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Monday, June 9, 2014

Bitcoin Smart Contracts: The End of Lawyers?

By New York lawyer and blockchain technology innovator Eric Dixon
From June 2014:

A revolution in information technology may soon turn the theory of “smart contracts” into an actual mechanism for increasing trust among transacting parties, reducing the risks inherent when third party intermediaries are needed and even redefining lawyers’ role in and stranglehold over the modern economy.  Universal access to mathematical proof can give new life to the Russian proverb (which Americans may know from President Reagan’s English translation): “Trust but verify.”1

Bitcoin2 – along with a growing number of similar cryptosecurity systems such as Ethereum3 -- is a series of algorithmic protocols which use mathematical proof to verify and secure data. Its ability to provide for the strongest, most verifiable proof of ownership with which to facilitate fast transfers of information and assets lends itself to other applications where the need to involve and trust in a third party (and the risk of third party negligence, malfeasance or failed performance) can be reduced or eliminated.  This gives Bitcoin a much wider potential than the almost exclusive conception of it – among the sliver of people who have even heard of it – as an electronic currency or the latest hope of anarchists and utopians who dream of a world run by benign computer code, anything other than bad men. The Internal Revenue Service is one of the few government agencies to even acknowledge Bitcoin but does so only to conceive of it as an alternative, unofficial currency alternative, labeling it in recently issued guidance in March 2014 as “virtual currency” as to which it is to be taxed as property.4

This development can redefine or turn obsolete entire old-economy professions, trades and jobs whose business models have been based on charging to provide a verification function.  Lawyers might be one suspect class – and as a particularly reviled segment of the economy whom everyone else loves to hate, they are the focus of this article.  But be warned: other suspect industries including segments of the insurance, medical billing, accounting and financial advisory industries may soon have their turn in the line of fire. Bitcoin can endanger or destroy the value-added feature of any rote act or advice or make it much less expensive if it could be performed by much cheaper lay people or even a computer algorithm.  But not all is lost. The real value-added components in those professions, featuring judgment and experience not replicable by computer code or outsourcable to clerks, will survive.  In fact, they may even grow in value and stature. Some lawyers may become more indispensable than ever!

The fantasy of the lawyer-free nirvana does not survive an encounter with reality or any fact-based understanding of the real function of lawyers.  Most people really expect that that lawyers are supposed to be paragons of truth. (Stop laughing!) It is neither true nor is it even their job! It is absolutely erroneous! Lawyers are not supposed to be neutral factfinders.  You know who has that job? Judges, that’s who. Huge difference! Some lawyers are very honest; others are incredibly dishonest yet not criminal. But let’s not lose sight of lawyers’ actual duty – something totally misunderstood or arrogantly dismissed by 99% of the population, including many ignorant lawyers – which is to zealously represent their clients’ interests within the law.5

These lawyers are advocates, and they are adversaries who do battle with the lawyers on the other side of a dispute or negotiation. They are not meant to be impartial. They are absolutely, positively not supposed to be neutral finders of fact or to “fight for justice.” They are not judges. Lawyers are advocates and are supposed to zealously represent their clients (and only their clients). This is the mandate for lawyers, whether they are representing clients before a regulatory tribunal or a judge, or drafting complex agreements to govern the relationship between parties and (hopefully) preclude future misunderstandings that often form the genesis for threats, lawsuits and acrimony.

These lawyers do battle for you – and you very much still want and need them on your side. In fact, as I’ll soon explain, you’ll need them even more.

There are some lawyers whose actual or perceived role is that of custodian or third-party verifier of facts. These roles emphasize the lawyers’ independence and the lawyers chosen for these roles are picked precisely because they are neutral and do not represent either party in the matter. In these situations the lawyer is not an advocate for the two parties – but is the lawyer for the third-party intermediary (such as the bank) between the two parties, and his importance arises from his neutrality (and his presumed integrity). Lawyers working for institutions which act as agents or fiduciaries have a neutral role but very much advocate and defend their client – their institutional employer.  The other independent lawyer’s role is that of a judge, who again does not represent either party but rather referees the dispute.  

Getting rid of the third party interference does not, however, eliminate the need for the two transacting parties to reach a mutually-understood agreement. On the contrary, it increases the need for the parties to agree, and for their respective lawyers to produce a physical agreement upon which trust may be placed. If that agreement becomes codified in a bitcoin-type protocol, that agreement had better be top notch. After all, trust in a bitcoin-ruled world will depend on the quality of the inputs (or in simpler terms, best to avoid “garbage in, garbage out.”). The essence of the electronic smart contract, therefore, becomes whatever would have gone into a 20th-Century paper contract. And the production of contracts will go from the domain of scriveners (glorified word processors) using boilerplate to proficient specialists whose judgment, talent and experience will be more critical and valued than ever. 

The result in many professions will be a new nirvana for talent where merit reigns supreme and customers get cost savings from efficiency. 

However, the legal profession is crucial for dispute resolution. How would a smart contract reduce or eliminate the need for lawyers? In the imagined lawyer-free world, smart contracts would have to eliminate all potential for disputes (honest or otherwise), all potential for nonperformance or evasion of obligations under the contract and, indeed, all potential for redress or challenge of such performance. This is far from nirvana; it would mark the loss of basic freedom!

This vision mistakenly views the smart contract as the enforcement mechanism which cannot be disobeyed. But this paradigm is not merely wrong in its premise. It is wrong as a policy and contractual rights matter. It ignores or disregards legitimate disputes in any relationship over the quality of performance, the degree to which an agreement is fulfilled, and a multitude of other terms and factors.  Parties cannot lose their rights and abilities to go to court to defend their rights, just in the name of greater efficiency. 

Any enforcement mechanism, the strongest and clearest contract, can be ignored. Even court orders can be disobeyed (although there are serious penalties for that).  But willful nonperformance is only one problem with any business relationship. Most contract disagreements arise out of disputed performance or disputed interpretations of contract terms. This is why contract litigation and business litigation continues to increase, paradoxically, despite greater reliance on increasingly complex agreements.  

These type of disputes then run smack into the brick wall of objections over the danger of eliminating the due process to which Americans are accustomed and to which many Western businesspeople rely upon.  Can a smart contract ever eliminate noncompliance? And can one ever be implemented without reducing or eliminating the right to redress for a party which considers itself wronged in the performance of an agreement? 

It seems the so-called smart contract is really a utopian fantasy that assumes that people are both as rational and honest as many of us wish we would be. The fantasy fails to account for malevolence and incompetence, of which both lead to many disputes and much litigation. It is entirely unclear how – if not flatly impossible for -- a smart contract to prevent, negate or account for events which are not legal problems nor legal system drawbacks, but instead reflect basic human failings intrinsic to imperfect human character.

Basic human nature will never be changed. Dishonesty is part of that and has been chronicled since the beginning of recorded human history. Blaming lawyers or the judicial system is like blaming the bullet for the murder. Such an approach is an easy way out for the truly responsible to avoid accountability for their willful, strategic defaults on contracts to which they freely entered and possibly engaged in deception in order to induce the counterparty to enter into and perform under the same contract. Some people break contracts often, and contract breaches are not uncommon. This is the same flaw that underlies the concept of overregulation and overcriminalization – the thought that if only we had more laws, or the right law, and were just tough enough on enforcement, that then we would have the safe and desirable society we all want.

The issue here is not the lawyers, the quality of the agreement or the judicial process.  The problems are the willingness of both parties to continue to perform under a freely-executed contract when one or both parties later decide – for a good and valid reason, or a dishonest reason -- it is no longer economically advantageous (for them) to continue to perform under the agreed terms.  This is a problem of “strategic default.” The contract, whether it be a Magnus Opus or smart contract, will not be the ironclad barrier. The parties will always be the issue.  How ethereum or any other smart contract paradigm would solve the human advantage-seeking dilemma by precluding or precluding legal process redress – and to Americans, the concepts of “due process” and “equal protection under the law” are considered fundamental constitutional rights and virtually sacrosanct (even if widely misunderstood by lawyers and laypeople alike) is unclear – remains uncertain.  

Unless, of course, protocols replace people.  So let’s get rid – of people? This sounds like the road to an endless nightmare loop of bad science fiction gone mad. Rise of the machines? What is this? Terminator 4? 

Does the smart contract replace the legal system? Or does it simply push us back to an earlier, less complex stage in human history when conformity was a stronger (if sometimes unfair or even discriminatory) impulse, when “the law” wasn’t necessarily needed because the social punishments of having no one do business with a dishonest player were enough of a deterrent?

Perhaps the root problem is the contemporary belief by bad actors that the legal system provides a way to avoid justice, to delay – and yes, to gamble that one can ultimately avoid -- the consequences of bad behavior.  That theory would explain the paradox, that there are so many more lawyers in Western society than there were two generations ago, that the standard business contract has grown much longer and more complex in the same interval, and yet the number of disputes and other metrics measuring litigation have exploded in that time.  

The common lay explanations – there are too many lawyers, lawyers are encouraging lawsuits, much of the legal work is substandard – incorrectly seek to deflect blame from the root cause: flawed human behavior manifesting as advantage-seeking within a justice system that allows bad actors to delay their day of reckoning.

There is no solution. Conflict and disagreement will always be with us. But there can be progress, and there can be ways to reduce unpunished, undetected bad behavior. Smart contracts can serve as a clearinghouse for information, so as to sanction and deter bad behavior by notifying the larger community of users that a particular contract party has failed to live up to his word in a contract and assuming the community will use its power of ostracization to levy a penalty.  

Bitcoin or Ethereum-type protocols for smart contracts have their efficacy in their ability to strengthen trust, but at its core, trust works only when society members (anyone within the group) obey a shared set of rules as part of the price of membership.  As part of this deal, there is an agreed-upon punishment for noncompliance – banishment or lesser sanctions, or “getting voted off the island.”  

Smart contract theory holds the potential for a creative use of technology, not to replace human nature, but rather to rediscover and celebrate human nature and rely upon it to reach its goal of fostering and facilitating commerce. This is progress! Revisiting what worked in the past, the old social rules, and discarding the failed recent paradigms of what we thought worked but really only made commerce more difficult with more lawyers, more litigation and more loopholes, makes for mature policy.

In these ways, smart contracts do hold the promise for improvement. They won’t negate or diminish the role of the legal profession, which will surely change.  However, they have the very real potential to strengthen human bonds by allowing parties to verify each other’s information.  Any inhibition in the ability of bad actors to harm others in commerce will necessarily decrease (but not eliminate) legal conflicts, at least until the bad actors adapt as all organisms do.

Trust will increase, when it can be objectively verified.

The trusted and trustworthy will increase in value and they will become more sought out.

Bad actors will be increasingly shunned and economic loss shall penalize and deter (but never eliminate) bad behavior. 

This potential, however, requires a credible, trustworthy protocol which is and remains impervious to attack.  And you can be sure that the bad actors will try very hard to destroy it.

They simply have too much to lose.

** ** ** ** ** ** **

FOOTNOTES

1. Illustrated World of Proverbs, accessed June 2, 2014 at  
http://www.worldof   proverbs.com/2012/05/trust-but-verify-russian-   proverb.html, attributing the saying to Vladimir Lenin.

2. Satoshi Nakamoto, “Bitcoin: A Peer-to-Peer Electronic Cash System,” 2008, whose authorship is attributed to Satoshi Nakamoto but whose existence is questioned.  The paper is referenced and relied upon herein while acknowledging the issue of uncertain authorship.

3. Gavin Wood, Ethereum Project, “Ethereum: A Secure Decentralised Generalised Transaction Ledger,” 2014.

4. Internal Revenue Service, Notice 2014-21, accessed June 2, 2014 at http://www.irs.gov/pub/irs-drop/n-14-21.pdf.

5. American Bar Association, Model Rules of Professional Conduct: Preamble & Scope (2014), accessed June 2, 2014 at http://www.americanbar.org/groups/professional_responsibility/publications/model_rules_of_professional_conduct/model_rules_of_professional_conduct_preamble_scope.html. The role and authority of lawyers varies by jurisdiction. The nomenclature does not change lawyers’ primary duty which is to zealously represent the client within the limits of what is legally permitted. See Preamble, paragraph 8, id.  For example, American lawyers are not permitted to turn in their own clients to the authorities unless there is imminent risk of commission of a violent crime or crime involving fraud. That is the crime-fraud exception to the attorney-client privilege. See Sue Michmerhuizen, “Confidentiality, Privilege: A Basic Value in Two Different Applications,” Center for Professional Responsibility, May 2007, accessed June 2, 2014 at http://www.americanbar.org/content/dam/aba/administrative/professional_respon    sibility/confidentiality_or_attorney.authcheckdam.pdf.

 

Eric Dixon is a New York lawyer who works extensively with blockchain and cryptocurrency innovators and startups. He is the co-inventor of two blockchain technology / FinTech innovations as to which filed patent applications have been allowed, and the grants of each are expected by late 2016.

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