Tuesday, January 23, 2018

Blockchain 101 - Part 3

This Part 3 of the article on blockchain (*1), Blockchain 101, deals with the legal issues arising from use of blockchain platforms and applications.

The blockchain is a “trustless” technology. “Trustless” means—for the first time in history—exchanges for value over a computer network can be verified, monitored, and enforced without the presence of a trusted third party or central institution.32 Because
the blockchain is an authentication and verification technology, it can enable more efficient title transfers and ownership verification. Because it is programmable, it can enable conditional “smart” contracts. Because it is decentralized, it can perform these functions with minimal trust without using centralized institutions.36 Because it is borderless and frictionless, it can provide a cheaper, faster infrastructure for exchanging units of value. (*2)

By definition blockchain is decentralized, highly encrypted and offers new capabilities to engage activities in ways that don’t fit neatly into existing legal frameworks. The current legal framework is a patchwork attempt to fit blockchain into existing legal frameworks.  Government regulators have identified some basic risks around blockchain-based currencies, and have begun staking jurisdictional claims. “Policymakers are currently revisiting complex, interwoven regulatory frameworks — primarily banking laws, commodities laws, and securities laws—to shoehorn the technology into existing frameworks and consider where new ones might be appropriate.” (*3)

Some of the following issues arise.

Transaction Reporting, and Taxation

In both Canada and the U.S., legislation is currently in place that requires banks and other financial institutions to report transactions over a certain amount. This is designed to counter money laundering and to ensure taxation of blockchain transactions. How will this be done? In blockchain there is no central authority tracking the transaction. Who is responsible for reporting it? Who is to collect the tax on it? This area of the law will have to be developed.

Money Laundering and Illegal Monetary Transactions

Blockchain transactions are essentially automated. Funds can be dispersed autonomously (using a cryptocurrency). Recently, lawmakers in West Virginia deemed it a felony to use bitcoin or other cryptocurrencies for money laundering, with an update to the state’s anti-money laundering statutes. The law specifically created a definition for cryptocurrency that is recognized as a ‘monetary instrument’ in the state. Other jurisdictions will have to follow. (*4)

Privacy Laws

Blockchain records on public platforms are visible to all, even though individual elements of the transactions are encrypted and not publicly visible. The platform is decentralized and this decentralization may give rise to privacy law breaches. Some financial organizations are required by law to be able to permanently remove data when required to do so by a court (right to be forgotten laws). Due to the nature of the decentralization of Blockchain platforms this is currently not possible. Blockchains don’t allow for data to be deleted, but rather only updated in subsequent blocks, which may not be sufficient to comply.

Evidence in Court

Blockchain records may have more legal bearing in courts due to the stringent encryption techniques and how records are created with time stamped blocks linked into chains by hashes. Some jurisdictions are already working towards making such records available in court proceedings. (*5):

A bill in Vermont passed that would make records verified through blockchain technology admissible as evidence in court.
Laws such as this create a kind of legal backing for blockchain-based information.
In Nevada, a bill has deemed smart contracts and blockchain signatures acceptable records under state law. 
As blockchain ledgers and systems become more common, their possible use in cases as evidence and discovery becomes more likely. This means lawyers will need to know such records exist as well how to handle that evidence as well as what specific information to request.

Smart Contracts

A smart contract is a computer program that controls the transfer of currency or assets or information or data between parties. The “contract” sits on the blockchain platform and is self-executing. It has been described as (*6):
Smart contracts help you exchange money, property, shares, or anything of value in a transparent, conflict-free way while avoiding the services of a middleman. The best way to describe smart contracts is to compare the technology to a vending machine. Ordinarily, you would go to a lawyer or a notary, pay them, and wait while you get the document. With smart contracts, you simply drop a bitcoin into the vending machine (i.e. ledger), and your escrow, driver’s license, or whatever drops into your account. More so, smart contracts not only define the rules and penalties around an agreement in the same way that a traditional contract does, but also automatically enforce those obligations.
Current contracts could be converted to smart contracts, possibly illuminating some grey areas. The risks are that the smart contracts are not as flexible or as encompassing as normal contracts. The conversion has been described as follows (*7):

“Commonly used terms in credit documentation such as ‘best endeavours’, ‘material adverse effect’ and ‘reasonable notice’ are currently very complex to translate into smart contracts. In case of the second definition for example, a borrower must inform the bank if something is happening within the company that could have a major impact on the company’s continuity. It’s very difficult to fully write out… 
If an attempt is made to do so, there’s a chance that unforeseen situations will not be covered. Additionally, there shall be a time consuming discussion between the borrower and the bank about the exact wording of each situation that needs to be described. A practical approach is to combine the two: a smart contract can record all measurable events and actions to be taken automatically, and all other more vague provisions can be included in the ‘normal’ agreement.”

 Some jurisdictions are in the process of implementing legislation that validates blockchain “signatures” and smart contracts. (*8)

Smart contracts will have to comply with existing laws. For example, if a smart contract issues a bill of lading, will the bill of lading be required to be in a certain format to be legal? According to which jurisdiction?

Jurisdiction and Conflict of Laws

The principles of contract and title differ across jurisdictions and therefore identifying the appropriate governing law is essential. At its simplest level, every transaction could potentially fall under the jurisdiction(s) of the location of each and every node in the network. The platform is decentralized and nodes may be in different jurisdiction. Important nodes are the nodes of the initiator of the transaction, the miner, and the recipient. Where the transaction involves a series of individual transactions, which law applies. In essence, it's the same problem faced in the shipping industry where, for example, the seller is in China, the carrier is located in Denmark, the goods travel by ship to a destination port and is railed, trucked and warehoused in different jurisdictions.

The inclusion of an exclusive governing law and jurisdiction clause is therefore essential and should ensure that a customer has legal certainty as to the law to be applied to determine the rights and obligations of the parties to the agreement and which courts will handle any disputes. The inclusion of the clause in a smart contract will be critical.


On a public blockchain platform there is no central authority. Who is liable for issues arising from the infrastructure itself? What if trades are not settled or are settled incorrectly. Who do you hold liable? The main issue affecting public blockchain is the inability to control and stop its functioning. How do you regulate a decentralized autonomous organization (DAO)? Should DAOs be granted some form of legal status? Should regulators require that a platform organizer (for example Maersk or IBM or Microsoft) be required to appoint a free-standing company tasked with maintaining the DAO and enforcing the legal obligations?  Would all users of the platform have to agree to an all-encompassing wrap around agreement on its use in addition to the terms and conditions of the smart contract?

Who Owns the IP and Data on Blockchain?

At common law, as a general principle there is no property right in information itself, but that while individual items of information do not attract property rights, compilations of data – for example in a database – may be protected by intellectual property rights. What if the information is of a technical nature subject to a patent? How is enforcement done? What if the database of information is sold? What happens when a customer exits a blockchain? Is the customer entitled to a copy of the data? Is the vendor is obliged to hand over all such data on expiry or termination of the agreement and a complete record of all transactions stored on the blockchain?

Due Diligence

Transactional lawyers will need to understand blockchain and the values associated with different model propositions, especially ownership of data residing on decentralised ledgers and intellectual property ownership of the blockchain. These issues will need to be considered in the context of the business value proposition and competitive barriers to entry.

Blockchain is simply an evolution. From the rise of ATMs in the 70s, internet banking in the 80’s, e-commerce in the ‘90s to the current debates around how the world will adapt to driverless cars, the adoption of blockchain gives rise to legislative issues.

(*1) see September 2017 FHLLP newsletter for Part 1 and October 2017 for Part 2.
(*2) Kiviat, Trevor “Beyond Bitcoin: Issues in Regulating Blockchain Transactions”, 65:569 Duke Law Journal.
(*3) Ibid, page 589.
(*5) Ibid
(*7) Supra, note 4.


Post a Comment

<< Home