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"Modern businesspeople and lawyers are, in fact, powerful sorcerers," or so says Yuval Noah Harari in his new book Sapiens. As a lawyer, this makes me feel exceedingly powerful and special. I am Merlin, I am Gandalf, I am the Red Woman! As a commercial lawyer, I take complex and abstract ideas and turn them into concrete obligations between companies and people. I create enchanted pieces of paper that, through the mere words on the page, control how people act.
I kid, but this magic, known as drafting contracts, is fairly remarkable – through precise language and the threat of judicial enforcement, our legal system allows us to create and enforce almost any agreement that we can imagine. Freedom of contract may sound banal, but it's the foundation of our economy; it's the basis of the largest deal and of the most complex derivative. It may be a dull, grey magic, but it's still kind of magic.
But sorcerers don't work for free, and legal magic can be costly. Sure, there is a cost in drafting a contract, but there is also a cost in monitoring, executing and enforcing a contract. Even something as simple as a call option requires that the buyer monitor the option and then execute the option if it's above strike price on its expiry date. And then, it requires that the seller deliver (and possibly first acquire) the stock to the buyer, and that the buyer deliver money to the seller. Each step in this simple transaction is relatively simple, but not costless. Increase the complexity of the transaction, and the monitoring and execution costs also increase.
If the seller fails to deliver the shares to the buyer, the recourse – a lawsuit – is not cheap. Contracts don't enforce themselves.
But wouldn't it be great if they did? If a call option automatically executed at the strike price, and if the shares and funds automatically transferred, contracting would be cheaper and more efficient. The contract would become a self-executing legal thing.
This is the premise behind smart contracts, a big part of the marketing behind the crypto-currency du jour Ethereum. Smart contracts are not new per se. Usage limitations on software are the most common kind of smart contract. Instead of having software users promise not to download the software onto multiple computers, the software is designed so that it can be copied only a limited number of times. Compliance with the contract is built into the contract itself: a far easier option than Microsoft suing everyone who shares Office with friends and family.
The proposal of Ethereum and other platforms is to use the blockchain to create smart contracts. As I've discussed, the blockchain is a decentralized ledger that allows parties to transact with one another without requiring a third-party intermediary such as a bank. Transactions are verified by the bitcoin community, which receives bitcoins in payment for this service, creating a (hopefully) secure record of all bitcoin transactions.
A smart contract would link the bitcoin transaction to a contingent outside event. So, in the option example, once the stock hit the strike price, funds would automatically leave the buyer's wallet and stock would automatically leave the seller's wallet (assuming there was a blockchain for stock), the transaction would be verified by the community, settling instantly, without any need for monitoring or enforcement by either party. Or trust between the parties. Proponents of these "programmable transactions" hope they will remove the need for lawyers.
It would take a bit of magic to make this a reality.
One of the biggest surprises of the practice of law is how highly mechanical the elements of corporate law can be. Many companies have paper share certificates that actually need to be moved from one place to another in connection with a deal closing, multimillion-dollar wire transfers are executed through a laborious back-office process where astronomical sums disappear from one bank account into the ether for hours before posting to another, basic financial transactions such as syndicated loans can take almost 20 days to settle.
If the blockchain fulfills its promise as a secure ledger allowing for private and near-instant transactions, it could be hugely helpful in making the business world a bit less mechanical.
But smart contracts themselves may have limited application. They are immensely useful when the rights under the contract are triggered by an event outside of the control of the parties, such as in the stock-option example. Automating the transaction is purely an efficiency gain.
But most events in contracts aren't easily verifiable and uncontroversial. Not only will smart contracts require drafters to anticipate the events that trigger a payment, but, as Matt Levine points out, even basic financial contracts contain commitments to adjust prices in a reasonable way in certain broadly described, but ultimately unspecified, circumstances. There is much room for dispute.
And it doesn't stop there. Some obligations may be dependent on the actions of one party. For example, a stock purchase agreement may contain various conditions that have to be true in order for the transaction to close. The agreement may also contain a clause stating that the buyer can refuse to close if one of those conditions is untrue (for example, a condition stating that there are no lawsuits against the company being bought) and that the untruth of that condition would cause material damage to the company – a concept known as a "materiality qualifier."
This can be a major negotiation point – the presence of a materiality qualifier means the seller can force the buyer to close if the potential for damages to the buyer from the litigation are immaterial; without the qualifier, the buyer can refuse to close if there is any qualification.
A smart contract is almost useless in this situation – whether a breach is material is a legal question requiring legal analysis. There's no set of verifiable events at the time of closing that can indisputably determine whether such a breach is material or not.
Vitalik Buterin, a founder of Ethereum, has proposed a solution to this problem – decentralized "smart" courts, which look an awful lot like the kind of trusted, third parties that smart contracts are supposed to eliminate.
Indeed, the only time when there is an easily verifiable event in this situation is when a court, or arbiter, or smart court, reaches a final, unappealable decision. In theory, then, smart contracts could make the enforcement of judgment easier.
This is now all speculative. But it's hard to see how smart contracts obviate the need to have lawyers drafting, interpreting and enforcing contracts. No matter which way you slice it, there seems to be only one reasonable conclusion: smart contracts will still need lawyers to work their magic.
Adrian Myers is a lawyer at Torkin Manes LLP.