"Smart" Contracts: Magic, Myth or Misnomer?

The potential to use blockchain technology to create so-called “smart contracts” for a variety of commercial transactions has been much in the news lately. Some see the objective as using the self-executing code of a blockchain to automatically create and implement a transaction, thereby increasing efficiency by avoiding the time, effort, expense, and burdens of negotiating and implementing “paper” contracts.

Blockchain: Does Power Equal Wisdom?

I am no expert on blockchain technology. My understanding is that a blockchain is essentially a database that keeps records in “blocks”. Each block is timestamped and linked to a previous block and once recorded are designed to be secure. They act as a shared distributed digital ledger (on either a private or public peer-to-peer network) that can record and update transactions chronologically and publicly. It could also be used to trigger transactions automatically, i.e., if some event occurs, then some action is triggered.

Blockchain is the technology underlying cryptocurrencies such as Bitcoin and one of its major attributes is the security of the transaction. As expected, this nascent technology has attracted a lot of attention in industries seeking to apply blockchain as a means to save time, reduce costs, increase security, and track the ownership of assets.

There is huge potential for the application of this technology including in the fields of finance, manufacturing, and supply chain management. For example, blockchain technology could ensure a chain of custody to guarantee that goods being sold are not counterfeit or that produce is in fact organic. There is also the potential to have machines interact in what might seem like a very contractual manner, e.g., machinery could authorize and pay for its own maintenance, repair or recharging as the need arose. It’s all very new and, like any new application of a developing technology, challenges and uncertainties remain.

Definitions: The Beginning of Wisdom.

Against this background, the term “smart contract” has entered the picture. As Confucius so wisely stated, “The beginning of wisdom is to call things by their proper name.” The term “smart contract” doesn’t help and is the beginning of confusion, not wisdom.

The problem with the term “smart contract” in the context of blockchain technology starts with the word “smart”. To me, being “smart” means applying learning and experience to make good business or personal decisions or choices. For example, I like to think that my students become smart (or at least smarter) about how to structure and manage commercial transactions as a result of taking my course on contract management. To paraphrase Oliver Wendell Holmes, “A young person knows the rules, but the wise person knows the exceptions.”

Using blockchain technology to create “smart” contracts, would require a very substantial exercise in putting into code all the nuances of language and the law, including statutes, treaties, conventions and court decisions. There is an old saying among attorneys that “No matter how flat you make the pancake, there are always two sides.” Some people see this as unavoidable ambiguity due to the nature of language. I see it as necessary flexibility given the complex ways in which people need to interact and communicate. And if an ambiguity does present itself or if some scenario occurs that was not anticipated by the parties to a contract, the general intent and objective of the contract can be ascertained by the parties through negotiation (or if need be by the courts or some other dispute resolution mechanism) by applying legal principles and precedent in the context of what is reasonable under the facts and circumstances.

Will taking language and the law and translating it into computer code make it easier to address complex issues? Aside from the challenge of doing so, there is the very real risk that “bugs” in the code could yield unintended consequences. I think most would agree that bugs in such a complex coding effort would be inevitable. “Garbage in garbage out” as the saying goes. Consider a scenario where certain information is not provided in the blockchain, i.e. an error of omission? How would code address that?

I have yet to discover a “smart” machine despite the efforts of skilled programmers and code writers. Moreover, despite being called “smart” most machines (e.g. smart TVs, smart cars, smart phones, etc...) are not really “smart” at all. You may be born with a certain level of innate measurable “intelligence”, but you get “smart” as a result of learning, making mistakes, and then adapting your experience to future behavior. Most machines or appliances labeled as “smart” are simply connected to the internet. To me that does not make them smart. Will blockchain technology breathe the ability to think into the code that will create “smart” contracts? Of course, the word "smart" can be a powerful marketing tool, e.g. "smart water".

Artificial Intelligence: “Summoning the Demon”?

Despite warnings from Bill Gates, Stephen Hawking, and Elon Musk on the dangers of artificial intelligence (“summoning the demon”), we can sleep peacefully secure in the knowledge that for the time at least machines are safely dumb. Perhaps a few machines (smart bombs?) are capable of making adjustments that resemble human decisions, but we are a long way from autonomous machines or technology taking over the world.For example, the software for "smart " cars still struggles with defensive driving. We are a ways aways from self-driving school buses.

Putting the word “contract” after the word “smart” doesn’t help. The definition of a “contract” is deceptively simple, namely: “An agreement between two or more parties creating obligations that are enforceable by law.” Black’s Law Dictionary. This small group of words is simultaneously clear yet complex; obvious but nuanced. In fact, it is simply not possible to completely define the term “contract” in a sentence or two. Any short definition requires further explanation of the underlying principles and facts under which a contract can be created, changed or ended. Moreover, many ill-defined terms and concepts populate contracts including the notions of “reasonable commercial efforts”, “material adverse effects”, “the duty of good faith and fair dealing”, “fraudulent intent”, “proximate causation” and “negligence” to name but a few. Will the underlying code be sufficiently “intelligent” to appreciate such nuances? In addition, most contract disputes are resolved by subsequent negotiations based upon the intent of the parties gleaned from the contract language. Will what amounts to business software functionality be able to do that?

I am reminded of the segment entitled, The Sorcerer’s Apprentice, in Fantasia, the wonderful 1940 Walt Disney movie, where the Apprentice is played by none other than Mickey Mouse. It is an old story brought to animated life. Unbeknownst to the Sorcerer, Mickey dons the Sorcerer’s magical hat and begins incanting spells which he does not have the wisdom to control. The moral of the story is that it is best to avoid practicing magic without the requisite wisdom. Hence, the dangers of power over wisdom.

“Misnomer”: Calling Something By Its Wrong Name

So, what is really meant by the term “smart contract”? There is room for both confusion and competing definitions. It would appear that many people use the term “smart contract” to mean essentially blockchain technology that uses code to create and administer a legally enforceable agreement. By the press of a button, could we eliminate the time, treasure and headache of the hard work of negotiating contracts, not to mention putting all those boilerplate scriveners out of work? Seems unlikely. Could some savant make the “smart” contract so “flat” that controversies would never occur? Even if the code operated precisely as intended, yet a party was disappointed, could you envision a scenario whereby the disappointed party would claim not only error, but fraudulent inducement, unjust enrichment, superior undisclosed knowledge, bad faith, violation of public policy, promissory or equitable estoppel and run to the nearest friendly jurisdiction? In my view, “smart contracts” are neither smart nor contracts, but instead an unfortunate misnomer.

The law makes it easy to enter into agreements as long as the elements of offer, acceptance, consideration, indicating a meeting of the minds for some lawful purpose are met. However, there is a huge variety and different types of contracts. In addition, the importance of individual facts and circumstances pertaining to a particular transaction as well as how the parties choose to allocate risks and responsibilities cannot be overstated. That’s not to say that certain simple circumstances could not be coded to be “self-executing”.

Certainly, payment could be programmed to occur immediately upon delivery and acceptance (after due inspection of course) of goods or services. But, rather than try to translate into code an endless variety of contractual transactions with so many permutations and combinations of outcomes, why not simply combine some simple “black and white” code-driven scenarios (like payment for conforming goods or services) with traditional legal language reflecting the rights, risks, and responsibilities according to each party’s capabilities and risk tolerance.

Moreover, a contract consists of many respective rights and responsibilities as well as the assumption of certain risks. How the parties choose to allocate those risks via the sometimes very complex contractual language used in indemnification clauses, insurance provisions, restrictions on the use of information, limitations of liability or other such language allocating risks and responsibilities between the parties varies. These and other factors may be a limitation to the application of so-called “smart contracts”.

CONCLUSION

We seem to be far from autonomous intelligent software that can be a substitute for traditional contracts. Even something as simple as “automatic” payment for conforming goods received might not be so simple given that the funds are not under the software’s control. Some application has to be made to a financial institution or the buyer. That’s not to say that blockchain technology has no role in facilitating transactions. It can be a real game changer for many industries, including supply chain management. Tracking and recording the quantity, quality, certifications and transfer of goods as well as sharing information about products, together with the greater transparency, scalability and security are among the benefits of using blockchain technology. However, let’s avoid blockchain fever and not let the magic of blockchain trespass into fever and myth.

For those who have an interest, see list of author’s books below.

“CONTRACT AND RISK MANAGEMENT FOR SUPPLY CHAIN MANAGEMENT PROFESSIONALS” is available through Amazon.com (Contract and Risk Management for Supply Chain Professionals). The book has been well received given its broad appeal to anyone involved in projects, contracts, logistics, risk management, purchasing, procurement or other aspects of supply chain. One of the central themes of this book is the advantage of applying a lessons learned approach to transactions whereby past mistakes are avoided and best practices are incorporated into future transactions. Many companies say they do this but have no real process to carry it thru on a consistent auditable basis.

“MODEL CONTRACT TERMS AND CONDITIONS WITH ANNOTATIONS AND CASE SUMMARIES” (Model Contract Terms and Conditions with Annotations and Case Summaries). The book has likewise received very favorable review by experts and practitioners in the field of risk and contract management. This book provides value in three ways: (1) model contract language is provided; (2) the contract language is annotated with explanations and suggestions; and (3) summaries of actual litigated cases are provided in synopsis form. This triple combination of language, annotations and key case synopses all work together to instruct and enlighten the reader.  

 “BUILD YOUR PLAYBOOK FOR MANAGING SUPPLY CHAIN TRANSACTIONS” (Build Your Playbook for Managing Supply Chain Transactions). The book includes desktop tools, references and sample forms. The book also deals with how to evaluate options, set priorities and assess goals while tracking progress. The book advocates a process defined approach to contracting and managing risk coupled with careful planning and stakeholder involvement. The book identifies and explains 49 steps an organization can follow either as a model or to modify its own supply chain transaction processes. It includes a Foreword by Dr. Darren Prokop, Professor of Logistics at the College of Business and Public Policy, University of Anchorage.