By: Hunter Becker
A smart contract is a computer programmed protocol intended to digitally facilitate, verify, or enforce the negotiation or performance of a contract upon the conditions being met. Smart contracts are one of many technologies coming out of blockchain that raise legal concerns. A blockchain is a distributed network that is used for various purposes, primarily business transactions. The main properties of blockchain are that it is immutable and distributed to create accuracy and safety. Blockchains, compared to traditional finance, have many benefits as well as many detriments. Some of the benefits are that it is trustless (only executes transactions when programmed conditions are met by both parties), unstoppable once the commands are executed, immutable so records cannot be changed or tampered with, and decentralized so no single entity maintains the network. Some of the detriments are that blockchain networks use a lot of electricity to validate a transaction. Additionally, the user is the final authority so if you lose your password to your online wallets, for example, your money is gone forever. Lastly, cryptocurrencies using blockchain technologies can cause fraud or deceit by using false narratives to entice consumers into purchasing.
Smart contracts were coined by Nick Szabo in 1994 when he identified the programmable language that could be used and the potential for greatly reducing transaction costs of executing some contracts. The first cryptocurrency that created the platform for coding smart contracts is Ethereum. With Ethereum and the other cryptocurrencies using smart contracts, parties to the contract do not need to rely on traditional avenues to execute the contract such as lawyers or banks. However, despite all of the alleged advantages, no one can say that Ethereum or other cryptocurrencies are fully secure platforms. If there is an unexpected bug in the smart contract code that causes the condition(s) to become satisfied, the contract could execute with possible losses to one or both sides of the transaction. One example of a smart contract failing is with a cryptocurrency called IRON, there was an issue in the code of the smart contract where the programmer had set a condition “greater than zero” rather than, as it should have been, “greater than or equal to zero”, which resulted in a couple hundred million dollars of permanent loss for its investors.
Recently, Mark Cuban, co-owner of the NBA Dallas Mavericks and main investor on the series Shark Tank, has voiced his concerns over smart contracts. Cuban stated that smart contracts are the most likely source of fraud by committing intentional omissions, undisclosed actions, and lack of clarity for the parties entering into the agreement. Cuban further stated that since there will be fraud the federal government will likely not allow for anonymous smart contracts. In the United States (“U.S.”), the Securities and Exchange Commission (“SEC”), generally has regulatory authority over the issuance or resale of any token or other digital asset that constitutes a security. Under U.S. law, a security includes “an investment contract,” which has been defined by the U.S. Supreme Court as an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.
William Hinman, the SEC’s Director of Corporate finance, stated in a 2018 speech that cryptocurrencies are not securities:
Returning to the ICOs [Initial coin offering] I am seeing, strictly speaking, the token – or coin or whatever the digital information packet is called – all by itself is not a security, just as the orange groves in Howey were not. Central to determining whether a security is being sold is how it is being sold and the reasonable expectations of purchasers. When someone buys a housing unit to live in, it is probably not a security. But under certain circumstances, the same asset can be offered and sold in a way that causes investors to have a reasonable expectation of profits based on the efforts of others.
Currently, there is a lawsuit in the Northern District of California where there are property rights issues related to obtaining crypto. Plaintiff Shin is bringing suit against South Korea crypto company ICX for freezing his assets. ICX supports smart contract facilitation like Ethereum. On this matter, Judge William H. Orrick ruled that Shin could still have a property claim to the ICX tokens because he had control before he was locked out as he “minted, created, and staked a claim to the ICX tokens on the blockchain.” Setting forth this standard raises some legal concerns. If a party can validly use a smart contract network to stake a claim to property against the creators’ desires and intent, what other types of transactions could occur between people using smart contracts where there is illegal use of fraud, deceit, unilateral mistake, or impracticability on one side? In fact, the creator of Ethereum, Vitalik Buterin, noted in an October 2018 Tweet that “To be clear, at this point I quite regret adopting the term ‘smart contracts’ … I should have called them something more boring and technical, perhaps something like ‘persistent scripts.’” This is most likely due to all the issues and shortcomings with smart contracts addressed in this blog.
With all this uncertainty, are smart contracts smart or contracts at all? If a programming bug can execute a contract worth hundreds of millions of dollars, there is no mutual assent and therefore no contract. If there is a failure to satisfy a condition, is a party able to sue and seek damages on these smart contracts? Would a contract transacting something worth so much money be considered “smart” if it operates on its own and is fallible to the programmer’s code? Regulators need to watch closely and analyze if these smart contracts are decentralized or if it is just a show in an attempt to get around regulation, bringing enforcement actions where necessary.
Student Bio: Hunter Becker is a second-year law student at Suffolk University Law School. He is a staffer on the Journal of High Technology Law. Hunter received a Bachelor of Arts Degree in Environmental Science and Policy from Florida State University with a minor in Computer Science.
Disclaimer: The views expressed in this blog are the views of the author alone and do not represent the views of JHTL or Suffolk University Law School.
