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Posted by: Michael Cathey on Mar 1, 2018

Journal Issue Date: Mar 2018

Journal Name: March 2018 - Vol. 54, No. 3

Disrupting the Legal Field Today

Have you heard of blockchain yet?  Like many other industries in Tennessee, the legal field is already being disrupted by this fast-growing, but little understood, technology. Businesses that rely upon contracts, transactions and services are quickly researching, experimenting and implementing blockchain in their industries and the legal field will need to adapt to survive as well.

conceptual illustration of blockchain technology

A blockchain, originally block chain, is a continuously growing list of records, called blocks, which are linked and secured using cryptography.

Wikipedia
Photos © iStock

To picture where blockchain technology is currently, IBM recently surveyed thousands of executives finding that 80 percent were either considering using it or were already using it in their businesses in order to keep up or innovate their business model. [2] Deloitte conducted their own survey and revealed that 28 percent of their sample executives had already invested a minimum of $5M or more in blockchain technology with 10 percent having invested more than $10M. Bitcoin, the most widely media-covered cryptocurrency based on blockchain, was formally recognized by Japan and Russia this year as a legitimate currency. [3]

Law professor, Angela Walch of St. Mary's University School of Law in San Antonio, Texas, teaches a class on cryptocurrencies and blockchain and has become one of the few experts in the legal field currently.  She has been active about sharing her views on where blockchain is going and its imminent impact on many industries including the law.  "People are saying this technology is going to make fundamental changes in how finance operates, how property records operate, how the rules of evidence operate, how actually we regulate different industries," Walch said. "Law is definitely among the fields that are potentially going to be transformed by blockchain technology." [4]

What is Blockchain?

Blockchain technology is a distributed ledger system via a decentralized database that stores linked records in the form of time-stamped blocks. Each block of information is linked to the previous blocks in the chain like a train with each car on the train having its own unique, sequential identifier.  Each block is publicly visible, and is confirmed by a consensus-based "proof of validity" or cryptokey. Thus, if someone tries to fraudulently add, delete or manipulate a record, everyone else has an encrypted record of what the information should be and the attempted change can be detected almost immediately thus halting a transaction.  This quality of "immutability", or the trust in the inability of the information to be changed, is one of blockchain's most valuable attributes per its believers.  Thus, the platform technology allows digital asset applications with computational capabilities like cryptocurrencies or smart contracts to be executed on the platforms.

"Distributed" and "decentralized" references the peer-to-peer aspect of a blockchain network. Currently, businesses and websites like Facebook.com or Amazon.com use a central database architecture where the content and computing power are in a datacenter controlled exclusively by the business.  In contrast, blockchain may feasibly utilize an infinite number of computer nodes with none, some, or all under their control on a global network and each would have an encrypted copy of the entire ledger.  The economic driver in this model is compelling.  Businesses that have long been burdened with crushing capital expenses for their computing and security infrastructures will be able to save on future upgrades on their current legacy network infrastructure.  Facebook's CEO, Mark Zuckerberg, recently stated that they are exploring using blockchain as a computing platform. [5]

The "public ledger" works like an accountant's ledger book.  Every user of the blockchain has access to the details of every transaction, although the identities of the transactional agents remain confidential.  Because blocks and the blockchain are not changeable, you will be able to see the full, trusted history associated with the ledger, or the "full chain of title" on a property for example.  This also makes fraudulent transfers almost impossible, since each and every other person on the chain can investigate every other transaction.

Blockchain's blocks of data are analyzed for uniformity by independent entities called "miners" multiple times per hour across the Internet utilizing cumulative processing power many times greater than all of Google's data centers.  Miners are incented with cryptocurrency to find, announce and sometimes fix these errors which is the foundation of blockchain's immutability.  The code is the absolute law to the blockchain technologists since every bit of data is continuously detected for non-uniformity, or fraud.  Thus, currency and contracting are thought to be unable to be changed or tampered with without discovery which establishes the "proof of trust", i.e. the code is law.

Do not let the "distributed across millions of public nodes" aspect make you uncomfortable. Blockchain networks can have public, private, or hybrid architectures.  A company can fully internalize a blockchain network and run a purely private network on its own servers to fully insulate proprietary data from the world.  Or if there are a limited number of companies or users, blockchain platforms can be fully public, fully private, or a hybrid. Cryptocurrencies are the best example of fully public blockchain networks.

This summer, Bank of America and Microsoft's Azure tested automating smart contracts for the small-revenue-but-high-touch-and-cost process of creating a standby letter of credit (LOC).  The firms studied the notoriously messy process and found that the creation of a single LOC had fifteen touch points on average with a cost of $8,000 to $15,000 per LOC. Further, the more parties involved, the more touch points and the more expensive the LOC.  Bank of America executes thousands of LOCS annually, so these costs add up.  The smart contracts were built on a private version of ethereum blockchain.  Instead of tasking individual humans with examining whether the contracts are properly filled out and properly granted, blockchain allows machines to do it, while still leaving multiple checks on the correctness and legitimacy of each transaction.  Many public finance companies are still utilizing patched together legacy hardware and software systems as their main IT infrastructure.  Adopting a blockchain platform would save them billions of dollars. [6]

Where is Blockchain Going?

We are currently in Blockchain 1.0 where decentralized payments are bypassing nationally-controlled institutions and currency is being democratized.  Anyone with a smartphone and an Internet connection can give or receive funds anonymously, expediently and safely.  Bitcoin, the most popular global cryptocurrency due to its early entry, is a darling of speculators worldwide even though experts consider its blockchain technology antiquated compared to Ethereum, a more recent blockchain platform technology and cryptocurrency.

The next stage is Blockchain 2.0 where digital assets and smart contracts evolve into the mainstream. If Blockchain 1.0 is meant to decentralize means of payment, then Blockchain 2.0 is intended to decentralize the overall global financial market. It was thought that Blockchain 2.0 would experience a difficult time with a lack of laws and financial regulations.  However, the regulatory environment seems to be giving the technology some space and some financial products are being publicly introduced. 

Per Kevin Gao of Seeking Alpha, there are "at least 5 exchange-listed bitcoin investment products, 3 U.S.-based ETFs under review by the SEC, and hedge funds that cover just about every cryptocurrency asset type and investment strategy. By my estimate, these funds represent roughly 5-10% of the $24B in total that's now invested in cryptocurrencies." [7]  Goldman Sachs is planning on trading cyptocurrencies as soon as June 2018. [8]  The Chicago Board Options Exchange (Cboe) is now trading cryptocurrency bitcoin futures with other financial derivatives planned for release. [9]  With SEC-approved funds trading on Wall Street, it is a very short jump to mass adoption.

Business Impact

Tennessee industries like Energy, Healthcare, Finance, Real Estate, Distribution, and Music/Entertainment Media are currently testing out blockchain technology.  Medical records will be migrated for storage on blockchain.  Smart contracts will be created for real estate closings, song purchases, stock trades and more.  With blockchain adoption, escrow businesses like property title companies will be the hardest hit as adoption quickens.  In a property closing, blockchain smart contracts efficiently execute escrow contracts by determining if a product or service like a deposit is delivered and checking if the property has no liens.  If both are positively affirmed at the programmed day and date, the contract transaction will automatically proceed and be mutually logged in seconds.  Thousands of business transactions that took weeks or months to process would only take minutes to hours. Healthcare data management, banks and real estate title companies will need to evolve or be upended. [10]

PwC's 2017 Global Digital IQ Survey recently asked firms to shed light on their investments in blockchain currently and three years in the future. The survey showed that Financial Services, Hospitality, and the Automotive industries currently investing the most in blockchain.  The study also asked about blockchain investment three years from now and Healthcare and Energy plan on joining the three existing blockchain dominant industries on increasing their investment levels. [11]

Tennessee's music industry will see three major area changes: Industry intermediaries, piracy issues and licensing and rights management.  Blockchains will enable content creators to register ownership of their creations without the need for big record labels since they are immutable distributed ledgers owned by no single entity.  Thus, artists will not need big music labels for distribution.  Songs and other digitizable art can be sold "smartly" by limiting piracy and flexibly charging more for use on a television commercial versus less for a fellow musician or a fan.  UjoMusic, a blockchain-based music platform, beta-tested their platform last year with "Tiny Human," a song by award-winning singer-songwriter, Imogen Heap, who was attracted to the distribution concept.  Musicians have been negatively impacted financially by the digitization era but blockchain will remedy that.  Fans and other musicians are a natural fit for blockchain as it gives the artist/content creator more control over how their songs and associated data circulate among user entities. [12]

Legal and Regulatory Issues

The law is struggling to keep up with blockchain's cryptology methods.  Blockchain-based cryptocurrency such as Bitcoin or Zcash, is often associated with criminal activity due to its user anonymity capabilities.  One of the more notorious criminal cases involving Bitcoin thus far is United States v. Ulbricht. Ulbricht involved the prosecution of the operator of the infamous Silk Road website that was a massive online market of illegal drugs with payments made via Bitcoin being absolutely anonymous and untraceable.  However, Ulbricht's private crypto key was discovered written on his contraband laptop allowing Federal agents to decrypt all messaging.  The eBay of the global drug trade fell because Mr. Ulbricht's ledger was discovered and the incriminating data could be linked directly back to him. [13]

Lest we think that Wall Street is not concerned by the lack of regulation or concerned by rival financial products, they certainly are.  Financial market players appear to be joining rather than fighting the trend.  The tech stock-heavy Nasdaq announced that it made the first share trade ever using blockchain technology at the end of 2016.  They believe that blockchain's visibility trait will make many processes easier to conduct, including governance and transfer of ownership and auditability.  "We believe this successful transaction marks a major advance in the global financial sector and represents a seminal moment in the application of blockchain technology," said Nasdaq CEO Bob Greifeld. [14]

The financial markets were disrupted by Internet technology decades ago and, like then, the SEC is struggling to ensure that they keep pace with blockchain.  Initial Coin Offerings (ICO) are like a stock IPO however there are important differences.  Currently, an ICO, a crowdfunding event that uses blockchain to make a cryptocurrency token, does not have to be registered with a government entity like the SEC since the funds raised are via cryptocurrency.  The funds are generally based on a blockchain platform like Ethereum or Bitcoin and the cryptocurrency raised is usually earmarked for a blockchain-based application.  The 1946 case, SEC v. W. J. Howey Co., defines a security via the "Howey Test," and determines whether a transaction qualifies as an investment contract. There are a number of current SEC cases where investors have charged fraud in cryptocurrency losses due to the volatility of the new currency.  Cleverly, most ICO tokens are structured as a sale of a service or product so as to not trigger the prongs of the test.[15] 

 

A close up shot of three main cryptocurrencies: photo of Bitcoin, Ethereum and Litecoin.
Three cryptocurrencies: Bitcoin, Ethereum and Litecoin.

 

There were 64 ICOs in 2016 that collectively raised $103M, excluding the Ethereum digital decentralized autonomous (DAO, pronounced "dow") which was a cryptocurrency venture capital fund. More than $5B was raised via ICO in 2017 and an exponentially higher number is expected in 2018.[17]  The Ethereum DAO was one of the biggest crowdsourcing funding that had ever taken place at the time.  In 2016, it had 18,000 plus stakeholders and reached a peak funding level of $250M (US). [18]  The risks involved with a new currency that has a limited supply of currency holders are high and the volatility can be severe.

Mistakes will be made and insurers will certainly want to recover from programmers who write flawed code. As we all know from rebooting our computing devices, software fails.  Who has the fiduciary duty when that software fails and duty is breached?  What about Product Liability claims?  Fraud and Negligence are supposed to be impossible as the "Code is Law" mantra, a deeply embedded blockchain culture tenet. 

Unfortunately, a hacker found a loophole in the DAO and executed a $70M heist via a flaw in the contracting code though the platform itself was uncompromised.  Though much of the funds were recovered, the growing pains show the dangers of a system with no central regulation. The Ethereum community stressed that the platform itself has never been compromised but the application on it was the issue.

Other basic legal issues are jurisdictional and applicable law issues.  Being a decentralized network with millions of nodes and the code being on each node, finding where the server is that a breach or failure has occurred is a challenge. As the code becomes more advanced and self-governance of applications becomes more complex, determining the legal status of a DAO as a corporation, or a specific entity will quickly become increasingly more important and difficult. 

The future has begun for certain legal practice disciplines.  Specifically, law firms will be asked to review transactions involving blockchain-based cryptocurrencies.  Some clients are already paying in Bitcoin.  Estate planning, probate, family law and bankruptcy practices will all see an increase in cryptocurrencies as part of the asset mix.  Real estate practices and title companies will work with proof of title and chain of title via blockchain-based systems.

Litigators will need to begin to be able to explain to judges and juries how blockchains work and why they can be relied on or not. Evidence and discovery phases will be impacted in an exponential fashion.  Likely, our clients from specific industries are already ahead of most lawyers about understanding blockchain technology.  Smart lawyers will start getting friendly now with smart contracting especially for simple transactions such as escrow and release.  After all, squeaky wheels usually get the grease and lawyers are usually viewed as the friction causing the squeaky wheels.

Conclusion

Ultimately, immutability relies upon the law behind the code, instead of the code as the law in our system.  To be sure, there will be flaws in the code.  For now there is a lot of gray area in who might regulate this technology and under what standards however the case law will quickly evolve as blockchain quickly permeates digital asset management.

Lawyers have multiple reasons to keep up with the blockchain evolution: ethics and survival. Comment 8 to Rule 1.1 of the Model Rules of Professional Conducts stating attorneys are to "maintain the requisite knowledge and skill, a lawyer should keep abreast of changes in the law and its practice, including the benefits and risks associated with relevant technology, engage in continuing study and education and comply with all continuing legal education requirements to which the lawyer is subject."[20]  As one of the professions that has been pointed to as outmoded and dinosaur-like, now is the time to evolve our practices and awareness to this majorly disruptive technology that is here.  We have a duty to be a constructive, knowledgeable resource to our clients because the alternative is extinction and the figurative meteor is already on the skyline.

Notes

  1. Iyke Aru, Blockchain: Shifting From Internet of Information to Internet of Value, (December 17, 2017), The Cointelegraph, https://cointelegraph.com/news/blockchain-shifting-from-internet-of-information-to-internet-of-value.
  2. IBM Study: C-Suite Executives Exploring Blockchain Aim to Disrupt, Not Defend, IBM News Release (2017), https://www-03.ibm.com/press/us/en/pressrelease/52418.wss, (last visited August 10, 2017).  
  3. Arjun Kharpal, Bitcoin value rises over $1 billion as Japan, Russia move to legitimize cryptocurrency, CNBC.com (April 12, 2017), https://www.cnbc.com/2017/04/12/bitcoin-price-rises-japan-russia-regulation.html.
  4. Angela Morris, Don't Know What Blockchain Is? You Should. This Law Prof Can Help, Law.com (August 4, 2017), http://www.law.com/sites/almstaff/2017/08/04/dont-know-what-blockchain-is-you-should-this-law-prof-can-help/.
  5. Jon Russell, Mark Zuckerberg is right to explore the potential of the blockchain for Facebook, Tech Crunch,(Jan 5, 2018), https://techcrunch.com/2018/01/05/mark-zuckerberg-is-right-to-explore-the-potential-of-the-blockchain-for-facebook/
  6. Michael del Castillo, Bank of America Eyes Adoption as Next Hurdle For Ethereum Test, Coindesk website (May 3, 2017), https://www.coindesk.com/bank-of-america-eyes-adoption-as-next-hurdle-for-ethereum-test/.
  7. Kevin Gao, The Cryptocurrency Funds Have Arrived, And They're Bringing Wall Street Money, Seeking Alpha website (March 6, 2017), https://seekingalpha.com/article/4052276-cryptocurrency-funds-arrived-bringing-wall-street-money.
  8. Brian Patrick Eha, Goldman Sachs plans to trade cryptocurrencies by June 2018, American Banker (December 21, 2017), https://www.americanbanker.com/news/goldman-sachs-will-trade-cryptocurrencies.
  9. Chicago Board Options Exchange, (last visited January 10, 2018), http://cfe.cboe.com/cfe-products/xbt-cboe-bitcoin-futures.
  10. Jessica Kim Cohen, Survey: 16% of healthcare executives plan commercial blockchain solutions in 2017, Beckers Hospital Review (December 30, 2016),  http://www.beckershospitalreview.com/healthcare-information-technology/survey-16-of-healthcare-executives-plan-commercial-blockchain-solutions-in-2017.html.
  11. 2017 Global Digital IQ Survey: Blockchain, PwC Next in Tech blog, http://usblogs.pwc.com/emerging-technology/2017-digital-iq-blockchain/ (May 8, 2017).
  12. Ben Dickson, Blockchain could completely transform the music industry, Venture Beat website (January 7, 2017), https://venturebeat.com/2017/01/07/blockchain-could-completely-transform-the-music-industry/
  13. United States v. Ulbricht, 858 F.3d 71 (2d Cir. 2017).
  14. Prableen Bajpai, How Stock Exchanges Are Experimenting With Blockchain Technology, Nasdaq.com (June 12, 2017), http://www.nasdaq.com/article/how-stock-exchanges-are-experimenting-with-blockchain-technology-cm801802.
  15. SEC v. W. J. Howey Co., 328 U.S. 293, 66 S. Ct. 1100, 90 L.Ed. 1244 (1946).  
  16. Connie Loizos, How to stage an ICO (and answers to other lingering questions you might have), Tech Crunch website (May 24, 2017), https://techcrunch.com/2017/05/24/how-to-stage-an-ico-and-other-related-questions-you-might-like-answered/
  17. John Patrick Mullin, ICOs In 2017: From Two Geeks And A Whitepaper To Professional Fundraising Machines, Forbes.com (December 18, 2017), https://www.forbes.com/sites/outofasia/2017/12/18/icos-in-2017-from-two-geeks-and-a-whitepaper-to-professional-fundraising-machines/#309776a6139e
  18. In re Dole Food Co., 2017 Del. Ch. LEXIS 25 (Ch. Feb. 15, 2017).
  19. Matthew Liesing, The Ether Thief, Bloomberg.com (June 13, 2017), https://www.bloomberg.com/features/2017-the-ether-thief/.
  20. Rule 1.1: Competence, Comment on Rule 1.1(8) (1983). In American Bar Association, Center for Professional Responsibility, Model Rules of Professional Conduct. Retrieved from https://www.americanbar.org/groups/professional_responsibility/publications/model_rules_of_professional_conduct/rule_1_1_competence/comment_on_rule_1_1.html.

Chip Cathey A native of Cookeville, CHIP CATHEY, MBA, MS, is a technology professional and a 2L at Nashville School of Law, living in Franklin. To further discuss this topic and any others, Chip can be reached at Chip@OldFranklinLaw.com.