A Blockchain Primer for Lawyers

“…if you want to survive, or dare I say thrive, as a 21st century lawyer, you need to know … about blockchain…”   – Caitlin Moon

Blockchain has emerged as a disruptive technology that has already transformed, and will continue to transform, the way in which value is exchanged in the global economy. The World Economic Forum and Bain & Company have estimated that digital technologies, including distributed ledger technologies such as blockchain, could augment global trade volumes by more than US$1 trillion over the next decade.

Blockchain technology has become known as the technology underpinning cryptocurrencies such as Bitcoin and Ether. Many believe that blockchain technology will be as transformative to the global economy as the internet has been.  Significantly, blockchain technology has been expressly recognized in at least six jurisdictions here in the United States:  Arizona, Delaware, Florida, Nevada, New York, Ohio, Tennessee, Vermont and Wyoming.  Each of Arizona, Florida, New York, Ohio and Tennessee defines “blockchain technology” in the same manner.  Legislation relating to blockchain technology is being considered and/or is pending in other states as well.

  • Arizona: “‘Blockchain technology’ means distributed ledger technology that uses a distributed, decentralized, shared, and replicated ledger, which may be public or private, permissioned or permissionless, or driven by tokenized crypto economics or tokenless. The data on the ledger is protected with cryptography, is immutable and auditable, and provides an uncensored truth.”
  • Nevada: “‘Blockchain’ means an electronic record created by the use of a decentralized method by multiple parties to verify and store a digital record of transactions which is secured by the use of a cryptographic hash of previous transaction information.”

“‘Cryptographic hash’ means a mathematical algorithm which performs a one-way conversion of input data into output data of a specified size to verify the integrity of the data.”

Blockchain applications are now being developed for key industries including finance, insurance, energy, healthcare and legal. And, blockchain is poised to significantly alter the ways in which attorneys engage with, and advise, their clients.

Blockchain Basics

A blockchain is a continuously growing, virtual distributed ledger comprised of digitally recorded and encrypted, or “cryptographically hashed,” data in the form of blocks, with each block cryptographically linked to the previous and/or subsequent block. The distributed ledger exists on a network comprised of computers or computer systems (or nodes), and there is not a single node that governs the entirety of the data being added to the blockchain. Each node in a network possesses, or has access to, a copy of the data in the distributed ledger relating to a transaction (or series of transactions), and each node can confirm in real time the status of a transaction (or series of transactions). Nodes that process and validate each block of the blockchain are called miners or validators. To incentivize miners or validators to authenticate a transaction, there is a processing fee that is awarded to the first miner or validator that is able to solve the complex mathematical formula related to the block that is to be added to a blockchain.

For a block to be uploaded to a blockchain, there must be a majority consensus of the nodes on that blockchain, with each blockchain network having a different consensus mechanism or means by which consensus among the nodes is reached. Miners or validators follow a blockchain’s consensus mechanism to verify the authenticity of each block before incorporating it into the blockchain. As each block is added in the blockchain, the block is digitally time-stamped, and each node in the network holds a copy of the transaction history of the network

The various consensus mechanisms that may be employed on a blockchain network are beyond the scope of this blog post, but discussions of the mechanisms can be found, for example, at the links listed below.

Each blockchain contains a history, or an account, of how data and/or transactions came to be stored on the blockchain, including the cryptographic hashes linking each block (containing data and/or a transaction) to the prior and subsequent blocks in the chain. Because the connections among the blocks are stored on the blockchain, the chain of blocks are intended to be inherently “immutable,” meaning that once the data and/or transactions are recorded on the distributed ledger, the data and/or transactions cannot be altered or deleted without extreme difficulty and without affecting other blocks in the blockchain. Once a block is added to the blockchain, it can be traced back to its date of origin allowing for the auditability of the ledger.

 

 

Types of Blockchains

The public blockchain is an open, permissionless network that allows anyone with a computer to become a node. The information on the public blockchain is shared amongst all of the nodes on the network, making a central point of control for the information unnecessary. The public blockchain is completely transparent to all users, meaning that when changes are made to the blockchain, it is visible to all users. Permissioned blockchains are similar to public blockchains, except, individuals that are interested in joining the permissioned network must secure permission from the owner of the network. This method allows for better identity management of nodes on the network. Finally, private blockchains are traditionally owned and maintained internally by a single entity, granting access to the network only to its own internal computers or outside computers.

Source:  https://blockchainhub.net (Adapted and modified from: Pavel Kravchenko (2016))

 

Blockchain Application: Smart Contracts

The appeal of blockchain arises from the security that is built into the design of the technology underpinning it. The security provided by blockchain technology comes from the ability of the users to leverage the cryptographic protocols and distributed consensus algorithms used to authenticate transactions and provide for auditability. One particular application that has been gaining acceptance and that will affect what attorneys need to know and how attorneys advise their clients is smart contracts.  Smart contracts, which conceptually date back to at least 1995, are, in the words of cryptographer Nick Szabo, “a set of promises, specified in digital form, including protocols within which the parties perform on their respective promises.”  More recently, definitions of smart contracts have been codified in jurisdictions including Arizona, Nevada and Tennessee.

  • Arizona: “[A]n event-driven program, with state, that runs on a distributed, decentralized, shared and replicated ledger and that can take custody over and instruct transfer of assets on that ledger.”
  • Nevada: “[A] contract stored as an electronic record pursuant to chapter 719 of NRS which is verified by the use of a blockchain.”
  • Tennessee: “[A]n event-driven program, that runs on a distributed, decentralized, shared, and replicated ledger and that can take custody over and instruct transfer of assets on that ledger.”

A smart contract (1) enables counterparties to monitor, measure or otherwise observe each other’s respective performance of terms to which the counterparties parties have agreed, (2) provides the data or evidence necessary to effect the exchange of value (including payments among counterparties) and (3) is “self-enforcing” of the remedies specified in the contract.  The full, partial or lack of a party’s performance of the terms, which are coded in smart contracts, automatically triggers events like payments, issuance of fines/penalties, or transfer or custody of documents, products, or funds, among other possible events.

There are many industries that will likely benefit from the implementation of smart contracts like the music industry, the shipping and logistics industry, the banking industry, the insurance industry and the real estate industry, among others, including government and non-governmental organizations. Consider, for example, the application of smart contracts in the real estate industry.  The Cook County Recorder of Deeds (Chicago, Illinois) successfully conducted a proof of concept pilot that allowed for the sale and purchase of real estate on the blockchain. The Cook County Recorder of Deeds wanted to create a platform that would permanently store transactional records more securely than its current centralized and isolated client-server model. The blockchain seemed ideal for the task as it would be a method of recordkeeping that is resistant to alteration. The proof-of-concept study found that by using asymmetric key cryptography, which locks the transaction with a password, property conveyances were protected from unauthorized alterations. The study also found that parcels of land could be conveyed from buyer and seller through the use of cryptocurrency.

Smart Contracts:  Legal and Operational Considerations

Smart contracts are often described as “self-executing” and/or “self-enforcing.”  Yet, those terms belie the operational complexities that, for now, go hand-in-hand with smart contracts.

So, then, additional considerations, among others, that will come into play are:

Finding a Qualified, Third-Party Programmer and Coding the Smart Contract

Traditional text-based agreements are generally drafted by attorneys with the input of their respective clients.  With a smart contract, now, a third-party programmer is an essential part of specifying the applicable code used on a blockchain so that the code reflects the agreement among the parties. And it is likely the case, for now, that the computer programmer, or coder, is not a lawyer.

  • How can parties find an impartial, third-party programmer to draft the smart contract?
  • How will the parties and their attorneys ensure that the code in the smart contract, when executed, accurately reflects the agreement of the parties?

Jurisdictional Considerations

  • Specification – Elements of a Smart Contract. As noted above, there are jurisdictional variances in the definitions of smart contracts. So, in addition to ensuring that the elements of a contract (offer, acceptance and consideration) are appropriately specified, attorneys will also have to ensure that the elements of a smart contract are specified and coded correctly.
  • Governing Law. Furthermore, it will be particularly important to specify the governing law of a smart contract (including addressing any applicable conflicts-of-laws issues that could arise in the chosen jurisdiction).  Failing to specify the governing law in a smart contract will undoubtedly prove problematic, given that smart contracts (and other blockchain applications) are likely to cross multiple jurisdictions as nodes could be distributed across several jurisdictions, depending on the blockchain network used.

Privacy

The European Union’s General Data Protection Regulation, or “GDPR,” went into effect on May 25, 2018.  GDPR sets forth the legal framework for the protection of the personal data of E.U. citizens, including the “right to be forgotten.”  (https://eur-lex.europa.eu/eli/reg/2016/679/2016-05-04).  Pursuant to the “right to be forgotten,” each E.U. citizen has the right to have personal data concerning her, him or them erased under the circumstances specified in the GDPR.  Yet, this “right to be forgotten” presents an issue in the context of blockchain technology, because an essential attribute of blockchains is that the transaction records and data stored on them are intended to be “immutable.”  That is, once the nodes of a blockchain network validate a transaction according to the applicable consensus mechanism for that network, the transaction is included on a block and that block, then, becomes part of the blockchain.  Blocks that are part of a blockchain cannot be modified or deleted without extreme difficulty and without affecting other blocks in the blockchain.

So, then, how will smart contracts be used in the E.U. or elsewhere globally when the underlying code and transactions stored on a blockchain contain the personal data of E.U. citizens?  Will it be that personal data of E.U. citizens will need to be stored off-the-chain, with the smart contract code stored on-the-chain?  Will the personal data need to be anonymized before it is linked to the smart contract code stored on a blockchain?

  • California is another jurisdiction that has enacted privacy legislation. The California Consumer Privacy Act of 2018 will go into effect on January 1, 2020.

Contract Amendments

  • What will the mechanism be for amending a smart contract?

Tech and Operational Considerations

  • Network-authenticated Reference Data. Since smart contracts are event-driven and reference data will be required to “prove” or demonstrate that an event trigger has occurred, how will the parties select an appropriate data source, or an “oracle,” to supply network-authenticated reference data?  How will the reference data be “pushed” to the smart contract?
  • Technology Failures and Hackers.
  • What about loopholes and bugs in the code?
  • What about technology failures?
  • What are the implications on a smart contract (including performance and enforceability) of internet service being unavailable for a period of time?
  • Can parties prevent the code comprising a smart contract from being hacked?
  • What would happen if an oracle, or data source, were hacked?

The Legal Profession

Currently, around 41% of firms state that they plan to incorporate blockchain technology into their transactional legal services. Consider DLx Law LLP.  DLx is a law firm looking to shake up the legal industry with its exclusive focus on blockchain. DLx targets clients who are (1) token issuers, (2) cryptocurrency exchanges and (3) blockchain enterprises.  In addition, DLx will accept payments in Bitcoin and Ether for its legal services and intends to replace its traditional billable hour engagement letter with, for example, a smart contract pursuant to which clients will be charged for pre-determined milestones achieved by the DLx legal team. DLx believes that the use of unorthodox methods like milestone-driven smart contracts will allow for a stronger relationship between attorneys and their clients.

While not all law firms will adopt the DLx model, firms will be well-served to understand how blockchain technology and its applications will affect their practices.   As Tsui S. Ng, Business Law Fellow for the American Bar Association’s Business Law Section, and Vice Chair of the Cybersecurity Subcommittee of the Section’s Cyberspace Law Committee, aptly asserts:

“Transactional lawyers may wish to learn more about the technical aspects of their future “smart contract” to ensure that it aligns with their client’s wishes and goals. In the future, litigation attorneys may no longer be litigating the “four-corners” of the contract, but rather expanding into the intent of the code.”

 

Given the nascent and evolving nature of blockchain technology, it is particularly important for attorneys not only to learn about the technology but also to progress the legal framework for the technology and its applications.

The Future of Blockchain

Though smart contracts and other blockchain applications are still experimental, blockchain applications are gaining a secure foothold in sectors throughout the global economy. The time for learning about blockchain technology and its myriad applications has arrived. Below are three resources with an in-depth review of blockchain and its potential applications, among many other resources now available.  Learning about blockchain technology and monitoring the state, national and transnational legislative efforts relating to the technology and its applications will be essential elements of an attorney’s tool kit in providing guidance to her, his or their clients.

Written by:

Karen M. Suber and Justin Evans

https://www.linkedin.com/in/karen-suber-96427612/

https://www.linkedin.com/in/justin-evans-62869144/

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#FroniterOfTheLaw

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#PracticeInnovation

What helpful insights, tips, or strategies might you be willing to share that would help other professionals think through how to incite innovation and efficiency gains into the practice of law?

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