If you have not heard the term “smart contract” before, go ahead and add it to your list of technology buzzwords. In a similar vein to the technologies discussed in our recent blog on cryptocurrency, this is an emerging technology that is a sort of self-executing contract poised to increase overall project efficiency by cutting out the “middle man” (i.e., humans) upon completion of certain conditions. Before getting into more detail, perhaps the most important question is why should you care about smart contracts?

Construction is an ever-changing, competitive industry whose players are constantly evolving to increase productivity, efficiency, and, ultimately, their bottom-lines. Companies quick to adapt certain technologies such as Building Information Modeling (BIM) or various project management programs to increase efficiency of the document exchange process enjoy certain, distinct advantages.  As is no surprise to anyone, keeping your business competitive inherently requires that you keep abreast of emerging technologies, particularly those that may become so directly applicable such as the smart contract. For example, imagine a world where a project’s pay application process is self-executed in minutes via the smart contract versus days (or weeks) via the current methodology. What is a smart contract? How are smart contracts applicable to the construction industry? What are some of the hurdles in smart contracts becoming more mainstream? This article aims to provide a primer on the above.

1.    How is a smart contract different from a “normal” contract?

Rooted in the construction industry is the “normal” contracting process by which the parties typically use some sort of standard form contract that fits their particular project, negotiate the terms based on their needs and apportion risk, agree to such terms, and begin the project with key personnel responsible to ensure the contract is executed in accordance with the terms. The smart contract aims to tackle the inherent flaws and lack of efficiency in the final part of that process, the root of many disputes among the parties, by removing the human element. How?

Smart contracts are electronic agreements whereby the terms and conditions, or portions thereof, are coded and “self-execute” pursuant to an algorithm that is recorded on a decentralized ledger (the blockchain) once the transaction is executed. A smart contract can be analogized to an “if/then” function. The if/then concept is obviously nothing new, but current technologies, specifically the blockchain ledger, are making the automation of such process more viable, reliable, and safe.

2.    The benefits: how might smart contracts be used on a project?

By way of a simple example, consider an agreement between Subcontractor and General Contractor, whereby General Contractor agrees to pay Subcontractor upon delivery of certain materials. If a smart contract component was added to their agreement, upon approved delivery to the jobsite, an automatic transfer of funds from General Contractor to Subcontractor would occur and be recorded, decreasing the administrative burden plaguing many projects. It is easy to envision different facets that could utilize such automation: Automatic deliveries upon depletion of certain jobsite materials or approval of certain submittals and automatic payment upon approval of a pay application or substantial completion. If the smart contract is so great, why hasn’t the smart contract become more prevalent in most projects?

3.    The pitfalls: what are some issues in utilizing Smart Contracts?

As with all new technologies, there are a number of practical hurdles and legal issues to overcome before smart contracts become more commonplace.

“Off-chain” inputs.
The “self-executing” code still requires certain outside inputs to complete and can only execute objective contract terms. Someone has to confirm the delivery is correct and “push” the data to the smart contract, which somewhat conflicts with the automated nature of the contract and adds back in the “human element.” Additionally, who would be responsible for such a confirmation? The parties would likely need to hire an additional third party to act as a sort of intermediary, thus, increasing administrative costs. Further, what timeline would that party need to make such input to trigger the transaction? These off-chain inputs somewhat undercut a few of the purported benefits of the smart contract and increase what will need to be negotiated on the front end.

Liability for errors.
An interesting and confusing legal ramification of a smart contract is who will be liable for errors. In many cases, especially for the foreseeable future, the primary parties to the contract will likely not have the technical prowess to create such a contract and will require a third party to create such a contract. If there is a coding error, how will the parties allocate responsibility for such an error. Will traditional contract remedies be sufficient for damages incurred resulting from such errors? As smart contracts become more commonplace, we are likely to see additional provisions added to your standard form contracts addressing such issues.

Amending a smart contract.
Maybe the largest hurdle to the construction industry’s routine use of smart contracts is that they do not reflect the realities of the business at this time, specifically, how contracting parties act. For better or worse, in a traditional contract, if the parties wish to change their agreement, they quickly draft an amendment or simply change what they are doing. Smart contracts do not currently offer such flexibility. Amending a smart contract would potentially require re-engaging with a third-party coder and modifying a smart contract recorded on the blockchain is far more complicated than modifying traditional software due its decentralized nature.

Despite the logistic and legal hurdles facing smart contracts, we can expect them to become more commonplace as the technology develops and parties become more comfortable with the automated technology. As you look to the future for your business, our attorneys in Dallas and Austin are available to answer any questions you may have and to help you and your company best prepare for what’s ahead.  Please contact us at info@gstexlaw.com.

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