Smart Contracts and Decentralized Autonomous Organizations: The Death of Lawyers?

Are you a business owner who dreams of closing a deal without hiring an attorney? When you buy a car from a stranger on craigslist, are you ever sure the person selling the car actually owns the car? Is your fair trade coffee really fair-trade, how do you know where it really came from? Are you a  supporter of Wikileaks and struggling to make a donation due to Wikilieaks being shut out of the payment networks (Paypal, Mastercard, etc)? Do you hate the idea of a few select mega-internet companies using and storing all your personal information?

Smart contracts and decentralized applications promise to remove middleman and reduce friction in all types of property transactions by using self-executing code and the blockchain, decentralized applications can reduce fraud, prevent censorship, and third-party interference .

By turning law into code, and turning that code into smart contracts, and by having those smart contracts combine with the blockchain technology underpinnings of bitcoin, with those few lines of code, programmers will soon be creating decentralized autonomous organizations (DAOs) can operate over a computer network without any human intervention. The need for the hated legal middleman will be greatly reduced (full disclosure: I am a contributor to the CommonAccord project which aims to turn law into code).

IN THE EARLY DAYS AND OUR CURRENT CENTRALIZED INTERNET

At first the Internet was a great equalizing platform. The promise of the early Internet was that the big and powerful would no longer have sole control over the dissemination of information. To some extent this is true today, but most of our Internet traffic is routed and filtered through large centralized entities, such as FaceBook or Google. In some cases, an entire country, such as China, filters the information available to the general public.

To a certain extent this has worked out well for consumers, as Gmail is a more reliable email service than a local provider (do you remember using your crappy unicorn@roadrunner.net account?) and using Dropbox is easier than creating your own cloud server. In China, citizens get a heavy dose of censorship.

The centralization of information on the Internet creates concerns about security, privacy, censorship, and the fragility of having our information stored with a few large entities.

RISE OF A DECENTRALIZED INTERNET

While many in the general public have heard of Bitcoin, an opensource decentralized cryptocurrency, which was created by the mysterious “Satoshi Nakomoto” after the 2008 financial crisis. Bitcoin entered the general public consciousness a few years later after its price shot to over $1000 a coin in a short period of time, it then became a mainstay topic on CNBC, and inspired other cryptocurrencies such as dogecoin and litecoin.

Once, the hype died down and Bitcoin prices crashed back down to the $300 range, many became dismissive of Bitcoin and cryptocurrencies entirely. In fact there is an entire reddit forum dedicated to this /r/Buttcoin. However, it is not the Bitcoin in and of it self that proved to be important, it is the underlying technology powering cryptocurrencies that has become important. The underlying technology/mathematical breakthrough is a public ledger system called the “blockchain.” Bitcoin works by having the entire decentralized network of bitcoin users publicly verify every single transaction via a series of complex math problems. These transactions remain public and traceable, because each transaction constitutes a step in the blockchain.

BLOCKCHAINS MAKE THE DECENTRALIZED INTERNET POSSIBLE

Currently contracts are an exchange of promises written on paper, and with the implicit backing of the legal system, a party releases money to another party if those promises have fulfilled. Smart contracts are essentially a contract that enforces itself. A smart contract is a computer program whose promises are automatically executed.

The original idea for smart contracts was conceived way back in the 1990s by Nicholas Szabo (who is also rumored to be Satoshi Nakomoto the creator of Bitcoin). Szabo provides a primitive example in the vending machine. Where the amount of loss to the user is limited to the cost of a candy bar, and the most likely the cost of paying a dollar for a candy bar outweighs the cost of smashing the glass and stealing a candy bar. Anyone with coins can participate, and the vending machine dispenses change and a candy bar. The lockbox on the vending machine provides sufficient protection against attackers.

Being able to execute entire programs/contracts on a blockchain allows for a “trustless” transaction to be verified solely by the blockchain. Like a vending machine, a trustless transaction allows the party to not care who the other party is on the other side of the transaction, because the code will serve as the law. For example, in a country where the rule-of-law can be arbitrary or where trust is low, then the code can serve as substitute, because money will be released when pre-determined conditions have been met. A trustless contract allows a smaller player to become a trusted party without having access to millions of dollars needed to become trustworthy.

Instead of a vending machine, say an obscure, but real and honest Nigerian prince acquired a domain name that eventually became worth a lot of money and now they want to sell it on the open market. Well due to the notorious proliferation of Nigerian prince email scams, nobody may believe that our prince actually posses this valuable domain name. Our prince could put the domain name on a decentralized exchange, where once a certain price is met on the buyer’s part(and possibly other conditions to sale) and the domain name is released by the prince, then our prince would automatically receive the money. In fact, nobody will care or be required to care that the seller is our Nigerian prince, because he will only be identified by his private key.

THE GOD OF MANY FACES: The Decentralized Autonomous Organization (DAO).

In fact, with smart contracts an entire organization –a Decentralized Autonomous Organization (“DAO”) running on code, could potentially be created and be the sole administrator for a group of shareholders, city, or any other group who agree to abide by a common code, and the DAO would operate based on votes verified by the blockchain. One DAO could be a shareholder in another DAO, in essence the DAO would no longer be serving a human master, but the needs of another algothim.

ENTER THE ETHEREUM PROJECT

Ethereum is the first blockchain platform designed from the ground up to be capable of processing transactions larger than cryptocurrencies and in much faster manner than Bitcoin. In fact Ethereum’s blockchain is designed for the creation of an entire decentralized internet: cryptocurrencies, smart property, smart contracts, and decentralized autonomous organizations (DAOs) can all be created by simply writing a few lines of code.

The rise of governance by algorithm could force humans into making choices that are dictated by a network of faceless DAO’s attempting to optimize our existence. For example, if a DAO employer wanted to cut healthcare costs for an overweight employee, and the DAO paid the overweight employee’s salary in cryptocurrency, then the DAO may allow the employee to enroll in a program to set the employee’s smart wallet so he could not spend DAO issued cryptocurrency on junk food until his BMI was lower (or a more judgmental DAO could automatically enroll the employee).

Anyone who has seen the Terminator movies can envision how DAOs could create a society where basic human rights are trampled by algorithms.
For example, say a DAO owned by DAO shareholders operated a car dealership of autonomous self-driving cars, and a customer had insufficient funds, and the DAO was programmed to automatically lockout the customer at certain time if payment was not received, this could lead to horrible scenarios where a customer was in a sketchy area at midnight or a baby was locked inside the car on a hot day at noon. Then to top it all off, because of its decentralized nature a DAO, could not be held accountable via lawsuits or criminal charges for its actions.

FUTUROLGY?

We are still in the pioneer days of decentralized applications and we haven’t even imagined all the possibilities of smart contracts and decentralized applications, let alone decentralized organizations, but Ethereum finally launched its version just the other day.

Bitcoin to the moon?

Now that the speculative popping of Bitcoin prices has occurred (from $1200 to $400), are Bitcoin, Dogecoin and other similar crypto-currencies (bitcoins) the beginning of the internet or something destined to remain on the fringes of libertarian conspiracy theorists wearing tin-foil hats and posting cat memes on Reddit?  I don’t think there is much value in bitcoins as a means to hide the nature of transactions, as regular cash in a suitcase is better suited for such purposes (at least for now).  I also don’t think bitcoins will replace fiat currencies, meaning legal tender issued by a country’s central bank,  which is required to be accepted for the settlement of debts.  For example, you may be able to go to the moon with Dogecoin or sponsor a NASCAR, but the IRS will not accept Dogecoin to settle your tax bill.

The real value of bitcoins is to undercut the payments and cash management cartel of the SWIFT/CHIPS  cartel (Society for Worldwide Interbank Financial Telecommunication and Clearing House Interbank Payment System). On average banks and other money transmitters charge $40 for per international transfer.  Payments and Cash Management departments are one of the most profitable divisions of banking, as the sheer volume of money practically ensures profit, for example CHIPS handles 1.5 trillion dollars per day.

The  merchant fees charged by Mastercard, Visa, AMEX, etc are around 2 to 3 percent depending on size of the business.  To get an idea of how this amount adds up, WalMart is filing a lawsuit against Visa for 5.7 Billion dollars, based on approximately a 2% transaction fee for customers who use Visa at Walmart.

The size of the payments pie is enormous, and lots of venture capital will be drawn to this pot of gold.  However, for bitcoins to go from fringe to mainstream acceptance, the biggest nut to crack for bitcoin exchange operators to achieve a relatively frictionless anti-money laundering regulatory and the ability to seamlessly track capital gains and losses.  People, myself included, are lazy at their core, and do not want to track these hassles.

The IRS has issued notice guidance that bitcoins are considered property for tax purposes and not currencies, and that all users of bitcoins are responsible for to track their capital gains and losses whenever buying or selling bitcoins, similar to if you were trading in baseball cards or Beanie Babies, hence the need to track capital gains and losses.   However, when it comes to tracking down money laundering terrorists/slash drug dealers the U.S. Treasury Department Financial Crimes Enforcement Network (FinCEN) thankfully has advised that only “exchangers” and “administrators  and not “users” of bitcoin exchanges have a responsibility under the Bank Secrecy Act (BSA), Anti-Money Laundering (AML) and Know Your Customer Laws(KYC) to report suspicious transactions.

Where does that leave peer-to-peer bitcoin exchanges, similar to original Napster or current BitTorrent networks for the purposes of FinCEN enforcement?  Under FinCen’s guidelines, it is possible that anyone buying, selling, reselling bitcoins would be regulated as a Money Service Business on such an exchange.  How will regulators react with the development of technologies that enable users to scramble their payment information with another users?

With yesterday’s ruling by the Federal Election Commission and the combination of emerging technology, soon a user will able to send unlimited and anonymous payments to their favorite local politician.  On HBO’s “The Wire” Senator Clay Davis would’ve slept a lot easier if he didn’t have to worry about all of that cash is his trunk.

What Happens When Computers Replace Attorneys?

Yesterday, I read an interesting article in The AtlanticiLawyer: What Happens When Computers Replace Attorneys?”   The article describes the rise of predictive coding being used in the discovery phase of litigation.  For those of you who are not legal eagles, discovery is essentially when opposing counsel dumps a massive amounts of emails, documents, power points, bank statements, etc in your lap and your job is to sort through it all and find the ones that are relevant to your case.

Predictive Coding allows an attorney to plug in search terms and have the software automatically pull the relevant documents.  The article suggests that predictive coding will eliminate the need for most attorneys.  I agree that as software becomes better at pattern recognition, attorneys will not be needed in the first phase of discovery and other rote tasks, however I don’t think better software will entirely eliminate the need for attorneys for a few reasons:

1.) The interpretation of law is ultimately a value judgment.   Our legal system is designed to be flexible and allow for all sorts of exceptions and based on the facts surrounding each particular situation.  For example, the U.S. Constitution’s Sixth Amendment guarantees a person’s right to a jury by one’s peers.  I don’t really see a day when being judged by robots for a crime will become an acceptable substitute for peers.

2.) Law is a dynamic system.  Just as the interpretation of law is a judgment of another individual’s actions, society’s views of what is appropriate changes over time.  At one time, society thought slavery was righteous, then we went through a civil war and did away with slavery, but still allowed segregation, and then we outlawed segregation, to allowing affirmative action.  Software programs are not dynamic enough to keep pace with society’s constantly changing mores and attitudes toward various topics.

3.) Computer programs are really bad at common sense.  A software program is only as effective as the human programmer.  For example, if you were to ask WATSON (the computer that won Jeapordy!) to mediate a custody dispute between two spouses in the middle of a nasty divorce, Watson may be able to pull up all sorts of case law, precedent, and cite statistics about whether or not kids are better off living with the higher earning parent. However, if the kids don’t want to live with their father, because he’s a raging alcoholic with anger issues, then it really won’t matter what case law or statistics a software program spits out.

So for the time being, I’m not worried about lawyers being completely replaced by robot overlords, but maybe I should be more worried about the rise of Skynet and programmable matter turned into autonomous killing machines?   See,Terminator 2: Genesis of Skynet

-Michael

How to Get a Bank Loan – Video

This short video from Inc.com provides a good introduction on how to get a bank loan.  In summary, a would-be borrower should  try to connect with loan officers at local banks and credit unions as they often have an interest in supporting the local economy as opposed to a large national bank where the small business lending department may not be as knowledgeable about local economic factors.  Don’t get me wrong all loan officers will absolutely want to make sure your business has the financials to support the repayment plan.  A loan officer is NOT a venture capitalist or angel founder and they do not typically invest in brand new businesses, so before attempting to obtain a loan be sure to have your financial statements in order.

 

Chinese Banks Are Coming to the United States

One of the largest banks in China has been cleared by United States federal regulators to acquire a controlling stake in Bank of East Asia.  Previous attempts to acquire controlling stakes in U.S. owned banks were unsuccessful.  Click here for the article on Bloomberg.

In 2009, I was an attorney at United Commercial Bank (NASDAQ:UCBH) when China Minsheng Bank Corporation (Shanghai Exchange: 600016:CH) tried to up its 9.9% equity stake to a majority stake.  This was the first time the United States was confronted with the possibility of having a Chinese majority shareholder bank authorized to operate a full operational bank in the United States. At the time, UCBH was in need of additional capital, otherwise it would lose the approximately 300 million dollars in T.A.R.P money (US taxpayer dollars) that had already been given to UCBH during the 2008 financial crisis.  China Mingsheng’s bid was denied by federal regulators for various reasons, including questions about the viability of China Minsheng itself, risk management policies, anti-money laundering controls, and a general fear of the unknown about China’s banking system.  Unfortunately, this was 2009 and almost 200 FDIC insured banks failed that year, a near unprecedented number of bank failures, and I believe due to the unique problems presented by a Chinese acquirer, the lengthy due diligence required by regulators, and general chaos in the financial system caused the deal to fall through before UCBH ultimately ran out of capital and costing U.S. taxpayers hundreds of millions of dollars.

One lesson I’ve learned over the years when doing international transactions, is do not underestimate the importance of culture, and I don’t mean the small thing such as presenting your business card to Chinese customers with two hands.  I’m thinking more along the lines of broad based things such as major differences in transparency in the rule of law between the U.S. and the rule of law in developing countries.

For example, based on my experience working in China and in the U.S. working on deals with Chinese companies there are many official rules and regulations in China, not all of them are enforced, and others rules are enforced arbitrarily depending on how much favor one has with local officials.  Some U.S. attorneys will try to work around the problem by stating that their contract will be decided by the laws of Hong Kong, U.S., or U.K.  However, if you are actually dealing with a Chinese company in China, that contract isn’t really worth more than the paper it is printed on, especially if the contract is in English.  Or for example, if a Chinese regulator is not familiar with certain U.S. customs or institutions, then the Chinese regulator may ask you for all sorts of things, such as, how does the F.D.I.C get its authority to do business, and you are left on a quixotic quest to explain to your China based attorney that the F.D.I.C. was created in 1933 via the Banking Act and then you hope and pray that this information is enough to clear Chinese regulators.

Bloggers take aim at Fashion Copycats–alternatives to litigation

In the Wall Street Journal today, an article (click here) about blogs, run by people more fashionable than the attorneys at Melwani & Chan LLP, dedicating a significant amount of time to putting fashion copycats on the spot.  For example, the blog Fashionista has an entire series titled Adventures in Copyright, which takes aim at copying designers and does a side-by-side comparison with the original.  If a small designer legitimately determines a fashion conglomerate such as Chanel, they can resort to remedies other than litigation–which is too expensive for many smaller designers to pursue, by publicly displaying the similarities between the two original design and the copycat.  Other non-litigation alternatives could be seek a licensing deal or contacting the  copycat to see if they are interested in purchasing the design outright.

Update: Crowdfunding portion of JOBS Act signed by Pres. Obama

Last Thursday, President Obama signed the JOBS act into law.  While the bill contained some dubious relaxing of accounting standards, the good news is that the crowdfunding portion of the JOBS act has been given the green light.  While the Securities and Exchange  Commission still has to set the rules for portals that want to host crowdfunding, this is a welcome step for small businesses seeking to raise up to $1,000,000.00.  See this Wall Street Journal article for a quick summary.

Update: Crowdfunding passes the Senate

The JOBS act passed the Senate today with bipartisan support (73-26).  However, the Senate added two notable restrictions to the crowdfunding provision to protect investors from fraud,the Senate’s amendment allows entrepreneurs to raise only $1 million a year and it must be through an SEC-registered crowdfunding site.  Before going to President Obama, the bill will go back to the House to reconcile the differences with the Senate version.

Crowdfunding moves forward in the House

Legislation allowing entrepreneurs to access capital through crowdfunding took a step forward yesterday when the JOBS (Jumpstart Our Business Startups) Act was passed with bipartisan support in the House of Representatives (see here for NYTimes article).  A version of the JOBS act is expected from the Senate sometime next week.  As written, the “Entrepreneur Access to Capital Act” portion of the JOBS Bill would allow for the following:

  • Equity Capital Raise of up to $1,000,000.00 from either unaccredited or accredited investors if the company does NOT provide investors with audited financial statements.
  • Equity capital raise of up to $2,000,000.00 from either unaccredited or accredited investors if the company provides investors with audited financial statements.
  • Individual Contributions are limited to $10,000.00 or 10% of the investor’s annual income–whichever is less.

Currently, crowdfunding is only permissible on sites, such as Kickstarter, where companies or individuals are allowed to solicit donations, and in return they are allowed to provide freebies back to donors (see our earlier post).   Debt and equity in a company could not be offered as investments.  There are still legitimate concerns about scams and internet fraud and how to prevent them while at the same time not undermine the purpose of the legislation: enabling entrepreneurs to access money outside of friends and family.  I’m not sure what the solution is to the potential fraud problem, maybe a verification process for fundraising sites that includes a background checks for company owners?

New York Legalizes Benefit Corporations = Profits + Public Benefit

As of February 10, 2012, corporations in New York who designate themselves as a “Benefit Corporation” can legally pursue a “double-bottom line” of social justice and profits (click here for the announcement from State Senator Daniel Squadron).   Normally, a corporation’s directors and officers are held to have a fiduciary duty to the shareholders, meaning that pursuing interests outside of profit seeking can open directors and officers to shareholders lawsuits.  By allowing Benefit Corporations to exist, directors and officers have legal protection to engage in activities that promote a social good, such as using environmentally friendly materials, even though it may hurt their financial performance.

Although the Benefit Corporation structure is relatively untested in terms of legal issues, such as what happens if the B-corporation or one of its officers doesn’t meet its social obligations or fails to adequately deal with compliance and disclosure, this legislation officially pens the door for a new way of doing businesses, and that can only be a good thing.

Click here to access the non-profit group “B-Lab” which promotes the legalization of Benefit Corporations across the United States.  NOTE: that a “Certified Benefit Corporation” via B-Lab is NOT the same thing as being a legally formed Benefit Corporation.  While being a Certified by B-Lab can assist a company in meeting certain standards, the certification process by itself will not provide directors and officers with the legal protections of a Benefit Corporation formed under the laws of New York.