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Smart Contracts Part 1 – Basics and Status at Law

For those readers that are tech savvy and keep up to date with financial developments, the buzzwords cryptocurrency, bitcoin, and blockchain should immediately ring a bell. Another development called smart contracts should also be on your radar. Essentially built upon blockchain and distributed ledger technologies, these smart contracts are one of the highly touted tools that are set to streamline transactions in a pseudo-contractual space.

A basic understanding of smart contracts:

Essentially, a smart contract is just computer code. It is arranged, for now, as a set of “if-then” statements in computer language. For instance, if Party 1 delivers a package to the delivery location, Party 1 will be paid $10 by Party 2. The delivery to the contracted location is the triggering event that disburses the funds to Party 1 from Party 2. The language used to program a smart contract may be unique to the distributed ledger tech that the smart contract software is based upon (e.g., Ethereum). Like other financial tech based on blockchain tech, the positives of a smart contract are efficiency and security. It is efficient because it no longer requires the use of a traditional intermediary (middleman) like a bank, clearinghouse, accounting department, or company. Once the conditions of an agreement are met, the transaction or any subsequent condition will automatically execute. It is secure in the same respect that virtual currencies like bitcoin are secure—the ledger (blockchain) is distributed, cryptographic, and immutable due to computer processing limitations. These contracts are not limited by simple if-then steps either, as the programming language can in theory result in very complex contracts.

Smart contracts are somewhat of a misnomer. It is still unclear how a smart contract will be a legally recognized as an enforceable contract in a court of law. One limitation is that it might lack the formalities required in legal contracts for certain transactions (e.g., a signed writing that satisfies a statute of frauds). Moreover, the terms may not be understood until translated from computer code to plain English, and that translation can form the basis of many misunderstandings or interpretations. Additionally, how will the blockchain handle amendments to a smart contract?

In North Carolina, a recent law was passed that formed “regulatory sandboxes” for financial and insurance technology enterprises. These sandboxes are basically a testing zone for innovative new products and services. The benefit of the sandbox is that it is a fast-pass to the marketplace—typically, there is regulatory red tape that must be navigated before marketplace entry. However, in the Act, our Legislature essentially stated that the Uniform Electronic Transactions Act adequately addresses the legal enforceability of smart contracts. The Uniform Electronic Transactions Act basically makes electronic signatures sufficient in electronic transactions.

Smart contracts, at this time, also lack flexibility. The rigidity of the smart contract’s if-then coding means that complex, or real-world transactions may not be best suited for the platform. For instance, many times a buyer may forgive a supplier for a one-time small breach to promote general good relations; in a smart contract, will there be space for such flexibility given its automatic nature? As it stands today, perhaps the smart contract is more of a tool than a replacement for the traditional written contract. A traditional contract can include a term for the usage of a smart contract and how disputes arising from said smart contracts should be resolved. There is a place for smart contracts; binding parties to terms in an automatic and efficient manner has many benefits, often saving both parties a lot of funds that would be spent on an intermediary. But the technology needs to develop, and the courts must find a way to adjudicate disputes if it is ever to transform into a true legal contract.