January 01, 2018

Blockchain 2.0: From Crypto to Contracts

Victoria Walker

Many liken the concept of blockchain to Wikipedia. Both blockchain and Wikipedia contain information on their public records that is not filtered through a central entity; anyone can theoretically contribute to the public record; and, there are mechanisms in place to create consensus on what should (and should not) be accepted as part of the record. This sounds like a headache waiting to happen, right? Well, that is pretty much where the similarities end. At its core, blockchain is simply one type of technology protocol that serves as a public ledger and aims to achieve network security by emphasizing decentralization, transparency, synchronicity, and invariability. There are many uses for this technology but only one regularly appears in the current headlines.

From Crypto

Cryptocurrency is the blockchain application with which attorneys are probably the most familiar. This application facilitates the electronic transfer of digital currencies such as Bitcoin. The recent proliferation of cryptocurrencies has stirred up a variety of interesting legal questions: Who, if anyone, is ultimately liable when cryptocurrency is stolen or lost? What are the tax implications of buying, spending or holding cryptocurrency? When does an initial coin offering or token sale need to be registered with the Securities and Exchange Commission? Federal and state regulatory landscapes are quickly evolving on the issue of cryptocurrency. As the answers to these questions come into focus, ways to challenge and leverage these laws will continue to emerge. While cryptocurrency is currently enjoying its moment in the legal spotlight, other blockchain applications pose equally challenging legal questions.

To Contracts

Enter: smart contracts. Designed to “cut out the middleman,” many compare the concept of a smart contract to that of a vending machine. Inserting money into a vending machine prompts the execution of a programmed “if-then” code that delivers a product based on the button you pressed. On a fundamental level, this type of automated performance based on a set of predetermined conditions is analogous to the workings of smart contracts. Automated performance characterizes smart contracts, which go a step further by memorializing the agreement and the parties’ performance on the blockchain.

Many blockchain enthusiasts are hopeful that smart contracts’ self-executing code will lower transaction costs by alleviating the need for middlemen such as attorneys. Parties to a contract can reasonably rely on the indisputability of the blockchain and the execution of the contract’s predetermined code. However, any contract is ultimately only as good as its terms. Terms are converted into self-executing code in smart contracts and someone needs to formulate those terms. For now, attorneys (and not programmers) remain best-suited to perform that task.

Attorneys will also continue to play a major role in dispute resolution. Smart contracts may be memorialized and automated on the blockchain, but even these contracts require some reliance on human inputs and performance. As such, there remains significant room for error and uncertainty—both on the drafting side (Will contract attorneys learn code?) and on the performance side (What if a change in law renders performance illegal?). When disputes arise over errors, unforeseen circumstances, or other contracting hurdles, parties will ultimately turn to traditional legal avenues for redress—at least for the foreseeable future.

But First, The DAO

Self-executing code by itself does not pose a threat to the work of attorneys. The legal profession should consider exploring, and even embracing, this form of technology. A smart contract is essentially a set of tools (blockchain and self-executing code) that facilitate performance or implementation of a legal agreement. Smart contracts create efficiencies that translate into cost-savings (i.e., fewer middlemen, distributed storage, consensus), but attorneys are still needed. The substance of any contract, including smart contracts, does not exist in a vacuum and is subject to constraints existing laws impose. To demonstrate this point, we will look at The DAO.

The DAO was founded in spring 2016 as an investor-directed venture capital fund. This decentralized autonomous organization operated through a series of smart contracts, meaning no single person or entity controlled the organization or execution of the code. The DAO set out to act as a crowdfunding vehicle that enabled individuals to buy DAO tokens using the cryptocurrency Ether. In turn, token holders were entitled to vote on how the fund invested in various projects with the promise of a return if the project was profitable. In summer 2016, a hacker exploited a flaw in the code, draining one-third of the fund. This event prompted Ether’s market price to decline sharply and The DAO died a slow death from there.

Admittedly, it is highly unlikely that an attorney would have been able to prevent exploitation of The DAO’s flawed code. Attorneys did warn about The DAO’s unregistered securities offering and potential violation of federal securities laws. In July 2017, the U.S. Securities & Exchange Commission (SEC) confirmed these warnings when it issued its Report of Investigation on The DAO. The SEC stated that blockchain-based securities are subject to securities laws and must register offers and sales unless a valid exemption applies.

The DAO failure is one example of how attorneys play a unique role in the adoption and success of blockchain technologies. As the next chapter of the digital era unfolds, attorneys can occupy a front-row seat as counsel and shape new laws as advocates.

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Victoria Walker

Victoria Walker is a blockchain enthusiast and associate counsel at the Board of Veterans’ Appeals in Washington, DC.