be subject to interpretation by courts in the future. It will undoubtedly be a challenge to code such contracts that preserve their original content when the code is translated into human-readable format.

The courts will certainly continue to resolve disputes on the basis of human-readable materials at least in the foreseeable future.

Which version will prevail, if there are discrepancies between the coded and the human-readable version of the contract? How will the obligation before public courts to translate codes into Finnish or Swedish be realized in connection with smart contracts?

The art of assessment

As described in this article, smart contracts self-execute based on certain pre-programmed conditions. But how do we translate legal expectations into code, especially if these conditions are subject to any degree of interpretation? Certain contractual terms, such as "reasonable", "in good faith", "best endeavours" and "material" always require a certain degree of assessment for establishing that the conditions are met.

Are we prepared to delegate this kind of discretionary power to technology and if so, to what extent?

Blockchain technology and smart contracts will have an effect on how we do business and enter into contracts. Simple and minor transactions will probably benefit from the technology already in the near future, but as many questions are yet to be answered, it is unlikely that complex transactions or contracts subject to interpretation would be translated solely into code anytime soon.

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