Traditional legal frameworks act as road maps for parties to create legal interests and rights when entering into an agreement. However, they are often subject to different – and sometimes conflicting – requirements. When a transaction shares the characteristics of different legal frameworks, disputes between parties can arise.

How does current law treat smart contracts?

Smart contracts have the ability to capture and transfer assets from one party to another. As such, they can conflate contract law with other legal frameworks, such as property, secured transactions and entity law. For instance, contracts are typically private agreements in which the rights of third parties are unaffected. As such, the terms of a contract may be kept confidential. A smart contract, however, can put assets out of the reach of third parties that claim an interest in them. Property law has the ability to affect third parties’ rights. However, property rights require the giving of notice to be enforceable against third parties, such as by recording a deed or mortgage at the county clerk’s office.How does current law treat smart contracts? #blockchain #digitalassets

A smart contract may also share the characteristics of a secured transaction governed by Article 9 of the Uniform Commercial Code (UCC). Imagine a smart contract where a creditor extends a loan to a debtor and takes as collateral a “secured interest” in the debtor’s personal property, such as a vehicle, patent or valuable artwork. This same smart contract may also contain a self-enforcing protocol that uses blockchain to automatically capture and transfer the collateral to the creditor if the debtor fails to repay the loan on a certain date. In this scenario, the creditor would engage in a sort of “digital self-help” by seizing the collateral without court intervention, similar to the rights of a secured creditor under UCC Article 9. As with property law, a creditor must provide notice to others by filing a financing statement with a state office to “perfect” its security interest. However, unlike property law, which typically allows one to abandon or even destroy owned property, a secured creditor is required to dispose of the collateral in a “commercially reasonable manner,” such as be selling it for value at public auction.

Smart contracts could also provide protections only available under entity law. Unlike a security interest, which prioritizes competing claims between creditors, entity law can completely shield assets from creditors’ claims. By incorporating and respecting corporate formalities, business assets of a corporation are placed beyond the reach of the creditors of the corporation’s owners. This ability is unique to entity law, and arguably its most important feature. However, a smart contract may have the same effect without requiring incorporation.

Given the overlap of these legal frameworks, smart contracts may be prone to litigation. Disputes over the nature of an agreement are not uncommon. Our courts are inundated with lawsuits requiring judges to decipher the “true” intentions of parties and enforce contractual obligations. What makes smart contracts problematic from a legal standpoint is that parties agree beforehand to both the execution and enforcement of the agreement using nothing more than computer code. If a dispute arises, there may be no way for a party to seek court intervention to resolve the dispute before the assets have changed hands. As a result, a court may be left in the more challenging position of trying to undo enforcement of the agreement.

Why is regulation necessary?

History has shown that a failure to regulate technological innovation that affects traditional legal frameworks can create systemic risks to the legal system. One needs only to look back to the global financial crisis of 2007-2008 to find an example.

During the early 2000s, the mortgage-backed securities market grew exponentially as large financial institutions bundled and sold millions of mortgages to investors. The industry relied heavily on the Mortgage Electronic Registration System (MERS), an electronic database for mortgages, servicing rights and ownership interests, which promised to reduce costs and increase efficiencies. When homeowners began defaulting in record numbers, mortgage investors sought to exercise their foreclosure rights under the mortgages. However, in many instances, courts delayed or even denied enforcement of these rights when MERS records made it difficult to decipher who owned the rights to a mortgage. The majority of these problems were eventually resolved, but not until after costly and time-consuming litigation. By then, the real estate market had crashed and billions of dollars in asset value were lost.

As smart contracts become more commonplace, parties must have confidence that they are creating intended legal interests and rights. As such, new regulations must be enacted to account for how blockchain and tokenization intersect with traditional legal frameworks – or perhaps create new ones. This process has already begun at the state level, where states like Arizona and Tennessee have enacted laws to define smart contracts and recognize electronic signatures secured by blockchain technology as valid and enforceable. Wyoming has gone even further, amending its state commercial code to specifically define and classify digital assets, and to establish requirements for the perfection of a security interest in a tokenized asset. However, these states remain the exception, not the rule.

Blockchain-based smart contracts have the potential to revolutionize business transactions and open the door to entirely new markets. But regulatory adoption cannot be outpaced by technological innovation. Much more is needed from lawmakers, including those at the federal level. Otherwise, the term “disruptive technology” may take on a whole new meaning.

Source :