Insights

Splitchain: Reconciling blockchain and the law

Technology & Digital
Abstract image of a double helix.

Blockchain is changing the way we think and do business. Its rapid growth is outpacing the law, and exceeding expectations of the nature of transactions that can be performed using its technology.

This article looks at the legal issues that need to be addressed when embracing blockchain and realising the potential of its technology, through the lens of a new concept I call "splitchain". By looking at this "chained economy" as two separate technological and legal strands that work in parallel, we gain a clearer understanding of how blockchain fits within an existing legal framework and can successfully be applied commercially.

"Splitchain": a new concept

Navigating emerging digital technologies can feel like negotiating multiple new and separate worlds that don't interact ─ meta and physical, public and private, centralised and de-centralised. But these new worlds remain very much subject to, and bound by, existing laws. These new worlds exist in the real world; more than that, they need to work together with the real world.

To help resolve this disparity, I've developed a term called "splitchain" ─ a term to describe a split structure that is co-dependent. The splitchain provides a conceptual tool for consolidating the technological and legal aspects of developing blockchain business models.

Like two strands of DNA forming a double helix, there are two strands to a splitchain: a strand of blockchain technology and a strand of legal rights and obligations, ideally working in parallel to achieve a single objective. One side represents "internal" technology-based rules, while the other represents "external" legal rules; one is written in the language of computer code, the other is written in the language of the law; one is on-chain, the other is off-chain (or a hybrid of on- and off-chain).

The splitchain concept is particularly useful in analysing the interplay between technology and law in smart contracts on the blockchain, and where failing to consider both aspects can expose users to risk.

1. Smart contracts

There is a common misconception that smart contracts are stand-alone and do not interact with or need "the law" as they are "above" the law.

In its purest sense, a smart contract is computer code stored on a blockchain-based platform, executing certain actions when triggered to do so. These actions are to typically release funds without the involvement of an intermediary, thus limiting time delay. The blockchain is then updated with the completion of the transaction, meaning that the transaction cannot, in principle, be changed. While such mechanisms are a great accelerator to online transactions, these decisive "if/when" statements alone fail to encapsulate the full terms, protections and considerations found in traditional "off-chain" contracts, and the broader body of law that may apply. Creator economy NFTs (discussed further below) are a perfect example of the interplay of a variety of laws with blockchain.

Smart contracts are therefore not really legal contracts. As well as considering the technological "strand" of a smart contract, the legal "strand" must also be addressed for the contract to be of any commercial value.

2. Smart legal contracts

A smart legal contract is a legally enforceable contract that is completely available in natural language, and partially available in computer code. To be enforceable at law, legal contracts need to satisfy certain formalities, such as "offer", "acceptance", "consideration", "intention to create legal relations" and certainty of terms. Legal contracts allocate risks and impose rights and obligations on both parties, and importantly provide remedies when things go wrong.

Smart legal contracts attempt to satisfy these requirements of contract formation in an online or blockchain environment ─ but they rarely exist only on-chain and they do not account for the rest of the law that may also apply. Importantly, smart legal contracts attempt to blend the strengths of both on-chain and off-chain environments, leaving clauses that involve human discretion (such as "reasonable" or "may" instead of "must") to written format and clauses represented by calculations and formulas to be automated by code.

Theoretically, smart legal contracts go some way to solving the problems of smart contracts. However, even online contracts must satisfy certain conditions to form a contract and even if they are satisfied, the written terms agreed between the parties are not always the whole story. A body of "rights" are implied by law into certain types of contracts, written, verbal and online.

The specific risks of entering smart legal contracts, beyond showing there has been offer, acceptance, consideration and intention to create legal relations, also include establishing:

  • legal capacity to enter a contract ─ which means having "legal personality" (that is, an identifiable company or individual)
  • certainty of terms ─ particularly what we call "essential terms" or "conditions". Certainty in pricing is usually an essential term of every contract

So, can these elements of contract law be satisfied using smart legal contracts? Do they identify clearly the contracting parties? Is there a way to prove the company you are entering a contract with actually exists? Often this is unclear in smart legal contracts and so arguably, a contract has not been formed because one of the parties does not legally exist.

Even if the contracting parties/legal personalities are identifiable, what about pricing terms? When you process a transaction on a blockchain, the transaction fee (or "Gas" in the Ethereum network) may not be certain even if the price of the crypto or the NFT is. Again, in this instance, a contract may not have been formed or may be partially invalid, where there is uncertainty.

There are also other laws that may cause a smart legal contract, even if legally formed, to unravel. For example, there are rules against unfair contract terms within the Australian Consumer Law, that invalidate certain clauses that are too unbalanced, taking into account the relative bargaining power and sophistication of the parties.

These legal considerations are just the tip of the iceberg. Smart legal contracts do not solve all legal issues; again, the technological and legal threads of the splitchain must be considered simultaneously.

3. Intellectual property on the blockchain

There is a common misconception that intellectual property rights don't matter in the digital sphere, or metaverse, because ownership on blockchain is foolproof.

What is intellectual property?

Intellectual property rights are a bundle of rights and they are proprietary rights. Proprietary rights represent some the most valuable legal rights in the world of commerce because they confer exclusive, often monopoly rights, to buy, sell, license or lease or otherwise exploit the assets. IP is the body of rights that are relevant to intangible assets.

NFTs as a means of ownership

Creator economy non-fungible tokens (NFTs) in some ways attempt to solve the problems that creators have experienced in the real world ─ eg. songwriters who have sold the copyright in their music to record companies, and creators and copyright owners competing with fake profiles, robot journalism, counterfeit designer clothes and jewellery, and other forms of "copying". A lack of a means of verification of ownership and authenticity in the online world has made the environment untrustworthy and the copyright works and brands or trademarks less valuable.

Creative NFTs seek to solve these problems by not only removing the middle man, but by recording ownership and change of ownership details. An NFT provides a source of truth.

The NFT marketplace resembles the Australian Stock Exchange. If creators wish to "list" an NFT for sale, they must first "mint" or "offer" the NFT to the marketplace ─ similar to companies wishing to IPO, they must first list their shares on the ASX. Secondly, if collectors wish to trade their NFTs they can easily do so on marketplaces, similar to how investors trade stock on the ASX. As part of any contractual agreement, terms and conditions of some kind exist. However in the developing market of NFTs, clear or express terms and conditions are rare. Where there are terms, there may be no certainty as to where they are located. At times, terms and conditions may be stored on a creator's website; at other times, not. This raises the question of whether, without a clear statement of what is being agreed and by whom, is there even a contract?

In Australia, the United Kingdom and other similar jurisdictions intellectual property rights cannot be assigned to another party without certain formalities being completed (ie most jurisdictions require transfer of IP ownership to be evidenced in writing and signed). On blockchain, there may be a record of "ownership" of a token ─ but is this sufficient? Does the token represent or link to something else? If so, have any licence terms to use the underlying digital artwork been implied in the transaction? What if the server, where the artwork is stored, goes down or the file deleted, and the online terms with it? Are these terms enforceable in any meaningful sense?

Simply because transactions can be recorded and verified automatically does not eliminate the usual risks and regulations that apply in the world of commerce generally. A "splitchain" analysis shows that "on-chain" technologies on the blockchain still require comprehensive "off-chain" governance and legal structures.

This article is adapted from a keynote delivered by Lisa Fitzgerald at the APAC Blockchain Conference 2022 on 2 May 2022.

All information on this site is of a general nature only and is not intended to be relied upon as, nor to be a substitute for, specific legal professional advice. No responsibility for the loss occasioned to any person acting on or refraining from action as a result of any material published can be accepted.

Key
Contacts