Why Smart Contracts Will Need 'Smart Term Sheets' to Match

In the era of smart contracts, lawyers will still have plenty of work ensuring that the devs get the code right, legal experts argue.

AccessTimeIconDec 9, 2016 at 2:36 p.m. UTC
Updated Mar 6, 2023 at 3:09 p.m. UTC

Ted Mlynar and Ira Schaefer are partners in the Intellectual Property practice at Hogan Lovells in New York City. They advise on patent and other intellectual property issues relating to blockchain and cryptocurrency technologies.

In this opinion piece, the authors argue that, in the era of smart contracts, lawyers will still have plenty of work ensuring the devs get the code right.

In a new world of smart contracts, many expect that formal written contracts, and the lawyers that draft them, will be obsolete.

It is presumed that the agreed-upon term sheet will be simply given to a software developer to convert into smart contract computer code.That code will be the final agreement.

But what does a software developer know about drafting code to implement a traditional term sheet? The negotiating parties know their deal, and the lawyers know the applicable law and the customary terms, but the software developer does not. A traditional term sheet is not enough.

A “smart term sheet” is needed to bridge the information gap between the agreed-upon business terms and the smart contract coding process. It can: specify the practical details necessary for implementing the agreed-upon terms, identify and address the terms that cannot be implemented in a smart contract, and add the “boilerplate” legal terms.

In short, the practical and legal hurdles to implementing a term sheet can be overcome.

A not-so-hypothetical example

As an example of the utility of a smart term sheet, let’s consider a hypothetical earthquake insurance policy for New York City (NYC).

In a typical ethereum blockchain implementation, each smart contract insurance policy will be associated with a particular blockchain address. Inputs to, and outputs from, the smart contract insurance policy take the form of messages sent to and from that blockchain address.

Computer nodes of the blockchain network will execute the smart contract computer code based on the messages received at the smart contract blockchain address.

Because the smart contract code stored on the blockchain is generally immutable and the blockchain runs on a distributed computing network, the contracting parties can be more confident that the agreed-upon terms will be timely performed even if NYC is significantly damaged by an earthquake.

A traditional simplified term sheet for NYC earthquake insurance might look like this:

  1. Parties: Earthquake Insurance Co (the “Insurer”) and Unshakable Corp (the “Insured”)
  2. Covered Zone: New York City
  3. Coverage: Insured receives $50m if an earthquake occurs within Covered Zone.
  4. Premium: $500k for 12 months of coverage
  5. Renewal Option: Policy is renewable for 12 months upon payment of Premium within three days of expiration date
  6. Minimum Solvency: Insurer will maintain liquid assets equal to at least 30% of Insurer’s Covered Zone exposure
  7. Additional: Customary terms and conditions

If this traditional term sheet were simply given to a software developer to code, it is left to the software developer to determine which terms will be included in the smart contract, which oracles will be consulted, and which customary legal terms will be implemented.

Unfortunately, the software developer cannot know what to do if the term sheet isn’t “smart” too.

Translating concepts into code

Lawyers familiar with coding can convert a traditional term sheet into a smart version that includes the practical and legal details required to implement a smart contract. Those important issues shouldn't be left to the software developer’s discretion, or worse, ignored altogether.

A smart term sheet can identify which contract terms will be implemented as a smart contract and which, if any, will not.

It can expressly identify the oracles and other smart contract inputs the contract will rely upon so the developer can link to those inputs directly. Key algorithms for performing the parties' intentions can be specified. Legal issues can be identified and addressed.

Drawing upon the necessary resources, the sample earthquake insurance term sheet can readily be converted into a “smart term sheet” ready for coding:

1. Parties: Earthquake Insurance Co. (the “Insurer”) and Unshakable Corp. (the “Insured”)

2. Covered Zone: Five boroughs of New York City (Oracle 1)

3. Coverage: Insured receives US$5m in bitcoin (BTC) if the United States Geological Service issues a public announcement that the epicenter of an earthquake was detected within Covered Zone

3.1 Trigger on magnitude 5.0 or greater earthquake according to USGS Earthquake Notification Service (or Atom Syndication data) (Oracle 2)

3.2 Currency exchange rate determined by live CoinDesk Bitcoin Price Index at time Premium paid (Oracle 3)

3.3 Determine location of earthquake epicenter relative to Covered Zone with Google Maps Geocoding API (Oracle 4)

3.4 Payout to Insured’s wallet at [wallet address] 

4. Premium: US$50k in bitcoin (BTC) for 12 months of coverage

4.1. Currency exchange rate determined by live CoinDesk Bitcoin Price Index at time Premium paid (Oracle 3)

4.2. Payment to Insurer’s wallet at [wallet address]

5. Renewal Option: Insured can renew policy for a second 12-month period upon payment of second Premium no later than 72 hours after expiration of first 12-month period

6. Minimum Solvency: Insurer will maintain liquid assets equal to at least 30% of Insurer’s maximum exposure in the Covered Zone during preceding 30 day period

6.1. Insurer’s liquid asset balance available at [wallet address]

6.2. Insurer’s daily exposure in Covered Zone available at [wallet address]

6.3. Insurer refunds Premium if liquid asset balance falls below 30% of maximum daily exposure during prior 30 days

7. Additional: Customary terms and conditions

7.1. 168-Hour Occurrence: Earthquakes and shocks occurring within any 168-hour (1 week) period shall be considered a single earthquake

7.2. Payout Capped: A maximum of two (2) payouts will be made per policy

7.3. Assignment: The Insurer cannot assign this contract, the Insured can

7.4. Choice of Law: NY law applies

7.5. Arbitration: All disputes relating to subject matter of contract will be submitted to binding arbitration in NYC

Be smart, be prepared

The smart term sheet provides a much needed interface between the contracting parties and the software developer. It specifies a whole host of details not included in the traditional term sheet that are, nonetheless, essential for a practical, enforceable contract.

By creating a smart term sheet, the parties can integrate needed practical and legal considerations and the advice of counsel into the instructions given to the software developer. With less left to the discretion of the software developer, there is much less room for error.

Although some predict a seismic shift toward smart contracts, the real-life practicalities and legal implications of complex contracts do not simply disappear on the blockchain.

We expect the smart term sheet will be a useful tool for contracting parties, lawyers, and software developers to use to comprehensively address those issues.

image via Shutterstock

Disclaimer: The views expressed in this article are those of the authors and do not necessarily represent the views of, and should not be attributed to, their firm, its clients, or any respective affiliates. This article is for general information purposes only. It is not intended to be, and should not be taken as, legal advice.


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