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.
Liability
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.
Endnotes
(*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.
posted by Rui Fernandes @ 4:46 AM
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