Law and Autonomous Systems Series: Smart Contracting Can Reduce Legal and Operating Costs
Like with any new and hyped topic, the current discussion on smart contracts is rather complex and confusing. I believe that asking What, Who and Why can help to structure the debate and shed some light on what I call the four semantic dimensions of smart contracts: the legal, the technical, the economic and, often overlooked, the ethical dimension.
Four Semantic Dimensions of the Current Debate on Smart Contracts
WHAT - The first question is: What is ‘smart’ about smart contracts? Most definitions of smart contracts focus on the aspect of “automation” – yet automation is no black-and-white matter. It is a continuous scale that extends from the mere automatic assembly of contracts to the self-execution of contractual obligations written as software code – with many different degrees of contract automation in between. As consumers, we often implicitly accept general contractual terms and conditions when buying things, for example when purchasing a train ticket at a machine. In Apple iTunes, software agents automatically enforce contractual obligations: only upon payment can we download the music we bought, and the restriction to 5 devices is enforced by some clever coding in the backend system.
WHO - The discussion of smart contracts is also characterized by the different perspectives of the participants: lawyers, software developers, and business managers. For lawyers, smart contracts are first of all a matter of material law: How can this new legal area be regulated and governed? Lawyers also think about how smart contracts and the digitization of the whole legal industry affect their profession, the services they provide, and the skills they require in the future.
Software programmers, on the other hand, primarily focus on how natural language can best be formalized as software code. They are also concerned with the Blockchain technology underlying smart contracts and with the goal of certainty of execution. In an uncertain world with an unlimited number of possibilities: how can the software reflect external conditions such as the “if/then/else” logic? Without such logic embedded in the smart contract, translating external conditions into computer instructions, contractual obligations cannot be executed automatically.
Finally, business managers who are engaged in buying and selling goods and services from other companies, are concerned with neither the legal nor the technological aspects of smart contracts. They view smart contracts primarily as a means to increase process efficiency and reduce internal operating costs.
WHY – The question “why are smart contracts such a hot topic?” leads us to a fourth semantic dimension of the current debate on smart contracts. I believe that besides the legal, technical, and economic reasons we also need to consider an important fourth reason, an ethical one which is intrinsically connected to the Blockchain technology. The main advantage of distributed ledgers is to make financial and other transactions fraud-resistant by eradicating the need for human interaction. Third parties such as banks no longer hold a central position, and transactions are instead validated de-centrally by the whole community. This radical decentralization and self-regulation of Blockchain Communities embodies the ethical ideal of equality, an ideal which is also present in contemporary political concepts such as Liquid Democracy.
The Business Practice of Smart Contracting
In my role as business executive responsible for global contract management in a software enterprise, I look at smart contracts primarily from an economic perspective –as a means for process automation and efficiency increase. I am not only interested in smart contracts themselves but also in the whole infrastructure and governance surrounding them – an area which we at SAP call “Legal Information Management” (LIM).
SAP has introduced a “LIM Maturity Model” that spans 5 phases from ‘Folder and File Management’ to ‘Central Layering,’ ‘Content Structuring,’ ‘Smart Contracting,’ and finally to ‘Artificial Intelligence.’ Using these 5 phases, we describe how to information-enable the legal departments of large enterprises – a stepped approach based on a (LIM) strategy.
At SAP, we progressed well from mere contract recording into phase 2 (the central legal content layer) to phase 3 (the deconstruction of Word-based texts into its clauses) – now, the time seems right to enter phase 4, ‘Smart Contracting’.
We use the term smart contracting to emphasize the business process perspective: How can we automate both, the assembly of contracts, but also the execution of contracts?
Smart Content as a First Step towards Standardization and Smart Contracting
Smart contracting starts with smart legal content: with contractual clauses, claims, policies and other legal content formulated in natural human language which is modular, tagged, and re-useable and can be automatically assembled in collaboration with internal and external contract partners.
Not so long ago, most companies had little or even no transparency on where contracts and other legal content existed in the organization. Contracts were often stored on personal drives, or as attachments to other documents like sales or purchase orders. IT systems treated these documents as ‘black boxes’ for which no ‘look inside’ function existed.
Today, most companies deploy Contract or Legal Content Management Solutions that control the whole lifecycle of legal documents, from planning to creation, usage and archiving. As such, the most important step for making legal content smart is to make it transparent and searchable - by putting it all into a central repository and turning it into a proper business object, with semantic metadata.
With such standardized smart content at hand internally, businesses can work with clients, partners and suppliers to standardize legal content across companies and for whole industries. While the same smart content principles of modularization, tagging and re-usability apply to cross-company contract negotiation as to internal contract drafting, there is one crucial difference: in the interactions between companies, smart content can no longer be mandated top-down, but must be achieved through bottom-up collaboration. With the exception of law firms, for whom contracting is part of their core service offering, contracting for most companies is only a necessary legal means for achieving a business goal. Collaboration on smart contracting thus is possible and makes sense even for companies who may otherwise be competitors.
Innovative collaboration can best be achieved through non-profit organizations representing the common interests of their members. The International Association of Contract and Commercial Management (IACCM) and the newly formed Liquid Legal Institute (LLI) are two examples of such non-profit associations.
IACCM and its 44,000-plus members have long been fighting for a less cryptic and a more business-friendly way of writing contracts. Currently, an IACCM workforce is developing smart content standards for Non-Disclosure Agreements (NDA) which should significantly reduce the time and effort for creating such contracts.
Also, a group of likeminded professionals representing a wide range of legal institutions has recently founded the “Liquid Legal Institute e.V.” (LLI), a non-profit association with the purpose of researching and promoting new technologies and other innovations in the field of legal design, development and usage. Among other things, LLI seeks to promote a Common Legal Platform (CLP) and to facilitate the contract negotiation process.
Smart Contracts: Automating Execution through Software Code
Automated contract execution, written as software code, is what most people understand as the crucial element of the definition of smart contracts (as stated above, the other defining aspect being the immutability of the smart contract record on Blockchain).
Smart contracts, i.e. natural language formalized in self-executing software code, require ‘oracles’ to interact with the outside world and interpret ‘external’ elements. It will take time to standardize such external conditions or elements of a smart contract – ultimately, it requires the digitization of the world (in the “Internet of Things”). Not everything can be formalized today, and, as stated above, foreseeing and formulating all possible real-world situations in a smart contract is unfeasible. Ambiguities, like “force majeure” or “material breach,” help us in the real world but might never be capable of formalization.
Hence it makes sense to focus on the formalization and standardization of the "if/then/else" logic in a smart contract. These smart contracts will be hybrids in the sense that some parts of the contract execution might be automatic, and other parts might still require human interaction. However, overall, the logic and the higher standardization and formalization of smart contracts will allow higher automation, transparency, security (lower risk), and overall contract quality.
Organizations like Legalese and CommonAccord are already working on this, and SAP is also engaging in smart contracting. Areas of standardization will be code, legal logic and business process logic (data, process, semantic). Smart contracts will include ‘views’, displaying the ‘logic’ in understandable language or graphics, depending on the context and the needs of the users, and using the idea of contract layering in prose and rules.
We have seen much progress in the field of text analysis used to interpret unstructured legal text. The new paradigm is to decompose legal prose and extract the legal logic from relevant clauses. Such clauses are currently enriched in various dimensions: re-usability, readability (simplified language), attributes. Formalization will allow us to push the envelope even further and codify contracts by adding software agents (parameters).
We can do this company by company – or we can join forces, collaborate and co-innovate and create cross-company standards. We want to bring together in-house departments, law firms, universities, legal tech companies and legal associations such as ACC, CLOC, IACCM or LLI.
What can be standardized should be standardized to increase efficiency. If the legal industry turns to standards, smart contracting can significantly reduce legal and operating costs.
Kai Jacob is Global VP for Legal Information Management at SAP SE.
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