The Law and Smart Contracts

Analysis of Legal Precedent as it Applies to Smart Contracts — Kurt Mattson

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What Is a Smart Contract

The term “smart contract” is a term that’s being bandied about these days. But what is it, and how does it concern TandaPay?

Investopedia defines a smart contract as “a self-executing contract with the terms of the agreement between buyer and seller being directly written into lines of code.”[1] That code and its agreements exist across a distributed, decentralized blockchain network.[2] The smart contract’s code governs the execution. These transactions can be monitored but are irreversible.

Smart contracts often look like “if-then” propositions, where, if Person A releases money into the blockchain, then the smart contract will self-execute to meet the obligation set out in the contract.[3]

Smart Contract Legal Issues

There are only a handful of court cases that discuss smart contracts. Some of these cases are based on securities law.[4] The actions allege securities fraud in violation of Section 17(a)(1)-(3) of the Securities Act of 1933[5], Section 10(b) of the Securities Exchange Act of 1934[6], and Rule 10b-5.[7]

Section 10(b) makes it unlawful to “use or employ, in connection with the purchase or sale of any security” a “manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe.”[8]

“Security” is defined broadly to include, among other things, stocks, bonds, debentures, a variety of other instruments, or, “in general, any instrument commonly known as a ‘security.’”[9] It is under this broad definition that some plaintiffs are including actions concerning cryptocurrency and smart contracts.

In a 2018 case, the pleadings describe the function of the smart contract in the purchase of cryptocurrency tokens: “When ICO [Initial Coin Offerings] purchasers send their ETH [Ethereum] to the relevant wallet address, the smart contract is automatically executed and the purchaser receives the appropriate number of tokens in exchange.”[10]

In 2015 case, where a Section 10(b) claim was alleged, the Court found that the defendant had clearly violated the law by making material misrepresentations in a February 2008 press release about an e-Smart contract with Samsung.[11]

In addition, basic breach of contract claims may arise. The elements of a valid contract are (1) an offer; (2) an acceptance; (3) a meeting of the minds; (4) mutual consent to the terms; and, in the case of a written contract, (5) execution and delivery of the contract with the intent that it be mutual and binding.[12]

As mentioned above, when a smart contract is created, computer transaction protocols execute the terms of a contract automatically based on a set of conditions.[13] Of concern legally is that fact that a party making a purchase via the smart contract wouldn’t be required to agree to any of the terms contained in the token sale agreement in order to complete the purchase and would have automatically received a corresponding amount of tokens based on the amount of Ether sent to the smart contract address.[14]

The fact that a party making a purchase via the smart contract wouldn’t need to agree to any of the terms in the sale agreement when making a purchase would be lacking mutual consent to the terms.

A plaintiff bringing a contract action would have to establish the following elements: (1) the existence of a valid contract; (2) performance or tendered performance by the plaintiff; (3) breach of the contract by the defendant; and (4) damages sustained by the plaintiff because of the breach.[15]

Federal Interest in Smart Contracts

Decentralized applications, also known as “Dapps” may be defined as money transmitters under federal in certain circumstances. [16] The Financial Crimes Enforcement Network (FinCEN) recently published a new guidance sheet that describes when and how different companies, individuals, and platforms in the crypto space may be money transmitters under the Bank Secrecy Act (BSA) and other relevant laws.[17]

FinCEN describes decentralized (distributed) applications as software programs that operate on a P2P (peer-to-peer) network of computers running a blockchain platform designed so that they aren’t controlled by a single person or group of persons and have no identifiable administrator.[18]

The reason this is significant is that entities like TandaPay and others that leverage Blockchain technology and smart contracts may be designated as money transmitters by FinCEN. If so, the agency’s rules mandate that the entity comply with federal AML and know-your-customer (KYC) regulations.

In addition to FinCEN and the SEC, the Commodity Futures Trading Commission also is looking at how to regulate decentralized products and transactions. In October 2018 in a speech delivered in Dubai, CFTC Commissioner Brian Quintenz cautioned the Commission’s jurisdiction included applications that run on smart contracts.

Quintenz noted, “In the context of decentralized blockchains, like ethereum, on top of which multiple applications can run autonomously via smart contracts, it requires identifying who is responsible for ensuring that activity on the blockchain complies with the law.”[19]

He when on to explain that “there are many actors essential to the functioning of the blockchain ecosystem: the core developers of the blockchain software, the developers of smart contract applications, miners that validate transactions, and users, who transact and execute smart contracts on the chain.”[20]

“Smart contract applications on blockchain networks hold great promise, the Commissioner said. “They have the potential to open up new markets and create efficiencies in existing ones.” However, “they also raise novel issues of accountability that users and policy makers alike must consider.”[21]

Takeaway

TandaPay must be aware of this federal presence, as well as common law and state statutes that may penetrate the environment and create additional challenges for the architecture. However, TandaPay’s decentralized and deregulated structure would make it difficult for the government to restrict its use.

[1] Jake Frankenfield, , Investopedia (Updated October 8, 2019). Retrieved at https://www.investopedia.com/terms/s/smart-contracts.asp.

[2]

[3] See Morgan N. Temte, 19 Wyo. L. Rev. 87, 96 (2019).

[4] №17–24500-CIV-KING/SIMONTON, 2018 U.S. Dist. LEXIS 220987, at *12 (S.D. Fla. Sep. 25, 2018).

[5] 15 U.S.C. § 77q(a).

[6] 15 U.S.C. § 78j(b).

[7] 17 C.F.R. § 240.10b-5.

[8] 15 U.S.C. § 78j(b).

[9] 15 U.S.C. § 78c(a)(10).

[10]

[11] Case №1:18-cv-02909-DLC (S.D.N.Y. filed April 2, 2018).

[12] 97 S.W.3d 631, 636 (Tex. App. — Houston [1st Dist.] 2002, pet. denied). “Mutual assent, concerning material, essential terms, is a prerequisite to formation of a binding, enforceable contract.” 245 S.W.3d 526, 530 (Tex. App. — Houston [1st Dist.] 2007, no pet.) (citing T.O. 847 S.W.2d 218, 221 (Tex. 1992)).

[13] Tsui S. Ng, Bus. L. Today, Sept. 2017 (Am. Bar Assoc.). retrieved at https://www.americanbar.org/groups/business_law/publications/blt/2017/09/09_ng/.

[14] №17–24500-CIV-KING/SIMONTON, 2018 U.S. Dist. LEXIS 100720, at *26–27 (S.D. Fla. June 14, 2018) (“When ICO purchasers send their Ether to the relevant wallet address, the smart contract is automatically executed and the purchaser receives the appropriate number of tokens in exchange.”).

[15] №01–18–00392-CV, 2019 Tex. App. LEXIS 9441, at *13–14 (Tex. App. Oct. 29, 2019). See 545 S.W.3d 479, 501 n.21 (Tex. 2018); S. Elec. Servs., Inc. v. City of Houston, 355 S.W.3d 319, 323–24 (Tex. App. — Houston [1st Dist.] 2011, pet. denied).

[16] Nikhilesh De, CoinDesk (May 9, 2019). Retrieved at https://www.coindesk.com/fincen-says-some-dapps-are-subject-to-u-s-money-transmitter-rules.

[17] FIN-2019-G001,, FinCEN (May 9, 2019). Retrieved at https://www.fincen.gov/sites/default/files/2019-05/FinCEN%20CVC%20Guidance%20FINAL.pdf.

[18]

[19] U.S. Commodity Futures Trading Commission, (October 16, 2018). Retrieved at https://www.cftc.gov/PressRoom/SpeechesTestimony/opaquintenz16.

[20]

[21]

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Incentives architect for TandaPay

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