As the financial world has become increasingly digital, smart contracts — predicted to eliminate paper contracts entirely as well as many collection efforts — are on the cutting edge of forward thinking legal innovation. Joseph Bonanno examines the steps required to make these contracts the norm as well as the legal issues surrounding their use.
In the early 1980s, a group of second-year law students who survived their first year of law school were in a Uniform Commercial Code Article 3 and Article 4 class studying banking laws. The professor presented a hypothetical discussion question to the class: “Do you agree that we can develop a checkless and cashless society? If we can, what laws would have to develop to enable that system to function?” The majority of the class chuckled and snickered … how could any banking or financial system function without checks or cash? It could never happen.
As we begin 2018, it’s obvious that the professor was right. Today’s discussion question for forward thinking legal innovation becomes what are legal scholars forecasting in 2018 for technological development and what types of laws will have to develop to facilitate those developments?
Contracts of the Future
The answer to the first part of the question is, legal scholars are forecasting the development of smart contracts. The complexities of technological innovation required to create these contracts aside, the end result is predicted to be the elimination of paper contracts and, 2018if the innovations are taken further, the elimination of a bulk of collection efforts.
Imagine a set of financing documents for multiple financial needs are in the cloud of a financial service provider. Once a deal is approved, the financing provider directs the customer through the financer’s website to the cloud for document execution. Both parties complete documentation on the cloud and affix their respective digital signatures to the cloud-based financing documents. After the cloud documentation process is completed, peer-to-peer payments are made by the debtor directly to the smart contract through the use of blockchain cyber currency, eliminating the need for payments to come through a third-party bank in any form (check, authorized debit or auto-pay).
The smart contract, through computer code, will track all payments made or not made. For payments that are made, the smart contract will send an email acknowledging the receipt and application of the payment. For each payment that is not made, the smart contract will send a notice that a payment due has not been received. After a sufficient number of missed payments, the smart contract will send a notice of default. A futuristic notice of default issued by a smart contract will contain language like this:
You have missed X number of payments, due on X, Y and Z date. In accordance with paragraph X of your contract, you are now in default, and this correspondence constitutes a notice of default to you. As a result, you have 10 days from the sending of this notice to remit the amount of $X to bring your payments current. If the aforesaid payment is not received, then as of the close of business on X day, the equipment will no longer function (or other functions of the financed asset will be disabled, such as deactivation of all electronic key cards). Once all past-due amounts are paid, the equipment will be turned on again.
Smart Contract Components Today
The technology for smart contracts exists. The cloud is here, but it presents legal issues with respect to contracts completed in the cloud. Digital signatures exist, but they are not 100% perfected. Blockchain cyber currency is in its infancy and can expect to encounter growing pains on its way to becoming mainstream. The ability to turn off equipment exists, and passkeys to buildings or secure areas of buildings can be deactivated. The technological ability of a smart contract to turn off equipment can be extended by technology to detect unauthorized movement of the equipment’s location through electronic tracking app technology. In the case of vehicles, the smart contract can have a provision defining a radius of the vehicle’s acceptable movement and indicating that the vehicle will be turned off if it leaves that radius.
Reaching the end goal will require the merger of existing technologies and the addition of code written to make the smart contract perform the desired functions. When this is combined with blockchain cyber currencies, the end result will be the total smart contract. As legal scholars forecast, this model will become the normal course of business in the future. But what are the legal issues?
The contracts of adhesion is a legal doctrine requiring the parties creating a contract to be in positions of equal bargaining power or the contract can be determined to be void. At the same time, case law has recognized that boiler plate contracts exist within our society and using a contract of adhesion defense to strike down an existing contract is difficult at best.
However, when comparing a traditional paper contract to a cloud-based contract, smart contracts lack the ability to cross out, amend and otherwise make changes. That opportunity alone, which exists in a paper contract, evidences equal bargaining power. Will smart contracts also have this feature? The only people who can answer that question are the code creators. If smart contracts have this feature, how will the mutually agreed upon changes be reflected in a cloud contract? Enforcing a cloud contract will be contingent upon confirming the parties had equal bargaining power prior to the formation of the contract and that the cloud contract is not a “take it or leave it” contract of adhesion.
The second legal issue to consider is the uniformity of digital signatures. During his presidency, President Clinton signed the digital signature law. However, legal scholars have struggled to define what constitutes a digital signature. Is a facsimile good enough? Is a PDF any better? Is /s/ sufficient to commit to a contract?
To resolve this issue, an entire “virtual notary public” industry is developing to verify digital signatures. The problem is, unlike a real notary public, they cannot act as a self-proving 100% guaranty of the authenticity of a signature as a real notary public does. It would not surprise me if some type of fraud overwhelms the industry as it develops.
Digital signatures will have to become more uniform. Perhaps they will be driven by fingerprints, face recognition, voice recognition or a combination of these, all from a personal computing device. Whatever the industry standard becomes, it will require a secure and uniformly-recognized form of digital signature, which will lend itself to duly-authorized execution of smart contracts.
The third issue is the development of cyber currency though peer-to-peer blockchain technology, which will eliminate the need of banks for payments. This industry is in the infant stages and who knows where the standard will end up? From a legal perspective, the law will have to develop to recognize cyber currency as equally as all other forms of currency. Government will have to get on board with this issue.
Lastly, the ability to shut down equipment through a smart contract will be known as a virtual repossession, which will be an entirely new area of the law. Imagine if someone is having a heart attack and has to get to the emergency room, but the ability to start an ambulance has been shut down due to non-payment by the ambulance company. Imagine if a portable ultrasound machine in a doctor’s practice was shut down due to an electronic error, and a patient’s blood clot cannot be found because the machine can’t be used. Where will the law go with these and even more issues that will develop over time?
Think this is over the top? Nevada, Vermont, Delaware and Arizona have already adopted legislation recognizing smart contracts and blockchain technologies. Many other states have created task forces to explore the development of legislation. Just as paper contracts now state that a contract is governed by the law of a particular state, the enforceability of smart contracts will also be governed by different state laws. Which state law? The law will have to answer that question.
Remember, not so long ago we were laughing at the idea of a checkless, cashless society as radical thinking!
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