For more than three decades, digital technologies have been changing how we work, how we consume and how we do business in almost every part of the global economy.
Despite these changes, the way businesses contract with each other has remained largely the same since the 1800s. Contracts are still negotiated, drafted and agreed with the assistance of a trusted third party intermediary, then stowed away in hard copy and only revisited when a dispute arises.
This article explores how Smart Legal Contracts (SLCs), based on blockchain or distributed ledger technology (DLT), have the potential to transform legal contracts into a powerful 21st Century business tools.
Digital transformation of business
The digital transformation of business began in earnest in the early nineties with the mass adoption of personal computers and the internet. Desktop publishing software, search engines, e-commerce platforms and digital communications enabled businesses to cut costs, become more efficient and, for the first time, reach a truly global customer base.
Over the last decade, the explosion of smartphone use and advances in AI have intensified competition in an already crowded digital marketplace. Consumers now have the internet and a myriad of smart digital tools literally at their fingertips. They are better informed and demand more of business. They expect superior and cheaper goods and more immediate services, while challenging the role of business within society.
In response, many businesses are turning to technological solutions to enhance their productivity and offering, and to help define and communicate the organisation’s purpose and values, for example by increasing transparency, adopting more ethical and environmentally sustainable practices, and improving employee welfare.
What does blockchain have to do with SLCs?
SLCs are one such technology that has the potential to transform how businesses negotiate and perform commercial contracts, as well as providing other digital capabilities that could deliver collateral benefits.
SLCs are legally enforceable agreements that contain certain clauses which are supplemented with computer programming code that to enable automation or other digital activities arising from the contract, and that can run on digital platforms such as a Distributed Ledger Technology (DLT) platform, such as blockchain.
DLT provides the basis of digital platforms that are most likely to be suitable for SLCs. DLT provides a decentralised database which records digital transactions between participants. Each participant (or in the case of SLCs, counterparty) can hold its own identical record of the database, which updates in real-time when there is consensus that a transaction has occurred. Once agreed, the transaction becomes the latest immutable ‘block’ on the ‘chain’ of historic transactions. Critically, the distributed nature of the database creates a new kind of transactional relationship where trust is not required, obviating the need for a trusted intermediary to process transactions. Where used in conjunction with SLCs, DLT databases may provide counterparties with an auditable, shared ‘single source of truth’ about the state and history of digitised contractual activities.
Our firm Herbert Smith Freehills, IBM and CSIRO’s Data61 are building the first enterprise grade and industry-agnostic DLT infrastructure that is specifically designed to provide a legally compliant platform for businesses to collaborate using SLCs. The DLT infrastructure will enable to businesses to pilot and experiment with SLC projects without the need to invest in bespoke private blockchain infrastructure.
How does an SLC work?
SLCs generally contain a mix of natural language (as in a traditional contract) and Smart Clauses: machine readable expressions of contractual terms that contain a form of conditional logic, such as computer code or programming. Computer code containing the smart clauses is embedded in the distributed ledger (or other agreed platform) and external data sources (known as oracles) can be connected to provide SLCs with real-world data to enable the computer code to monitor and evaluate whether the conditions of the smart clause have been met. If satisfied, the SLC will then carry out the digital promise and execute transactions in accordance with the terms of the smart clause.
A simple example is a contract which contains smart clause for the notification of a delivery of goods. A weighbridge or other IoT sensor, connected to the internet, feeds data to the SLC that Party A has delivered goods at a specified time and location which satisfies the conditions of the smart clause. This automatically triggers a notification to be sent to Party B. This transaction will then be recorded to the distributed ledger shared by the parties. Further conditions can also be included, e.g. the automatic release of payment when goods are received.
For businesses, SLCs means that legal agreements can be created, executed, managed and maintained in a cheaper, more transparent and efficient manner. There are also a number of other practical ways in which SLCs can add value for business.
Joined up thinking
SLCs have the potential to introduce automation across a range of complex contractual processes across the lifecycle of a contract and integrate these processes with other technologies.
For example, a complex construction project often involves multiple layers of multi-party contracts, based on timings set out in the head contractor’s construction program. These contracts usually contain specific procedures for a contractor to claim extensions of time and/or costs when delays are caused by certain events, e.g. bad weather, legislative changes.
An SLC can be connected to an external data sources (such as weather reports or legislative websites) to verify whether circumstances have occurred giving rise to a claim, and if so, automate the claim notice within the specified time period. The SLC can then also automate the adjustment to payment milestones and the construction program. Automated processes can similarly be applied to liquidated damages regimes for delay or non-performance, where payments are automatically made on default in certain pre-agreed circumstances, subject to pre-agreed conditions.
Over time, businesses that use SLCs can apply run data analytics on the data produced by their smart clauses, to carry out risk modelling, identify trends, and determine the best contractual structures for certain types of projects.
The power of transparency and data
Supply chain management is an area that has become increasingly complex, particularly for global businesses that source and process materials all over the world. Many challenges exist in relation to traceability, with managing risks and disruptions, and the need to build trust and reputation with third parties and socially conscious consumers.
SLCs provide a potential solution. They can provide an immutable record of all supply transactions, with the capability to make certain components, transactions or elements of those transactions visible to all stakeholders to whom permission has been granted. Internet connected devices can also transmit real-time information back to the SLCs on the whereabouts of goods and stock levels, enabling the parties to have a single trusted audit trail, reducing the potential for fraud, miscommunications, errors and bureaucratic frustrations or redundancies. SLCs also have the potential to improve the sustainability and inclusivity of the supply chain, by cutting out middlemen that invariably charge a fee, reducing value paid to the producers, such as farmers, at the start of the chain.
The University of Cambridge Institute for Sustainability Leadership recently completed a year-long pilot program with Unilever, a consortium of banks and other large corporates, using DLT to collect and record social or ecological data on tea farmers in Malawi and smart contract technology to convert supply chain sustainability data into automated preferential access to trade finance. The data collected enabled the buyer to communicate this information to potential customers and demonstrate to regulators, its compliance with environmental and labour standards and well as showcasing other ethical credentials.
Given the potential for systemic impact of SLCs (along with the underlying DLT infrastructure) on global business in the next decade and beyond, it is in the interests of governments, regulators, the legal industry, the technology community and business to collaborate and proactively engage with the technology in order to develop its potential for increased efficiency, innovation and co-operation in the digital sphere.
The more diverse the group of stakeholders, the more likely it is that new use cases will emerge for SLCs to become digital tools that can reshape and add value to current businesses practices. We expect that doing business in 2030 will look rather different.
The contents of this publication are for reference purposes only and may not be current as at the date of accessing this publication. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on this publication.
© Herbert Smith Freehills 2020