Smart Contracts and the Role of Lawyers (Part 3) – About Lawyering Transactions on Blockchains

In Part 1 I attempted to unpack some of the  semantic baggage related to the term, “smart contract,” and in Part 2 I attempted to unpack some of the semantic baggage related to the term, “code is law.” With a more nuanced understanding of these legal-sounding terms, now we can better consider the possible role of lawyering in the emerging blockchain era, hopefully with neither too much fantasizing and hype nor too much hostility and dismissiveness. In this post I review how seven transaction-related lawyering activities either become irrelevant, increase in importance or remain unchanged when applied to blockchain-based transactions. Note that the categories I’ve focused on below are not inclusive of all lawyering activities for all kinds of contracts, and their relevance varies by transaction type and size, jurisdiction, etc., but collectively they give a pretty good overview of contract-centered lawyering.

Deal Structuring and Advising

Law firm partners get paid the big bucks for structuring transactions that maximize desirable outcomes for their clients while minimizing risks. The more unique the situation, the more important the legal structuring and advice, but even commoditized transactions can be traced back to predecessors that were novel at the time and required some amount of lawyering. New modes of human social interaction, new markets and new laws/regulations trigger at least a temporary flurry of lawyering of the structuring and advisory variety and the same will be true with respect to emerging blockchain-based technologies. Beyond the first-mover benefits, however, long-term expectations regarding blockchain transaction structuring and advising need to be tempered. Disintermediation, process automation and elimination of escrows, agents and back office functions are common themes in almost all blockchain initiatives. Crypto-pragmatists might be doing it to increase efficiency, and crypto-purists might be doing it to reduce dependence on centralized authorities, but either way, the result is likely to be lots of commoditized, highly-templatized blockchain transactions and relatively few uniquely coded ones.

The efficiency advantages of commoditized business processes conducted on blockchains like those described in the World Economic Forum report are what excite the banks and other crypto-pragmatists. Remove the economic benefits of standardization and volume, however, and even the lowest cost and most lawyer friendly crypto-pragmatist blockchain is hard to justify as a preferred platform over traditional off-chain means of structuring, executing and recording legal transactions. It follows that low-volume, one-off asset sales, financings, M&A and other complex deals that require the most intensive legal expertise at the structuring stage are the least likely transaction types to show up on crypto-pragmatic blockchain platforms. In sum, there will likely be an inverse relationship between the usefulness/benefit of crypto-pragmatic blockchains and the complexity/uniqueness of of the real world assets, obligations and parties involved. As a corollary, legal structuring work will spike as new transaction types are brought on-chain but will quickly flatten once automated/templatized smart contracts are successfully launched. 

As for crypto-purist initiatives, the same efficiency factors affecting legal transactions on crypto-pragmatic platforms will, likewise, apply to smart contracts conducted on crypto-purist platforms. Furthermore, crypto-purist projects (like TheDAO) gain additional efficiencies from bypassing most, if not all, legal costs and overhead associated with the creation, acquisition and management of real space entities and assets. This additional efficiency opens up all sorts of possibilities for totally new types of transactions feasible only on crypto-pure platforms but also severely limits the usefulness for transactions that require financial covenants or other legal prose not expressible as computer code, identification of the parties involved or off-chain performance or transfer of assets. In sum, there will likely be an inverse relationship between the types of transactions that work well on crypto-purist platforms and the types of transactions that benefit from or require traditional forms of legal structuring and advice.

Due Diligence

In big deals a substantial amount of (primarily associate and paralegal) time is spent conducting corporate colonoscopies – a/k/a due diligence reviews – of corporate actions, leases, material contracts, patents and trademarks, executive compensation, labor, environmental and litigation issues, tax matters, etc. Professionalized review of public and private transactional records, contracts, filings, etc. is typically undertaken to confirm the value of an entity or assets being acquired or the capacity of a contractual party to perform its obligations under the contract. Today, information concerning the assets and liabilities of even “public” companies is obscured, widely dispersed and often untrustworthy. But imagine a future in which a target company’s internal financial and transactional history (including all substantive contracts with third parties) is readily accessible online to permissioned legal counsel and financial auditors, fully traceable back to their sources, immutable and completely trustworthy. Also imagine a future in which the current status and filing history of the target company with all relevant governmental institutions is available online with cryptographic certitude. That’s the promise of a world based on blockchains, and in such a world the need for traditional lawyer-based diligence reviews and “comfort” for prospective transactions largely goes away. Terms like “due diligence,” “title search” and “audit” become quaint artifacts of the papered past.

Of course, the gulf between today’s reality and this grand vision of all business and governmental activity conducted on-chain is a huge one. Government bureaucracies are slow to adopt new technologies and standards, and many corporate transactions and business operational processes will remain off-chain indefinitely. Legacy records and many recordkeeping processes are still paper-based and still dependent on human review and approval and will continue to exist in analog mode or antiquated digital mode for a long time. Even in a best case scenario for the acceptance and growth of blockchain usage for all types of formal business messaging and data management, we will be living in a rolling state of disruption as the world transitions over time from conducting business largely off-chain to largely on-chain.

The good news here for lawyer pocketbooks is that disruptive conditions almost always add complexity and uncertainty during the transition, and complexity usually means more time and specialization and higher legal fees. In the interim, the demand for transactional due diligence will live on. Just bear in mind that, if the true believers are correct about all of the long-term possibilities for blockchain-based business transactions, governmental filings, registrations, bookkeeping, etc., then there will be an inevitable corresponding decline in the need for traditional legal due diligence activities. [Note: Some commentaries have described smart contract beta testing by lawyers as an important new form of “due diligence.” Due diligence, as I’m referring to the term here, relates to validation of content related to or provided by the client, whereas checking the contract code generated by the law firm itself is an internal drafting/review exercise as discussed in the next section.]

Drafting and Review

Many years ago (more than I’d care to specify) “document assembly” was widely touted as the first legal technology killer app. The evangelists of the era predicted that it would revolutionize the practice of law, and I was one of the eager acolytes who jumped on board. I even developed my own document assembly system based on the WordPerfect scripting language and offered it to the world as an open source application. My Lawgical Document System was free, functional and easy to learn even for lawyers with no programming skills, but it languished unused like so many other similar document assembly tools over the years. The reason? Lawyers love precedent and hate forms and checklists. Consider it axiomatic that if an experienced lawyer is given the choice to use prior work product that is “close enough” or a Q&A-based automated template system that cranks out a near-perfect first draft, the prior work product option will invariably get the nod. This seemingly irrational, inefficient and risky behavior is deeply ingrained and difficult to overcome even in today’s increasingly cost-conscious and tech-savvy legal environment. Despite the fact that powerful document automation technology has been around for over thirty years and is inexpensive and proven, it has had a relatively minor overall impact on how law is practiced. Bear this in mind as we look at how making contracts “smart” completely changes the traditional drafting and review workflow.

Drafting. Legally well-formed smart contracts will consist of computer code and prose. What’s clear is that the computer code must be highly formalized and well structured. What’s not clear is how the associated legal prose will be generated and whether the drafting cycle will proceed along typical computer programming lines (waterfall, agile, etc.) along typical legal drafting lines (prior work product editing, drafting from templates, etc.) or some hybrid. Regardless of the particulars, it’s difficult to imagine the process not being strongly influenced by what works best for generating the computer code. Drafting based on the CommonAccord framework, for instance, is highly structured and borrows heavily from open source computer coding practices, and it looks like creating smart contracts in the R3 Corda environment will be template driven.

Review. Because well-formed smart contracts must be verbose enough to be read and understood by lawyers and formalized enough to be read and understood by machines, final review of a smart contract before it goes on-chain should determine that:

  • The legal prose accurately summarizes in human readable form all material inputs and outputs of the computer code,
  • The computer code will properly execute on-chain as specified (and only as specified) in the legal prose,
  • Legal prose for any contractual terms to be applied off-chain is correct and complete.

Even assisted by testing tools, the final review will likely require some combination of legal and programming skills and experience. Whether the final review and sign-off is performed by one (extraordinary) individual with combined skills or a coordinated group effort of lawyers and programmers, the ultimate financial risk still falls on the law firm’s partner(s) who are likely to be the least code-savvy and the least comfortable with promoting the use of smart contracts in novel ways or for complex transactions that require customized coding.

Template Development and Support. If, as appears likely, much of smart contract drafting will become template-driven, then the task of template development and support becomes a critical lawyer/programmer undertaking. As most of us in the legal KM biz understand, getting lawyers to develop and maintain simple text-only forms is really tough and getting them to engage in the development and support of document automation applications is even harder. This is true despite progress made by vendors in simplifying template authoring. Technology is the least of the issues. Obtaining partner consensus and approval of preferred text and usage and juggling all of the legal, terminological and stylistic differences in multiple jurisdictions and practices is extraordinarily difficult. The real killer, though, is maintenance: sustaining user interest and feedback, continually identifying and correcting technical errors and updating to reflect changing laws and practice norms. It never ends, and these very same challenges will also apply to smart contract template development and maintenance. Looking to communal models (e.g., CommonAccord’s proposed use of Github to manage smart contract code/prose as open source content) is an intriguing idea and commercial solutions may also emerge, but both of these support options are generally counter to the proprietary approach that law firms have followed since the dawn of time. Dependence on generic “open source” or purchased legal code/prose also raises problematic professional, ethical, business and liability questions that may limit their attractiveness to many lawyers.

Entity Formation and Authorization

Lawyers are often called on to set up new corporate entities and arrange corporate authorizations. While the relevance and volume of these lawyering tasks is not likely to change much with crypto-pragmatic smart contracts, crypto-purist smart contracts are a different matter. That’s because non-pseudonymous contractual parties can be subjected to regulatory control by real space authorities, and counterparties can seek legal recourse against them as well. A lot of “purist” energy and effort is expended to protect digital pseudonymity through cryptographic and other computer coding tricks. However, lots of transactions require interaction with identifiable real space entities, in which case some form of real space pseudonymity may be a necessary evil for a crypto purist transaction. In these instances lawyers might be called upon to create real space pseudonymity by forming corporate entities or setting up agency arrangements that buffer the ultimate party from identification to counterparties or state authorities. The propriety and effectiveness of taking such steps will vary from deal to deal and will depend on the willingness of some jurisdictions to sanction such efforts (e.g., some Swiss cantons apparently already have options for crypto-friendly entity formation).

Regulatory Compliance and Associated Filings/Approvals

“Regulatory compliance” implies that we are operating in a real space sovereignty and pragmatically accepting its authority over transactional activity in cyberspace. It should come as no surprise, then, that we are already seeing considerable efforts by various cyber-pragmatic initiatives (e.g., R3, tO, Chain and Digital Asset Holdings) to embrace and promote efficient regulatory oversight as a key feature of their respective platforms. Crypto-purists, on the other hand, tend to seperate blockchain design, structure and operation (viewed as strictly “alegal” and beyond regulation) from the transactions and users of the blockchain (permitting but not necessarily requiring pseudonymity). The crypto-pragmatic approach is integrative, holistic and accommodating to regulatory authorities; the crypto-purist approach is segregated, ad hoc and distrustful of regulatory authorities. Expect lawyers to be actively engaged in the growing number of crypto-pragmatic fintech initiatives on private blockchains aimed at making financial transactions more cost-effective for the parties involved and more compliant with regulatory oversight. The prospects for non-coercive regulated transactional services on public blockchains is less certain, but I would expect that those efforts that succeed will be embraced by lawyers and their clients pursuing the potential efficiency benefits of doing business on-chain.

Opinion Giving

If processes associated with due diligence reviews, entity formation/authorization, contract execution and regulatory compliance change as a result of business transactions going on-chain, then the supporting facts, levels of reliance and qualifications on which legal opinions are given at deal closings will surely shift as well. More interesting is the question of whether the legal substance of the opinions will also have to change, especially with respect to enforceability of the terms of a smart contract that may have no explicit legal prose at all or that contains overt or unforeseeable conflicts between the terms described in embedded legal prose and the actual smart contract code that executes on the blockchain. I am certainly not qualified to speculate in detail on how opinion-giving will need to change as smart contracts become a significant reality, but it seems likely that the challenges of evolving this incredibly cautious and standards-bound element of transactional law practice will be significant and perhaps a major drag that holds back deals that normally require opinions (and normally generate lots of legal fees).

Documenting, Closing and Recording

Documenting terms, collecting signatures and organizing, distributing and filing the essential and ancillary materials of a transaction in a permanent form is central to the function of lawyers. These are the essential contract form and formation activities that are missing from Szabo’s original conceptualization of smart contracts (as I explained in Part 1). Let’s briefly look at how these non-smart elements could be managed on-chain:

Documentation. In a smart contract that lacks explicit legal prose, all terms are either inferred by decompiling the explicit computer code into human/legal readable form or from application of legal concepts (common law, UCC, etc.). In that respect, a proseless smart contract possesses many of the same qualities and limitations of a traditional oral contract. Integrating explicit legal prose with smart contract code addresses the following critical needs:

  • Source Code/Annotations. Control of unintended and unforeseen outputs due to computer coding errors and inadequacies,
  • Functions. Access to useful contract functions (e.g., financial covenants, reps & warranties, choice of law, remedies) that are impractical or impossible to model in deterministic computer code,
  • Values. Incorporation by reference (e.g., schedules and exhibits) of factual states and conditions that exist off-chain and are not otherwise accessible on-chain through trusted oracles.

Closing. Traditional forms of contract acceptance by means of manual signing of paper documentation is dying out and being replaced by end-to-end digital creation and execution of contracts. Digital signature solutions that lock the documents and establish provable acknowledgement by the signing party are already commonplace. What is lacking (and what blockchains enable) is permanent access to the documentation in provably unchanged form. Logistically speaking, the possibility of coordinating and conducting transactional closings completely online saves time and costs for the law firms and clients involved.

Recording. Some blockchain platforms, like Bitcoin, have extremely limited text storage capabilities, but options will become increasingly available for utilizing blockchains and related peer-to-peer content storage for immutably preserving contractual documentation, metadata and supplemental content. The contracts themselves can be either “smart” or “dumb” traditional text files and either private or publicly visible. This means that regardless of how your contractual transaction is documented and closed and regardless of how much of the transaction is performed on-chain or off, blockchain technology can become the solution for electronically binding the transaction with cryptographic certainty that’s as immutable and permanent as the blockchain platform itself. The utility of this blockchain binding for all types of transactions is compelling. I expect that law firms will play a central role in promoting and supporting this elegant solution.

Are We There Yet?

Yes, finally! It’s been a long journey (and if you’ve stuck with me the whole way, I’m duly impressed). We’ve discovered that what makes smart contracts “smart” also makes them incomplete as contracts. We’ve seen that this shortcoming of smart contracts can lead to chaos as it did with TheDAO. We’ve learned that addressing the legal deficiencies of smart contracts compromises their usefulness for some applications. And we’ve explored how transactional lawyering itself must change to accommodate the unique challenges and opportunities presented by smart contracts and blockchains.

I’ll leave you with one final thought: the emergence of the internet over the past twenty years changed so much…and yet, so little…about the practice of law. Over the next twenty years I expect smart contracts and blockchains to have the same impact! 😉