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The Smart Kid on the Block

Attorney: Cindy R. Hughes | Published 11.27.17

Blockchain technology is the “new kid that is moving into your neighborhood.” This innovative technology may revolutionize the business world by changing the way contracts are entered into and performed.

What Is Blockchain Technology?

Blockchain describes the technology that creates a database that continually grows with records of transactions. The transactions are permanently recorded on an electronic file called a “block” until it is full. A new block is formed once each preceding block reaches its limit. Subsequent transactions are recorded onto the new block, and the blocks are organized in a sequential manner, creating a chain.

An identical copy of the blockchain is distributed to a network of computers. Each computer on the network independently verifies that the updated blockchain it receives is identical to the copies on every other computer, which virtually eliminates fraud. Currently, one network has over 22,000 computers that validate whether a blockchain is consistent.

Smart Contracts Are Being Developed

Major enterprises are currently developing smart contracts with blockchain technology. A smart contract is computer code programmed to self-execute functions when certain conditions are met. Smart contracts will create more efficient transactions that are permanently recorded in a manner that prevents fraud.

Smart contracts may disrupt the real estate industry, for example, by possibly eliminating the need for third parties such as escrow agents. Using a smart contract, a purchaser of real estate would electronically transfer funds to the smart contract platform and the seller of real estate would similarly transfer the title. The smart contract will automatically distribute those items once all conditions are met. All of those steps would be recorded on a blockchain, which creates an undisputable record that each act occurred. Such transactions would be completed quickly and eliminate the need for an escrow agent.

Possible Legal Issues Related to Smart Contracts

Legal issues may arise if language used in a smart contract is ambiguous or open to interpretation. Simply adopting language from standard-form contracts could create uncertainty. For example, one standard real estate form includes language that property must be delivered in “substantially the same condition” as it was on a certain date. Use of that language may possibly require the smart contract to interpret the meaning of that term and compare insignificant details of the property on two different dates. If a smart contract executes a function when it misinterprets those types of ambiguous terms, then a legal issue may arise.

Another legal issue may occur when a party has the right to terminate a contract. In California, an insurance company has a statutory right to rescind an insurance policy if there has been a misrepresentation of an important fact in an insurance application. Thus, a smart contract will need to determine whether an insured made a misrepresentation of an important fact in the insurance application for a proper rescission to occur. For a homeowners insurance policy, a smart contract may be programmed to verify measurable facts, such as the age or size of a single-family home, to determine whether there has been a material misrepresentation of those facts. However, information like whether a building is a primary residence of an individual is not measurable if that individual owns multiple properties and inconsistently stays at all of them. Several facts will need to be gathered by the smart contract for a proper analysis if a large loss occurs at the designated primary residence and it is questionable whether the owner resided there. A bad-faith lawsuit against an insurance company may arise if an insurance policy is improperly rescinded by a smart contract.

Parties that decide to use smart contracts for transactions will likely need assistance from attorneys to draft specific and unambiguous terms. While smart contracts are innovative, they are not yet smart enough to solve all problems.