Pamela Morgan: Innovating Legal Systems Through Blockchain Technology
Presented at Bitcoin South; Speakers list and videos
Below is an article summarizing and building upon the presentation entitled Smart Contracts: Dispute Resolution + Multi-sig = Today’s Solution, delivered by Pamela Morgan, founder of Empowered Law PLLC at the Bitcoin South Conference in New Zealand. The information is not legal advice and you should consult with an attorney in your jurisdiction before taking action on any of the information provided.
Smart Contracts: What are they?
The term smart contract is interesting, edgy, new, even exciting for those of us who are super geeks. Like kids, everyone wants their contract to be smart. But what does the term “smart contract” really mean? If you talk to enough people you’ll realize there’s no real consensus - particularly in the crypto space. Therefore, we need to define terms before we can continue the discussion.
What is a contract?
A contract, at its core, is simply an offer, an acceptance, and an exchange of value (the technical term for exchange of value is consideration). Some contracts must be in writing but many do not. And no matter what you call it, if there is an offer, acceptance, and exchange of value then it is a contract and so contract laws would apply. There are many nuances of contract law, the basics are covered in a year-long law school course, and they are obviously far too detailed to discuss here. All contracts, however, contain these three basic elements: offer, acceptance, exchange of value.
What makes a contract “Smart”?
The Fully-Automated Contract of the Future!
Many people in the bitcoin 2.0 space believe in and are working on contracts that are fully executable without human intervention. These contracts require a combination of integrated and automated assets, processes, and payment systems.
The closest example we have today is something like Uber or Lyft. In practice, the Uber or Lyft applications allow the users (riders and drivers) to create smart contracts. The application provides a platform to exchange value, in this case rides for money. Specifically, the applications allow customers to create an offer which includes a ride request, price request, and a promise of automatic payment if the service is provided. It allows the driver to accept that offer and deliver the service of the ride. Both parties have exchanged something of value, the driver - time and vehicle, the rider - payment. If all goes well, the rider gets into the car at a specific location and gets out at the destination - no further action is required. While this works well for short duration, small value transactions we have yet to see widespread adoption of similar applications for longer and/or higher value contracts.
A number of companies in the bitcoin 2.0 space are working on asset automation. The most interesting example I’ve seen is combining a computer-controlled door lock with crypto-currency transactions to allow access to a building or residence if payment is made. It’s easy to see the benefit of this application to something like Airbnb, where coordinating key exchanges and access to the premises is often a hassle. While I’m excited to see where the technology takes us, today crypto-currency isn’t mainstream enough to provide for widespread adoption of these types of assets yet.
The Semi-Automated Contract
Uber and Lyft align more closely with the semi-automated contract, which is where human interaction is still required at some points in the process. One example of a semi-automated contract could be a construction contract. In the construction industry, typically a large sum of money is deposited with an escrow agent before construction begins. The contractor is entitled to payments based upon the milestones, or progress, they make on the project. When a milestone is provably met, by way of in-person inspection or something similar, the contractor is paid for the work they have completed. These types of systems can be automated using bitcoin transactions now, by using time delay (nLocktime) and multi-signature addresses. I’ll cover creating these types of processes and systems in a forthcoming article.
Even if a contract is not completely automated, crypto-currencies can be used to make existing contracts much smarter by introducing new features such as automated escrow, multi-signature control and time-delayed execution. It is possible to make contracts much smarter even if they are not fully automated.
Today’s Smart-Provision Contract
No matter what level of process automation you’re using, all bitcoin related contracts today should have two specific elements: dispute resolution and multi-signature process provisions.
Why you need government to recognize your smart contract
Even though many adherents of the bitcoin 2.0 space see no role for government in their smart contracts, the reality is that if a dispute arises one party always has the option to go to their local courts and seek enforcement. Ignoring that possibility doesn’t negate it, nor does the lack of a chosen jurisdiction remove the contract from all jurisdictions. Instead, lack of choice exposes the contract to multiple jurisdictions that might find be introduced in a dispute and increases uncertainty, risk, time and cost. Selecting a suitable legal context, jurisdiction and adjudication process actually reduces the risks and uncertainty.
Dispute Resolution or How to get governments to recognize smart contract solutions
How do you get governments to recognize smart contracts? The simplest answer - include a written arbitration clause in every contract. Commercial arbitration offers a private ruling that is enforceable in the public courts of 150 countries, pursuant to the New York Convention (technically called the Convention on the Recognition of Foreign Arbitral Awards). The NY Convention requires the nation parties to recognize and enforce most foreign arbitration awards. While the details of the convention and other applicable laws are beyond the scope of this article, a valid arbitration clause must: be in writing, include choice of law and processes, define what disputes are (or are not) subject to arbitration, and the necessary provisions from the applicable rules.
Why go through all that work? If its done right (with parties from one of the 150 countries), a local court must enforce the arbitration award. If we combine arbitration clauses with properly executed arbitration hearings, local courts won’t have to decide if your smart contract is valid or who wins. The arbitrators, who you choose, decide all of the issues related to your smart contract including who wins and who loses. The arbitrators then make their decision, also called an award, which is binding on the parties. If the losing party won’t independently abide by the award, then the winning party takes the award to the losing party’s local court and says “enforce this please”. The local court must enforce the award, without second guessing the arbitration proceedings, so long as the arbitration was conducted properly. Better yet, arbitration clauses let you tailor almost every aspect of the process: location, duration, language, medium (video or in person) etc. further reducing uncertainty and giving the transacting parties control over the process, instead of governments or courts.
Escrow and Multi-Signature Addresses
What is traditional escrow?
At its core, traditional escrow brings in a neutral or trusted third party to hold assets and act as an intermediary between the parties. It’s typically used for high value transactions such as the purchase of real estate or businesses.
Comparing Traditional Escrow and Bitcoin Multi-Signature Addresses
In traditional escrow, a banker or a lawyer typically serves as the third party. This person takes custody of funds and their consent is required to release funds to either party. Transactions are limited to banking days and hours, with significant costs involved. Bitcoin’s multi-signature addresses can be constructed to provide protections of traditional escrow, while providing the parties additional flexibility, convenience, and protection against the third party itself. Using multi-signature addresses anyone can serve as the third party, so long as both parties agree. The third party does not take custody of the funds and the parties can execute transactions anywhere anytime (across borders) without approval of the third party. There is no cost to create a multi-signature address, though some third parties may charge a fee for providing signing services.
What is a Multi-Signature Address?
Let’s start with how a traditional bitcoin address is created. For our purposes it isn’t really important to understand the technology behind address creation. What we need to know is that a traditional bitcoin address is created from one private key while a multi-signature address is created from more than one private key. A multi-signature address has an M of N signature set up, with N being the total number of signers and M being the (subset) number of signatures required to execute any transaction. Many multi-signature addresses use the 2 of 3 signature scheme, where three keys are used to create the address and any two of them are required to sign (authorize) a transaction. If a 2 of 2 address scheme is created then both private keys must sign every transaction, which provides no room for error and actually can increase the likelihood that you’ll lose access to the bitcoin secured in this manner. Step-by-step instructions on how to create and use multi-signature addresses are available at http://www.empoweredlaw.com.
Comparing Traditional Bitcoin Addresses and Multi-Signature Addresses
Traditional bitcoin addresses start with the number “1”. One private key is required to sign transactions and spend (transfer) bitcoin. The benefits of keeping a single-signer address include the ability to maintain complete control over the funds and to maintain privacy. Alternatively, single-signer addresses provide a single point of failure and increased likelihood of losing bitcoin by way of theft or loss of the single private key.
Multi-signature addresses start with the number “3”. More than one private key is required to sign transactions and spend (transfer) bitcoin. The benefits of using a multi-signature address include removing a single point of failure, thereby reducing the risk of loss, and potentially improved self-governance. Multi-signature schemes can be used to provide resilience by having “backup” keys that are stored separately. However, multi-signer addresses require coordination between parties which introduces overhead and could potentially delay transactions.
Additional Use Cases for Multi-Signature Addresses: Corporate Governance and Estate Planning
While the majority of this article focuses on using multi-signature addresses for escrow, today they’re also being used for corporate governance and estate planning purposes.
Corporate governance uses include division of duties, where more than one manager is required to sign off on transfers from the operations account or investors are given signing rights on the capital account. These controls, if implemented according to a detailed signing plan (as described below), provide additional oversight by those who stand to lose most - the investors, managers, employees and perhaps even customers. By requiring more than one signer on transactions they provide protection from external threats like coercion, equipment failure or loss, and internal threats like embezzlement or mistake. You can get more information about the benefits of using multi-signature accounts for corporate governance and how to structure these accounts at http://www.empoweredlaw.com.
For those who own cryptocurrency and consider it an important asset, estate planning is a must.Nothing highlights the importance of planning more than this issue. If you’ve secured your private keys properly, as we all hope to do, no one but you should be able to access them. However, no one also means your family may not have access if something happens to you. Planning becomes even more important if those closest to you aren’t bitcoin savvy. Some people are using multi-signature accounts as a way to ensure continuity and family access even if they are unable to provide access to their own private keys. While each estate plan is unique, the basics are the same: protecting your bitcoin while providing a means of access in very limited circumstances. I’m currently working on an article about estate planning and bitcoin, to be published in the near future.
Signing Plans and Multi-Signature Addresses
Aside from testing the address, a signing plan is the single most important component of using a multi-signature address. A signing plan might sound boring but in this case boring is good. Although each signing plan is unique, every signing plan should include the following: who are authorized signers, under what circumstances should they sign, under what circumstances should they not sign, how can signers verify the authenticity of the transaction origination, who broadcasts the transaction, what happens if a signer’s key is compromised, what happens in an emergency. Signing plans should be reviewed at regular intervals preferably when signing and recovery processes are tested - at minimum annually.
In the bitcoin space, it’s easy and inexpensive to use arbitration clauses and multi-signature addresses to make contracts smarter. Thanks for taking the time to read this article, I hope you’ve found it helpful.