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Contract Formation, Smart Contracts and the Blockchain

07 May

Contract Formation, Smart Contracts and the Blockchain

The Basics of Contract Formation

            In many legal systems,[1]for a contract to be formed between parties, there must be (i) an offer, (ii) an acceptance of that offer, (iii) exchange of consideration, and (iv) mutuality.[2] Two other requirements are needed to guarantee that the contract, once formed, is enforceable in a court of law. First, each party must have the legal capacity to assent to (or to be bound by) the contract.  Individuals who are mentally incapacitated and minors (or those under a certain age) cannot be bound by an otherwise fully formed and legally enforceable contract.[3] Second, the contract must serve legal goals. Contracts that are contrary to public policy are not enforceable.  For example, in jurisdictions which forbid gambling, contracts related to gambling or gambling debts will be unenforceable between the parties.

Elements of Modern Commercial Contracts

            There is typically no requirement that a contract be in writing, but custom and practice dictate that commercial contracts (like patent licenses) be written. These contracts often provide detailed descriptions of the goods sold or the services provided.  Many of these contracts include elaborate payment terms, term and termination clauses, indemnity clauses, representations and warranties between the parties, various terms related to how the contract will be interpreted, and clauses related to dispute resolution.  Typically, some or all of these clauses are actively negotiated between the parties to address particular circumstances of the deal. It was previously thought that a written document was the only way to accommodate these types of agreements. However, new types of technology have emerged that will radically change how commercial agreements are drafted and performed.

Smart Contracts

            A major driver of this change will be smart contracts implemented on blockchains. In the context of blockchain technology, small pieces of code can be interwoven into the blockchain’s design. “This code, generally referred to as a ‘smart contract’, executes automatically when certain conditions are met.”[4]

            While smart contracts are a powerful tool that can greatly expand the utility of blockchains, it important to keep in mind that they are essentially computer applications.  Whether a particular smart contract is really a contract depends on whether it includes all the elements required to form a legal contract.   

Smart Contracts as Part of a Contract

            Many commercial contracts are too complex to implement as one or even a series of smart contracts.  For example, licenses in intellectual property agreements may include complex royalty terms such as tiers, different rates for different products, various incentives, and limits in geography and time.  Such terms are often negotiated intensively by the parties.  This negotiating process may be difficult to replicate as a smart contract.  Other aspects of complex agreements are may be irreducible to smart contract functionality. For example, certain licensing agreements include quality control provisions, some of which can be quite onerous.  To the extent that these provisions include inspections of products or manufacturing facilities, they will require activity to take place off the blockchain. Finally, parties may explicitly desire that certain contractual obligations take place off of the blockchain.  For instance, parties may prefer that contractual disputes be handled by certain courts or arbitration panels.  

            Even if a contract is too complex or simply ill-suited to complete implementation as a smart contract, portions of its performance may be implemented using smart contracts.  For example, in a patent licensing agreement, payment between the parties could be accomplished by the licensee paying the licensor in tokens on the IPwe Platform[5]as determined by a smart contract between the parties.  Also, the transfer of property rights in a portfolio of patents between parties could be accomplished in part by a smart contract implementing this transfer on the Global Patent Registry.  As these examples suggest, even if a contract cannot be completely reduced to a smart contract, certain aspects of the agreement can be efficiently implemented on the blockchain, eliminating costs for the parties.

Smart Contracts as Contracts   

            For simpler types of transactions, the smart contract may be the only manifestation of the contract required.  Some forms of licensing, patent transactions, and annuities payments may not require a significant portion (or any portion) to take place off the blockchain.[6]  Currently, even simple versions of these agreements may be cost intensive to negotiate. These costs, however, arise partially from the habits of vested interests and the intellectual property community’s overreliance on secrecy.  Certain actors have benefited from the fees and expenses accrued in long, drawn-out, but often unnecessary, negotiations.  Furthermore, because terms of existing agreements are often kept secret, parties begin negotiations unaware of what similarly situated participants have offered and agreed to in the past.  One benefit of smart contracts is that their negotiation can be directed to only the key market terms (with the other terms already decided by the design of the blockchain).  The blockchain can also make reporting of key metrics related to a marketplace straightforward and relatively effortless, incorporating such metrics into smart contracts, streamlining negotiations and reducing the need for expensive market research.[7]

The Flexibility of the Blockchain and Smart Contracts

            Smart contracts can greatly increase the efficiency of implementing aspects of contracts agreed to by the parties.  In some instances, a smart contract may be all that is needed to create a contract between the parties.  In either case, smart contracts, such as those implemented on the IPwe Platform, promise to lower the cost of contracting for parties and, in certain instances, pave the way for agreements that would otherwise never be entered into outside of the blockchain. Despite the obvious benefits of smart contracts, all participants must recognize that smart contracts have to conform to the applicable jurisdiction’s legal requirements. Smart contracts must include all the essential elements for contract formation or be implemented as part of a contract which does.

[1]These requirements are generally accepted in most jurisdictions following the English common law tradition.  The interpretations of the elements may be different and certain jurisdictions have added other requirements for contract formation in specific circumstances. This essay will focus primarily on contracts in jurisdictions following the English common law tradition when other requirements are generally not legally required.    

[2]http://jec.unm.edu/education/online-training/contract-law-tutorial/contract-fundamentals-part-2

[3]http://law.jrank.org/pages/5690/Contracts-Elements-Contract.html

[4]http://theconversation.com/can-blockchain-a-swiftly-evolving-technology-be-controlled-73471

[5]Certain features of the IPwe Platform will be available in the later part of 2018.

[6]It is important to note that the nature of the blockchain and prevailing local law will play an important role in the feasibility and design of these smart contracts.  Certain regulations dealing with know your customer (KYC) and anti-money laundering (AML) may restrict the nature of and circumstances under which some transactions between parties can be made.Other local requirements requiring specific formalities for specific types of contracts may prevent certain agreements from being implemented as smart contracts.  

[7]Certain aspects of transactions on the IPwe Platform can be kept secret at the request of the parties but the platform itself can be a springboard for greater transparency in the marketplace.

 

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