From certain corners, we hear that smart contracts will serve to make transactions ‘frictionless’: they will result in contracts being enforced automatically without the need to resort to a court or arbitration. There are even suggestions that they will, ultimately, remove or greatly reduce the need for the personnel involved in contract formation and administration, such as contract managers, commercial teams and even lawyers. This article looks at smart contracts in the context of the construction industry.
Terminology – what is a ‘smart’ contract?
First, it is necessary to clarify what the term means. A contract is an agreement between two or more parties which binds them to something in the future. The key feature of a ‘smart’ contract is that it can be enforced automatically. This concept of automatic enforcement is used (somewhat confusingly) to refer to ‘trustless execution’. It has led to the term ‘smart’ contract being understood by some to mean a computerised protocol that executes a contract.
This issue of terminology is not trivial: when a smart contract is understood (merely) as the protocol that executes a contract, it is easy to see why commentators have said that the legal status of smart contracts as legally binding agreements is uncertain. As any first year contract administrator will know, something that simply executes the terms of a contract does not meet the legal requirements of a contact (i.e. offer, consideration, acceptance).
A better definition for the term, and the one we will use in this article, is that a smart contract is a contract which includes “promises, specified in digital form, including protocols within which the parties perform on these promises". This quoted phrase first originated in the mid 1990’s by Nick Szabo, a computer scientist and legal scholar. Viewed in this way, a smart contract is a contract which contains certain ‘smart’ contractual clauses. These smart clauses are embedded in hardware and software in such a way that the clauses can ‘self execute’.
In this sense, a smart contract has all the hallmarks of a standard legally enforceable agreement, but some of the contractual provisions are backed-up by computer code. Importantly, this code operates in such a way as to give effect to those contractual provisions without the contracting parties having to take any other steps. For example, smart contractual clauses operate so that on the occurrence of a particular event, such as goods being delivered to site, certain contractual provisions take effect. For instance, legal title to goods transferring to a purchaser, or a payment being made to one contracting party.
The process of implementing smart contracts
As will be seen, a very large part of smart contracting requires digital and physical assets to be structured in such a way as to make the contracts ‘alive’ and responsive to events as they happen. This reconfiguration of digital and physical assets will happen, but will require substantial investment for all involved.
The following provides a (very) brief overview of the elements involved in implementing smart contracting.
Drafting the smart contract: The easy part, at least the conceptually easiest step, is drafting the smart contract. This first involves identifying contractual provisions that can be sensibly translated into computer code.
Secondly, the contractual language of these provisions must be translated into a script that can be understood computationally (i.e. if this happens, then that happens). Finally, these contractual clauses, in the form of computer code, are uploaded so that they can interface with the world.
Linking code to the real world: The smart contractual coding then interfaces with other digital infrastructure. An example might be the code interfacing with a sensor which is attached to a piece of equipment and the sensor is connected to the internet (i.e. the internet of things). The data from the code and the sensor interact and, if certain pre-requisites are met, the combined information is sent to a ‘blockchain’ for validation. The information might be, for example, that equipment to be delivered under a contract is recorded as having arrived at site.
Blockchain: As the smart contract clauses are, effectively, a piece of software, that software needs somewhere to operate. This is provided by blockchains which provide the backbone of the digital infrastructure needed to run smart contracts. For present purposes we will describe a blockchain as a simply collaborative way of recording data.
Central to the concept of a blockchain is that this data, which maintains a record of transactions, is held on decentralised ledgers which are maintained by all the blockchain users. A disparate group of users on a blockchain is essential to the integrity and independence of a blockchain. A blockchain which had only two users – say, the employer and contractor, for example – would fail to achieve the central premise of a blockchain, which is to validate the authenticity of data in circumstances where the parties who are reliant on the data do not (and need not) trust one another.
A transaction occurs on a blockchain when a package of data is split into a time-stamped, encrypted ‘block’ and this block is distributed to all users on the blockchain who are responsible for validating the authenticity of the block. When the block is validated by the users (or in blockchain terminology, they reach ‘consensus’), it is added to the chain of earlier blocks, thus making the blockchain an immutable record of all previous transactions.
In our example above, the ‘package of information’ that is transmitted to the blockchain contains the contractual term regarding delivery of equipment to site and the record of actual physical delivery of that material to site. The information is then validated and, on confirmation, the corresponding contractual event that is linked to the validation occurs (for instance, payment is made to the contractor).
Case examples of use of smart contracts in the construction industry
In addition to a smart clause automatically triggering payment on delivery of materials mentioned above, another obvious example of a potential smart clause in a construction contract is in relation to contractual communications. In the smart contracting world we can imagine that notices are issued during a morning site walk by a project manager with her tablet.
However, smart contract clauses need not be limited to procedural matters. An EPC contract for the construction of a power station will typically include different liquidated damages regimes, both for delay to completion and also for meeting specified performance criteria.
With a smart EPC contract, we can imagine that delay liquidated damages might be linked to the need for the power station to distribute electricity into a grid by a set date. If a sensor placed on the grid does not record electricity distribution by the required date, liquidated damages could be automatically levied by deducting funds from the contractor’s bank account. Similarly, conducting performance tests for the power station, which may be relevant to the achievement of performance guarantees and avoiding performance liquidated damages, might be determined based on a digital record of things that actually occur at the power station, such as the quantity of feedstock used to generate electricity, the level of noise and air pollution produced by the station and the amount of power fed into the grid. Whether contracting parties would agree to hand over control of these often contentious matters to automatic procedures is, however, another question.
In each instance, smart contractual coding interacts with digital infrastructure that records events in the real world. This information is then validated on a blockchain which then automatically trigger (“enforce") the operation of certain contractual rights (payment, transfer of title, etc).
Turning standard contractual provisions into smart contractual provisions will serve to automate a large part of parties’ contractual relationships and will have many benefits. However, the effort required to turn all contracts into smart contracts should not be underestimated.
The potential benefits of smart contracts suggest it is inevitable that smart contracts will be widely adopted, though it is likely that transaction-based industries such as finance and commodities will see more immediate acceptance and use than the construction industry. While smart contracts will be implemented in time, there are many steps between having a written contract and having a smart contract that serve the needs of those in the construction industry.